CHINA - China's emergence as an investment destination for foreign investors has coincided with a boom in the country's domestic equity markets, but with the ‘A' shares market now 40% off its peak level, questions are being raised about transparency of reporting and lack of protection for minority shareholders.

A new study by RiskMetrics entitled Corporate Governance in Greater China: What to Expect When Investing in China vs Hong Kong,  and being released tomorrow, reveals the shortcomings of China's investor protection and corporate governance and highlights the main challenges for institutions considering buying into Chinese companies.

While China has moved forward on governance reforms, the report's findings show these improvements have yet to be tested.

"Investors are probably going to be more focused on corporate governance in these choppy market conditions, and will be looking to actively manage corporate governance risk," said David Smith, analyst and author of the RiskMetrics Group report.

Capital market development in China has not been without scandal - the most notorious being that of the Guangxia ‘Yinguangxia' Industry Corporation - often referred to as ‘China's Enron'.

Following a meteoric rise in its share price, an investigation by the China Securities Regulatory Council (CSRC) found that Yinguangxia had falsified profits of RMB 745m (approximately €630,000) during the period 1999-2000.

It was also revealed the firm's auditor was partly responsible for these misrepresentations and the fallout of this caused the collapse of Zhongtianqin, at the time the largest auditing firm in China.

In recent years, China has made progress on investor protection, reforming its securities markets, mandating independent directors and making it easier to sue company directors, while bringing financial reporting substantially into line with International Financial Reporting Standards.

However, the RiskMetrics report concludes board structures in China often lead to confusion, ambiguity, and potentially serve to undermine the board of directors, and highlights the shortage of trained and experienced auditors and accountants in China.

The study also contrasts the corporate governance protections available to investors in Hong Kong and China as many mainland Chinese companies are majority-owned by the State, while the Hong Kong market is characterized by family-controlled entities.

"Until share ownership becomes more widely dispersed across the region, investors are unlikely to see progress toward a culture of genuine independent directorship," said Smith. "Investors should apply special scrutiny to related-party dealings in the absence of independent boards."

One area where regulations in mainland China deviate significantly from those in Hong Kong is in the realm of proxy voting.

While Hong Kong's British law and regulatory legacy have left the Companies Ordinance and various listing rules well-equipped for proxy voting, the Chinese regime has little by way of content to give shareholders rights to information related to proxy voting, and attendance at AGMs.

Smith continued: "In essence, we would counsel shareholders to manage risk when investing in both Hong Kong and China, but to be particularly wary when investing in China through the A Shares market."

Richard Newell is managing editor of Investment & Pensions Asia, sister publication to Investment & Pensions Europe.