Signs of progress on governance

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The challenge with corporate governance (CG) reforms is that China started its reform efforts in an environment where most of the elements of a well-functioning financial market, such as a well-defined legal system, efficient regulatory agencies, rigorous law enforcement, etc, were not in place.

There is a perception that private entrepreneurs in China operate under ineffectual checks and balances and lack transparent financial reporting. For some this may be true. However, the majority of Chinese businessmen are seeking not just domestic leadership for their businesses, but are setting their sights higher. They seek to become influential multinational companies. The International Finance Corporation has noted that a growing number of Chinese managers and entrepreneurs show a willingness and a desire to improve their CG practices. They are becoming aware that a commitment to well-defined shareholder rights, higher levels of disclosure and an empowered board of directors makes a company more attractive to both investors and lenders and ultimately more profitable.

To gain a better understanding of CG issues in China, in August-September 2006 the Chartered Financial Analysts’ Centre for Financial Market Integrity conducted a study of CG practices in China. As part of the study, a survey of members investing in or having interests in Chinese companies was carried out to obtain members’ opinions and views on the following:

CG issues among Chinese companies;
effectiveness of recent reforms made by China to improve CG practices; and
suggestions on how to further improve CG practices in China.

A web-based survey was distributed to 3,780 CFA charterholders and CFA Institute members in Hong Kong and China. The analysis of the survey findings was based on the responses of 475 charterholders and members who completed the survey.

The respondents were presented with 16 CG-related issues, which were categorised under:

board composition, structure, and mechanisms;
relationship with stakeholders and shareholders; and
disclosure and transparency.

For each issue presented, respondents were required to rate on a scale of one to five how important each issue was to initial investment decision- making, and how each issue has changed over the past three years.

A key component of China’s CG reform is the privatisation of state-owned enterprises (SOEs). The restructuring of SOEs, which started in the 1980s, has seen more than 80% of the SOEs being transformed into corporate entities under the Company Law 11 to facilitate listing on the stock exchanges. More than 1,200 enterprises have raised funds through IPOs and sought subsequent listing on one of China’s two stock exchanges. The state, however, still holds a majority of the shares in the listed companies (estimated at 60%).

It has been observed that the SOEs in the process of becoming private enterprises faced a number of governance challenges. Many still carry on the practices of a state-dominated decision-making regime. They tend to have complex and opaque corporate ownership structures, overlapping bodies of corporate control, management teams with continuing links to the Chinese government, and reporting practices that are more often focused on meeting the needs of the major shareholder rather than the needs of investors.

Conversely, companies that seek a listing on the stock exchange are required to adopt good CG practices, such as the inclusion of independent directors on the board. It has been pointed out that the process of getting listed, particularly on the Hong Kong or other foreign stock exchange, has the potential to enhance the quality of CG in Chinese companies. As such, this initiative has been proclaimed as one of the more successful vehicles for China’s SOE reform.

he following discussion highlights some recent CG reforms undertaken by the Chinese government:

Conversion of non-tradable shares into freely tradable shares Coupled with another government regulation eliminating non-tradable shares in all future IPOs, many investors view this as a significant reform that will continue to shift the balance of share ownership from government ownership to public ownership by minority shareholders, especially among institutional investors. Coupled with another government regulation eliminating non-tradable shares in all future IPOs, many investors view this as a significant reform that will continue to shift the balance of share ownership from government ownership to public ownership by minority shareholders, especially among institutional investors.

Coupled with another government regulation eliminating non-tradable shares in all future IPOs, many investors view this as a significant reform that will continue to shift the balance of share ownership from government ownership to public ownership by minority shareholders, especially among institutional investors.

New accounting standards In February 2006, the Ministry of Finance released the Basic Accounting Standards for Business Enterprises (ASBE), consisting of 38 standards to be applied to all listed Chinese companies. The aim of this initiative is to facilitate further development of a market-like economy in China, raise the quality of financial information, and boost investor confidence.

The new ASBE standards are intended to bring Chinese accounting practices largely in line with the IFRS, although there are concerns that these new Chinese standards do not completely replicate the IFRS as intended.

The Ministry of Finance also released a new set of 48 auditing standards for certified public accountants, which will bring China’s auditing rules more closely in line with the International Standards on Auditing. The new accounting and auditing standards in China both took effect on 1 January 2007.

In February 2006, the Ministry of Finance released the Basic Accounting Standards for Business Enterprises (ASBE), consisting of 38 standards to be applied to all listed Chinese companies. The aim of this initiative is to facilitate further development of a market-like economy in China, raise the quality of financial information, and boost investor confidence.

Quarterly reporting This directive from China Securities Regulatory Commission (CSRC) focuses on the form and content of such reports and requires listed companies to deliver them within one month after the endof the first and third quarters. These quarterly reports must include, among other things, a profit and loss statement and data on total assets and net cash flow from operations.

Of the four reform measures, the conversion of nontradable shares to freely tradable shares was viewed by the survey respondents as being more positive for the development of China’s capital market than the directive on quarterly reporting. The full conversion of non-tradable shares would add liquidity to the stock markets along with increased transparency of ownership. In addition, one of our discussion group members remarked that previously, with two sets of shares, two different shareholder meetings would need to be held. In theory, with one class of shares, all shareholders would be receiving consistent information and the value of all share types would converge.

Another suggestion of survey participants to improve CG practices was to increase institutional investor participation. For instance, increasing the qualified foreign institutional investor (QFII) quota would attract more foreign institutional investors. It has been acknowledged by most market participants that mutual funds and other institutions have contributed positively to the Chinese securities markets by agitating for improved governance practices. Hence, promoting greater institutional participation could result in better self-regulation of the marketplace.

A significant concern of both foreign and domestic investors in Chinese companies relates to the adequacy and transparency of disclosures. In view of this, the government has moved recently to strengthen disclosure rules. Moving forward, investors will have more information available in quarterly and annual reports.

Due to the complex nature of the ownership structure of SOEs, a listed company will continue to have significant on-going business relationships with the parent (holding company) and other related companies within the state-owned group, post listing. A low level of transparency and inadequate disclosure of related-party transactions create additional concerns for investors because they do not have a clear picture of where or how the listed company resources are channelled or valued.

To date, regulations governing related-party transactions have been strengthened. Amendments to the Company Law have established procedures for entering into related-party transactions and when shareholders’ approval is required before a company can provide security to a major shareholder or to the actual controlling party/entity.

The CSRC Code, issued in 2002, clearly states that information disclosure is an ongoing responsibility of listed companies. In addition to disclosing mandatory information, companies are encouraged to disclose all other information in a timely basis that may have a material effect on the decision of shareholders and stakeholders. This includes information on the composition of the board of directors and supervisory board; attendance records, performance assessments, and compensation of directors; establishment of functional subcommittees and their operating details; independent directors’ opinions on related-party transactions; controlling shareholders’ interests; and executive appointments/removals. Companies seeking a listing have financial statements prepared in accordance with local rules for the three years prior to an IPO.

Furthermore, the ‘comply or explain’ rule in the CSRC Code requires all listed companies in China to disclose the gap between their existing practices and the recommendations in the code, reasons for any gap, and whether/how they plan to close such a gap. Meanwhile, it should be noted that there is no penalty for failing to close the gap or requirement that the company must do so.

In 2001 and 2002, the CSRC released a series of disclosure standards and requirements to ensure quality of disclosures. The new Ordinance on Disclosure requires the heads of the company, the accounting department, and the external accounting firm to make a public announcement attesting to the true and complete disclosure of the reports. The ordinance also requires disclosure of any cross-shareholdings among the top 10 largest shareholders.

All publicly listed companies have to file and disclose financial results on a quarterly basis. Although continuous disclosure is not required, any significant event that may impact stock prices has to be publicly announced immediately. Because Chinese regulations are generally principles based, no specific definition of what constitutes a significant event exists.

Survey respondents urged that annual and interim reports should include increased information relating to business segments, intercompany and related-party transactions, and more detailed cash flow disclosures. As the Chinese reporting system evolves, there will continue to be significant disparities in both the quality and quantity of information from one company to another.

Some respondents further suggested that if the investment community were to reward listed companies that provide high-quality financial disclosure with higher valuations, it would be an incentive for both those companies and others to improve disclosure quality.

Respondents also noted that most of the disclosures are in Chinese and urged that timely disclosures and updates on the companies’ websites should be in both Chinese and English.

China adopts a quasi two-tier structure of board governance, designed very loosely on the German governance system, with a board of directors and a supervisory board. The board of directors is the main decision-making authority, in which members work closely with management on the day-to-day operations of the company. Conversely, the supervisory board is the independent board that provides independent views and monitors the executive management and the board directors.

Recent revisions to the Company Law have clarified the structure and the roles of the board of directors and the supervisory board, as follows:

This directive from China Securities Regulatory Commission (CSRC) focuses on the form and content of such reports and requires listed companies to deliver them within one month after the endof the first and third quarters. These quarterly reports must include, among other things, a profit and loss statement and data on total assets and net cash flow from operations.

The board of directors is styled after the ‘board of directors’ in the Anglo-Saxon model of CG, where the board oversees and aids management decision-making. Similar to practices followed in the UK and US, guidelines issued by the CSRC require that at least one-third of the directors on the board be independent.
The board of directors is the main decision-making authority, with the supervisory board designated with legal powers to overturn decisions made by the board of directors.

In August 2001, the CSRC issued specific guidelines on the qualifications of independent directors of listed companies, the Guideline on Establishment of Independent Director System in Listed Companies. The guideline, which covers all companies listed on the Chinese stock exchanges but not Chinese companies listed overseas, includes specific rules on the definition of independence as well as giving independent directors more power in the functioning of the board.

In many cases, the chairman of the board is also the chief executive officer (CEO) of the company. This is consistent with other major markets but is a structure that is often criticised as creating the potential for conflicts of interest. Chinese officials and companies cite difficulty in recruiting talent in the market as a reason for not separating the two roles. Currently, there is no requirement for the separation of the roles by either the CSRC or Hong Kong Exchanges and Clearing (HKEx). It is only a recommended best practice by HKEx. Companies that are not in compliance simply have to explain and suggest a time period for compliance. Again, there is no penalty for noncompliance.

It has been observed that several of the large China companies have separated the roles of the chairman and CEO (eg, Petro China, China Construction Bank, China Shenhua Energy, Air China and China Southern Airlines).

Of all the issues presented under the board composition, structure and mechanisms section of the questionnaire, the skills and experience of management emerged as the most important factors in investment decision-making and were viewed as having improved the most over the past three years compared with the other issues raised.

There were a number of respondent suggestions relating to independent directors. First, there should be a mechanism to allow appointment of independent directors by minority shareholders. Second, there should be more independent directors that can communicate with foreign shareholders given the increasing foreign interest to invest directly in China. And third, the appointment of non-Chinese nationals with international experience in running western-style boards may help in CG reforms; this is already happening.

It is unlikely that a separation of the role of the chairman and CEO will happen soon in China. Even if a separation were mandated and enforced, it is questionable whether enforcement would be effective. Under the Chinese model, the board chairman is viewed as the de facto head and everyone defers - including the CEO, who often takes a back seat. Furthermore, most Chinese companies have a single dominant shareholder - for example, the state- that generally appoints both the chairman and CEO positions. Having a separate chairman and CEO under these circumstances may be of little value.

Within the public sector and SOEs, executive compensation generally consists of a fixed salary plus a cash bonus. It has been suggested that the provision of efficient managerial incentives may be a crucial ingredient in the transformation of SOEs into more profitable modern companies. A recent revision to the Securities Law paves the way for the issuance of stock options for managers and directors, an important tool for aligning manager and shareholder interests. The Chinese government is promoting equity-based pay as one component of compensation because it sees it as a way to encourage growth in the capital market. We expect to see a growing number of Chinese companies adding stock-based incentives to the compensation mix.

It was noted by several respondents that a potential issue with SOEs is a change toward having senior management employed on a contractual basis. Such term contracts together with revised pay packages linking to share performance will lead to a shift toward shorter-term performance of the company.

In China, minority shareholders are a highly fragmented group of individuals. The presence of institutional investors (eg, pension funds, mutual funds, asset managers) is still not sizable. Retail investors in China, as with many markets around the world, often lack investment knowledge and awareness of shareholders’ rights. This has traditionally made it difficult to organise opinion and investment actions to encourage shareholder activism and improved CG.

The CSRC Code is an attempt by the authorities to draw attention to the importance of minority shareholders’ rights. Coupled with revisions in the Company Law and Securities Law, which came into effect on 1 January 2006, minority shareholder protections have improved, including the following allowances and developments:

Proxy voting is permitted.
Cumulative voting is encouraged, thereby empowering minority shareholders to appoint directors and/or supervisors.
A stricter duty of care has been imposed on directors, supervisors, and senior management.
Shareholders are granted the right to bring a derivative suit or direct suit against directors, supervisors and senior management.
The concept of ‘piercing the corporate veil’ has been introduced, enabling courts to look beyond the principle of limited liability.
Shareholders are granted the right to check and copy the company’s account books and meeting minutes, allowing share buybacks and granting shareholders the right to petition for liquidation of a company.

In this section of the questionnaire, the protection of shareholders’ rights emerged as the most important issue in the investment decision-making process. When asked about the change over the past three years, the average rating from the respondents for all four identified issues was closer to ‘no change’ than ‘improved somewhat’.

Respondents remained concerned that despite the efforts taken so far by the authorities to emphasise minority shareholders’ rights, significant or observable changes have yet to take effect in the listed Chinese companies.

Such progress has been made in respect to the rights of shareholders; the duties, responsibilities and independence of board directors; greater information disclosure and transparency; and strengthening the role of the auditor. It is important to the China market and to Chinese companies generally to continue along the path of improving CG structures in consultation with the investor community and in concert with global best practices for CG. Such improvements will further secure China’s place as a global competitor and major global marketplace.

Lee Kha Loon is the Asia Pacific Head of the CFA Institute, based in Hong Kong