CHINAs CORPORATE GOVERNANCE & sECURITY MARKETs

Copyright 2012 Nigel Lo www.Nigel-Lo.com

This essay will highlight the transformation of China since the Opening up Policy by focusing on 2 separate topics:
1. 2.

Improving corporate governance. Investor protection in Chinas security markets.

1.0 ACCEDING INTO THE WORLD TRADE ORGANIZATION (WTO) China acceded into the WTO in November 2001. This was widely viewed as a significant event in Chinas endeavour in pursuit of economic reform and opening up to the outside world. Many changes have occurred in China since that time, bringing in many opportunities as well as challenges for Chinese enterprises. Consequently, Chinese enterprises are now required to be responsive and adaptable in the face of this dramatic transition; this is because time is of the essence and they have to enhance competitiveness to catch up with global western standards. This task is even more urgent for Chinas 1200 or so listed corporations, as they are the pillars of Chinas market. They will take the lead in its transformation. Therefore, fresh tactics have been developed in Chinas continuing efforts to improve its corporate governance practices; in this context, 2002 was named as the Year of Corporate Governance of Listed Corporations in China.1 2.0 CORPORATE GOVERNANCE IN CHINA 2.1 INTRODUCTION Corporate governance has to do with how organizations are run. Organizations with proper corporate governance have accountability and transparency. People in authority at those organizations know that their actions will be seen and judged by others. Therefore, those leaders are more likely to act in ways that benefit the organizations stakeholders. They are also less inclined to act in ways that benefit themselves personally at the expense of the organization.2 In terms of legislation and regulation, Chinas corporate governance regime is now as comprehensive as that of developed Western nations. Yet it has failed to result in noticeable improvements in the performance of Chinese corporate managers. In this article, we argue first, that the continuing failures of corporate governance in China are partly due to Western-style reforms being inappropriate in the current Chinese corporate context. Second, even the effectiveness of such reforms in their countries of origin, such as the United States, is highly doubtful. In some cases, such as creating incentives to align the interests of management with shareholders, the reforms have been counterproductive. In other cases, such as the system of establishing independent directors and auditors, reforms have not stopped the abuses that they were designed to address. To transpose these dubious reform methods to China and expect them mysteriously to succeed in the Chinese legal environment is like flogging a dead horse. Instead of tinkering further with imported corporate governance rules, we propose some innovative and culturally specific measures that the Chinese Government, media and business leaders
1 S Shen Chinas new corporate governance measures after its accession into the WTO(2004) 17 Aust Jnl of Corp Law 6 2 E Jackson, Why Corporate Governance is So Important to China. (2011) Forbes: http://www.forbes.com/sites/ericjackson/2011/07/06/why-corporate-governance-is-so-important-to-china/

can take to foster greater public awareness of the importance of good corporate governance and to begin to create a culture of compliance among Chinese corporations. 3 2.2 INEFFECTIVENESS OF CORPORATE GOVERNANCE REFORMS IN CHINA In this sub section, we will focus on three major areas of corporate governance reform: (a) The introduction of independent directors and, in Chinas case, foreign directors, onto corporate boards and committees; (b) The use of incentives to align the interests of management with shareholders; and (c) Tightening up accounting and auditing standards. These three areas have been central to reform programs in many different countries but their effectiveness has yet to be proven. Indeed, many of the corporate collapses and scandals in the United States over the past five years occurred despite what appeared at the time to be adherence to the letter of the law in corporate governance by the offending corporations.4 There are several flaws with this attempt to rely on foreign investors and directors as we have seen, even local Chinese independent directors find it difficult to monitor and influence corporate management due to their minority position on the board and information imbalances. How much more difficult it will be for foreign directors who may not even be based in China and may face major linguistic and cultural hurdles to understanding the information they are given to find out what is really happening within the corporation and the true value and purposes of the corporations transactions. Another policy proposal that commentators on Chinese corporate law frequently raise in relation to improving board performance is to provide greater financial incentives for directors and managers to increase returns to shareholders. As shares and stock options are rarely granted to directors and executives of listed Chinese corporations under the current system, it is obviously not in their self interest to distribute generous dividends. Instead, they tend to siphon off company funds through related party and other insider transactions, to the detriment of shareholders.5 In China, various regulations have been introduced since 2000 to tighten up accounting standards for Chinese business enterprises, especially listed corporations, and to increase disclosure requirements. Nevertheless, as with the other corporate governance reforms discussed above, it is highly questionable whether raising accounting and auditing standards to international levels will result in improved management practices among listed Chinese corporations and a corresponding reduction in financial fraud by corporate executives. This is because no matter how comprehensive the disclosure and auditing system appears, it can readily be manipulated by dishonest managers.6 Further evidence has emerged that international audit firms have failed to report egregious accounting irregularities at a number of Chinese corporations in some cases the auditors appear to have been
3 C Hawes and T Chiu, Flogging a dead horse? Why Western-style corporate governance reform will fail in China and what should be done instead (2006) 20 Aust Jnl of Corp Law 25 4 J C Bogle, The Battle for the Soul of Capitalism, Yale University Press, New Haven, 2005, pp 412. 5 Q Liu, Corporate Governance in China: Current Practices, Economic Effects, and Institutional Determinants, (2005) draft paper prepared for CESifo Economic Studies conference on understanding the Chinese economy, available at <http://www.econ.hku.hk/~qliu/wp/> 6 HIH Royal Commission, The Failure of HIH Insurance, Commonwealth of Australia, Canberra, ( 2003), Chs 2021.

actively involved in fraudulent schemes in collusion with the corporations that hired them. One high profile example was the arrest in 2004 of the CEO and five other executives of Kelon, one of Chinas largest manufacturers of refrigerators and air conditioners, for economic crimes. Deloitte Touche, which acted as Kelons auditor until the scandal broke, is currently under investigation due to its failure to report serious accounting irregularities relating to the valuation of the companys assets.7 2.3 IMPLEMENTATION OF CORPORATE GOVERNANCE FROM THE WEST TO CHINA Television contests, national examinations and Internet feedback sites may seem unorthodox and indirect methods when compared with the typical package of corporate governance reforms proposed by external consultants, but all of them are variants of techniques that have proven effective in other areas of Chinese legal reform. They steer clear of the assumption that Western-made solutions will be appropriate in China at its present stage of development. Instead, they aim at two of the foundations of the corporate governance problem: lack of knowledge and persistent ethical shortcomings within the Chinese business world. Such methods will help to spread understanding of corporate governance principles throughout the business community in China and will raise public awareness of the importance of business ethics in resolving the performance problems of Chinas business corporations. This, in turn, will make it more likely that the impressive canon of Western-style corporate governance legislation introduced over the past decade will actually be implemented and followed by the majority of Chinese corporate managers in the long run.8 3.0 SECURITY MARKETS Security Markets are economic institutes within which take place sale and purchase transactions of securities between subjects of economy on the base of demand and supply. It can be said that a security market is a system of interconnection between all participants (professional and nonprofessional) that provides effective conditions: to buy and sell securities, To attract new capital by means of issuance new security (securitization of debt), To transfer real asset into financial asset, To invest money for short or long term periods with the aim of deriving profit. 3.1 HISTORY OF SECURITY MARKETS IN CHINA The PRC securities markets emerged in relatively recent times and its current securities markets only arose in the early 1990s. The history of corporate securities in China can be traced back to 1869 when the Changli Company traded in the shares of foreign companies. Foreign business people set up the first stock exchange in China in 1904. The first Chinese securities dealers organisation was the Shanghai Shares Business Association which was established by Shanghaiese business people with the approval of the then North Ocean Government in 1914. In the same year, the North Ocean Government enacted the Stock Exchange Law which was the first national securities law in China. In 1919, the first Chinese stock exchange was established. Subsequently, other stock exchanges were also set up. The Nationalist Government (which succeeded the North Ocean Government) enacted its Stock Exchange Law in 1929. This was more comprehensive than that enacted by the North Ocean Government and was later inherited by Taiwan and provided the foundation for the current Taiwanese securities legislation. At the beginning of 1949 the Chinese Communist Party established its first stock exchange in Tianjin and then another one in Beijing in early 1950. With the so-called socialist reform movement the PRC government adopted a USSR type of planned economy and stopped the issue and trading of shares and other securities. The stock exchanges were converted into state-owned
7 J Fan, Ministry of Finance raises an accounting storm: PricewaterhouseCoopers involvement signals the end of the Big Four [auditing firms] myth (in Chinese), Xinjing bao, (2005) <http://www.jscj.net/ jscj/53/20050812084128.php>. 8 Ibid ^ (2006) 20 Aust Jnl of Corp Law 25

companies in the late 1950s. With the adoption of the open-door policy and the economic reform in the late 1970s, the issue of debentures and shares gradually became a means of capital-raising. After a number of experimental issues of shares in some major cities, the Shanghai Stock and the Shenzhen Stock Exchanges were formally established in 1990 and 1991 respectively.9

3.2 GROUP AFFILIATIONS In Chinas securities market there are also similar kinds of group affiliations in which both listed and unlisted corporations are controlled by ultimate owners which directly or indirectly hold shares in more than one listed corporation and exert their influence on business decisions.10 Group-affiliated firms are characterised by more complex ownership structures than those in independent firms. In particular, the deviations of voting from cash flow rights through stock pyramids and cross shareholdings will often be used to allow a controlling shareholder behind the group or intermediate firms to gain effective control of a firm with low cash flow rights. Bertrand, Mehta and Mullainathan argue that the controlling shareholder will want to transfer, or tunnel, profits across firms, moving them from firms where it has low cash flow rights to firms where it has high cash flow rights.11 Evidence of the separation of cash flow rights and voting rights and internal capital markets in group affiliations in Chinese listed corporations will thrive from further research of agency problems that stem from the controlling shareholder (the largest ultimate owner) exceeding the ownership stake. Available evidence has implications for corporate governance of such affiliated groups. It is possible for the ultimate controlling owners to transfer business resources between the member firms affiliated with the group at the expense of minority shareholders interests. 12 This is due to an undeveloped external capital market, weak corporate law and limited disclosure. Claessens et als empirical study found evidence that firms in business groups organised as pyramids, especially those in which the divergence between votes and cash flow is the greatest, have lower Tobins Q.13 Tobins Q ratio is defined as the ratio of the market value of the firms assets to their replacement costs. The market value of assets is defined as the sum of the market value common stock and book value of debt and preferred stock. The book value of assets comes from the balance sheet.14 Business group affiliation of the listed corporations occurs where a collection of non-listed and listed firms are linked together by equity interlocks. Furthermore, every group affiliation features the holding share stake of at least two listed corporations and the control of at least one listed corporation. A firm being controlled by a business group depends on whether the largest percentage of its equity is held by the other firms in the group, including the ultimate owner. Affiliated firms are nominally
9 H Zhang, Improvement of the Chinese Securities Legal System and its Theoretical Development (2000) 2 Civil and Commercial Law Rev 154221 10 M Zhong and C Lin The ownership structure and internal capital market in Chinese business group affiliations of listed corporations (2004) 17 Aust Jnl of Corp Law 33 11 M Bertrand, P Mehta and S Mullainathan, Ferreting out Tunneling: An Application to Indian Business Groups (2002) 117 Quarterly Jnl of Economics 12148. 12 Ibid ^ (2004) 17 Aust Jnl of Corp Law 33 13 S Claessens, S Djankov, J Fan and L Lang, Disentangling the Incentive and Entrenchment Effects of Large Shareholdings (2002) 57 Jnl of Finance 274171 14 J Tobin and W.C. Brainard, , Economic Progress, Private Values and Public Policy (1977)

independent legal persons. If the business group controls a firm, the firm has to be a group member. If a firm has two large shareholders, one of which is a group member and the other who is not, it will not be regarded as a group member. Ultimate owners prefer to be controlling shareholders of listed corporations through an intermediary holding company. In China, it is not easy to establish group affiliations in listed corporations as there is limited corporate information disclosure. There appears to be 35 business groups affiliated with about 200 listed corporations7 but the exact affiliation and details of the ownership structure are difficult to establish.15 3.3 DISCLOSURE PRACTICES Efforts to impose Western securities market models on China have been difficult. This is obvious from the adoption of information disclosure practices. While the integrity of disclosure practices is a fundamental element in maintaining investors confidence in securities markets, disclosure practices need to be attuned to Chinas systemic features, especially in regard to its legal structure and rules. Market failures, such as the collapse of Enron in the United States, have led to a realisation that US disclosure models have their own difficulties and that these should not be uncritically used.16 An argument presented by Lucian Bebchuk and Mark Roe: that although economies and business practices have converged in many countries since World War II, corporate structures in different countries around the world has remained different.17 According to Bebchuk and Roes theory of path dependence, earlier corporate structures have a direct effect on subsequent corporate structures and have a heavy influence on prevailing corporate rules. The theory of path dependence is extremely important for countries with transitional economies, such as the Peoples Republic of China (PRC). The theory of path dependence applies to the PRC and suggests that while trying to adopt foreign corporate disclosure rules, the PRC should realise that its own corporate disclosure regime should be based on its own corporate structures which are significantly different to those within advanced economies, such as the United States.18 Chinas corporate disclosure regulatory regime has mainly drawn upon US models. This was not only because the dominant rule makers in the PRC thought that the US market was a mature one, with a mature regulatory regime, but also because of the wider trend in the 1990s of adopting the US model by Germany and the United Kingdom. To conclude in regard to disclosure practices, The China Securities Regulatory Commission (CSRC) should be granted more powers to investigate and conduct court proceedings against companies and their directors who have breached disclosure regulations. In the absence of such a power, it is hard to enforce disclosure rules if this role is only vested with the judiciary. The current poor enforcement of disclosure rules has placed the improvement of corporate governance in the PRC in jeopardy. It is clear that, despite their detail, Chinas corporate disclosure rules have yet to fully accommodate to the particular problems that have proved to be so intractable in the PRC securities market. Until this occurs, the effectiveness of these laws and regulations will remain a matter of considerable concern for those concerned with corporate governance in China.19
15 Ibid ^ (2004) 17 Aust Jnl of Corp Law 33 16 J Fu Information disclosure and corporate governance in listed companies in China: From Yinguangxia to Enron. (2004) 17 Aust Jnl of Corp Law 48 17 LA Bebchuk and M J Roe, A theory of Path Dependence in Corporate Ownership and Governance (2000) 52 Stanford L Rev 18 Ibid 19 Ibid ^ (2004) 17 Aust Jnl of Corp Law 48

REFERENCES
S Shen Chinas new corporate governance measures after its accession into the WTO(2004) 17 Aust Jnl of Corp Law 6 E Jackson, Why Corporate Governance is So Important to China. (2011) Forbes: http://www.forbes.com/sites/ericjackson/2011/07/06/why-corporate-governance-is-so-important-to-china/ C Hawes and T Chiu, Flogging a dead horse? Why Western-style corporate governance reform will fail in China and what should be done instead (2006) 20 Aust Jnl of Corp Law 25 J C Bogle, The Battle for the Soul of Capitalism, Yale University Press, New Haven, 2005, pp 412. Q Liu, Corporate Governance in China: Current Practices, Economic Effects, and Institutional Determinants, (2005) draft paper prepared for CESifo Economic Studies conference on understanding the Chinese economy, available at http://www.econ.hku.hk/~qliu/wp/ HIH Royal Commission, The Failure of HIH Insurance, Commonwealth of Australia, Canberra, ( 2003), Chs 2021. J Fan, Ministry of Finance raises an accounting storm: PricewaterhouseCoopers involvement signals the end of the Big Four [auditing firms] myth (in Chinese), Xinjing bao, (2005) <http://www.jscj.net/ jscj/53/20050812084128.php>. H Zhang, Improvement of the Chinese Securities Legal System and its Theoretical Development (2000) 2 Civil and Commercial Law Rev 154221 M Zhong and C Lin The ownership structure and internal capital market in Chinese business group affiliations of listed corporations (2004) 17 Aust Jnl of Corp Law 33 M Bertrand, P Mehta and S Mullainathan, Ferreting out Tunneling: An Application to Indian Business Groups (2002) 117 Quarterly Jnl of Economics 12148. S Claessens, S Djankov, J Fan and L Lang, Disentangling the Incentive and Entrenchment Effects of Large Shareholdings (2002) 57 Jnl of Finance 274171 J Tobin and W.C. Brainard, , Economic Progress, Private Values and Public Policy (1977) J Fu Information disclosure and corporate governance in listed companies in China: From Yinguangxia to Enron. (2004) 17 Aust Jnl of Corp Law 48 LA Bebchuk and M J Roe, A theory of Path Dependence in Corporate Ownership and Governance (2000) 52 Stanford L Rev