REGULATIONS
Corporate Governance: Close, But Not There Yet
October 9, 2006
Christopher Bjorke, AFP

"If you were to take one issue as the biggest problem for corporate governance in China, I think financial disclosure is one. I think a close second related to this is delivery, not only the quality of information that is delivered to investors, but the timing." ARTICLE TOOLS Print Version Reprints RECENT ARTICLES Different cities, same customers China is the region's top stop for exporting Improving wire transfers Quantifying your banks' performance

China’s government and businesses are still adjusting to demands of openness and accountability in publicly listed corporations. In many cases, the country’s practices have yet to catch up with its laws, which tend to be sound as written but poorly enforced or obeyed.

The Organization for Economic Development and Cooperation (OECD) has stated that China has improved public and private governance, but “laws and regulations are often applied in an unsystematic manner and can be skewed by special interests.”

Michael Burke, an associate in international practice at the law firm of Williams Mullen in Washington, D.C., has watched the evolution of corporate governance in China as a lawyer, visiting fellow with the Asian Institute of International Financial Law at Hong Kong University and as co-chair of the China Committee in the American Bar Association’s Section of International Law.

According to Burke, while Chinese authorities have made progress, investors in publicly traded companies still are put at risk by weak application of laws, a lack of timely information about corporate finances and little recourse for wronged shareholders.

What is the general state of governance of publicly traded companies in China?

The general state of corporate governance is uneven. It’s improving, but the Chinese have a long way to go to really get the majority of their domestic companies to what you would consider international standards of corporate governance.

One big issue, at least for publicly traded companies, is that the share structure of publicly traded companies is such that the securities markets in China don’t really exercise much of a disciplinary function over companies and corporate governance.

For example, in the States you have a lot of institutional investors. The California State Employees Retirement Fund is one of the largest institutional investors in the country, and in the past they have been able to influence companies and businesses on corporate governance issues through the purchase or sale of stock, and that really doesn’t exist in China yet.

There have been improvements.  They’ve amended the company law and they’ve amended the securities law, each within the past year, and the amendments do a lot of things, all of which are aimed at improving investor oversight over the companies in which they invest. Part of that deals with improving the timing and quality of informational disclosures made to investors. Part of that also is to change the state of play in securities litigation to allow investors to seek redress for corporate governance violations in Chinese courts. There are improvements, but there’s a lot that can and probably should be done in China.

Is there recognition of the importance of sound corporate oversight?

The government, I think, understands. Some of the regulators on the China Securities Regulatory Commission (CSRC) understand the necessity of having adequate corporate governance structures.

I think that part of the issue is making sure that Chinese domestic companies understand the value of having strong corporate governance or having a mechanism in place, whether it’s through the market or through the regulator, to really more effectively discipline corporate governance problems as they arise.

How safe are investors?

It very much depends on the company. There have been some instances even in the past year where investors have lost everything because a company was built on a sham. That does happen. It happens in other jurisdictions as well. It really does depend on the company.

If you’re going to invest in a Chinese company, you’re going to need to do a lot of due diligence. For example, you can go to Hoovers.com, or you can go to Dun & Bradstreet, and you can really pull up the guts of a U.S. company and really get a sense of who’s who and what the operational history is. Outside of asking the company directly that information, there are avenues to obtain that information. In China, Dun & Bradstreet, I think just recently started operation, so there’s not a real avenue to independently verify a company in China, so you’re dependent either on the state or a state regulator or the company itself.

The Chinese government retains a large stake in many companies. What ensures that decisions are made in the best interest of the company rather than the best interest of the state?

The IFC, the International Finance Corporation, did a study a couple of years ago that seemed to indicate that, on average, the state will retain about 51% or 52% or more of a company’s shares, which means by definition they’re the majority share holder. There’s a tension between operating a company for the benefit of the state versus operating a company for the benefit of its investors, and that’s a lesson that’s still being learned in China, that the state is not a great investor, in the sense that its goals for companies are not always the same as what the market might suggest the goals for the company should be.

What standard of transparency are Chinese companies held to?

That’s a real problem. If you were to take one issue as the biggest problem for corporate governance in China, I think financial disclosure is one. I think a close second related to this is delivery, not only the quality of information that is delivered to investors, but the timing.

Part of the issue of financial disclosure in China is that for years there were multiple accounting standards that were used. Some companies would use GAAP. Some companies would IAS. Some companies would use domestic Chinese standards. So for a long time there was no consistency in how companies approached doing their books.

Part of that issue, too, is that companies themselves are not great record keepers. The old saying was that Chinese companies would keep two or three sets of books. You had the true set of books. You had the set of books that you would show a potential foreign investor that showed everything is great. And then you had the set of books that the Chinese company showed the tax authorities that said we’re not making any money, so we don’t have to pay any taxes. That does exist on a much smaller scale than it did in the past, but there are still pockets of that.

The other issue when you’re dealing with financial disclosure is that there are not a lot of internationally trained domestic Chinese accountants. The big accounting firms, KPMG, Deloitte, they’re all over in China and they do great work for what they do, but for certain things Chinese law specifies that the financial reports have to be vetted by a domestic Chinese firm.

What are the potential problems of related party activity, especially concerning state-owned companies and state-owed shares of companies?

The Chinese have issued, I think in 2001, a code of corporate governance for listed companies. One thing they do try to regulate better is related party activity, and what they try to get is full disclosure of the terms of their related party transaction and approval of disinterested directors. So the framework is there to regulate this, but there still are problems. One area where we’ve seen some issues recently is what they call asset stripping.

What was happening was managers of state-owned enterprises would contribute the assets of a state-owned enterprise, at least the title of the assets, to an off-shore, usually a British Virgin Islands special purpose vehicle and they would then go out and try to attract venture capital or private equity or even list that special purpose vehicle on a foreign stock exchange.

There wasn’t always a full overlap, if you will, between the ownership interests of the state enterprise and the ownership interests in the special-purpose vehicle. So, there was more than one case where investors in the state-owned enterprise were really left with just the shell of the state-owned enterprise after these off-shore transactions took place.

What the Chinese government over the past two years has been doing is really looking hard at how these special purpose vehicles are used and really trying to better protect investors—the innocent investor or passive investor—and provide better protection for them, to keep the asset stripping from really adversely protecting their investment. That’s a big problem.

To what extent are corporate boards involved in governance, and how do they differ from those in other countries?

As a Chinese domestic company grows gets to the point that they are potentially looking to list on the Chinese stock exchange, you do see a lot of these boards becoming more active. As for independent directors, they say that a majority now should be independent. A lot of companies are getting there, not all of them are, and there’s not a real significant disciplinary function on companies, and certainly if they don’t have a majority of independent directors. There is on paper a lot that the CSRC (Chinese Securities Regulatory Commission) or stock exchange or someone else could do, but not a lot that happens from time to time.

In a lot of Chinese companies you have a kind of dual board structure similar to what you would find in Germany or in other European nations. You’ve got the board of directors, which is what we consider the board, at least in the States, and related to that you have a board of supervisors, which is made up labor and other kinds of interest groups within the company who are not necessarily shareholders within the company.

The Chinese were trying to get rid of that dual board function. It still exists in a lot of places. You’ve got people, such as organized labor representatives, who are not shareholders necessarily—a lot of them are shareholders, but they’re on a supervisory board because they have an interest in the company’s operations apart from being shareholders. So, there’s a little bit of tension there.

Do Chinese corporations use “golden shares,” giving majority privileges to minority shareholders?

They don’t use golden shares per se. There are a restricted number of shares that can be publicly traded or offered to non-state or non-legal person investors. That’s how they retain state ownership. In China, it’s generally about a third of a company’s equity that is publicly traded. The rest remains with state or legal-person shareholders: unions, pension funds, other state-owned enterprises, things like that.

The Chinese Securities Regulatory Commission is trying to increase liquidity. Liquidity in Chinese securities markets is a problem. One the things they’re doing to improve liquidity is to increase the float of Chinese listed companies, increase the number of shares or the percentage of shares of a company that is publicly listed.

What kind of legal recourse is there for investors who have been hurt by mismanaged companies?

The idea of class actions is still foreign in China. There’s been some recent regulation of what they call mass claims that seems to indicate that class actions as we know them aren’t really going to be feasible in China.

There are cases where the government has imposed penalties on companies. They’ve de-listed companies. They’ve fined companies for noncompliance with financial disclosure or other types of financial governance issues. There have been a few isolated cases where individual investors have recovered money against a company for securities fraud, but they’re isolated. It’s not a widespread phenomenon.

In the most recent revisions of securities law, China has proposed to set up an investor protector fund, where, when a company lists in China, a stated percentage of that listing would be in cash deposited into this investor fund that would provide some point of recourse for investors, which is a really unusual way of doing things, because you would think that the way, in the States at least, the recourse issue would be addressed would be by going after the companies or the managers of the companies that have committed corporate governance-related wrongdoing. Each company pays into that fund in some way or another even if that company has corporate governance practices and structures that are wholly above aboard.

Unfortunately, it looks like they’re penalizing companies with good corporate governance and rewarding companies with bad corporate governance by suggesting that investors as a first place of recourse may have to go to that investor fund and then go to the company.

I don’t think that’s how the regulators intended it. It just seems to be how it evolved.

Copyright © ChinaForum 2006