Friend or foe? The impact of controlling shareholders’ share pledging on firms’ financial distress risk: A cash flow perspective

Controlling shareholders’ share pledging has been intertwined with the Chinese economy for three decades. Whether it is a friend or foe to firms’ sustainable development has yet to be systematically explored. Since financial distress risk is fatal to a firm’s sustainable development, this study examines the internal links between controlling shareholders’ share pledging and financial distress risk to understand the role of controlling shareholder pledging in a firm’s development. Our analysis reveals that the pledging of controlling shareholders' shares exacerbates the risk of financial distress. However, this effect decreases as the company's existing distress risk increases. By detecting the underlying mechanisms, we find that controlling shareholders intensify tunneling through operating, investing, and financing strategies after share pledging, by reducing firms’ operating and investing cash flows, and by increasing firms’ debt financing costs. In addition, we find that controlling shareholders re-channel pledged funds only when the company faces imminent financial distress. These findings reflect the trade-off between agency theory and stakeholder theory in the behavioral intentions of controlling shareholders, highlighting the essential role of regulating controlling shareholders’ actions in monitoring firms’ financial distress risk through better use of share pledging.

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