Trust Investment Companies - A Vehicle for a Corporate Restructuring in China

Unfortunately, to date, these reforms have had mixed results. Too often, SOEs are restructured into limited liability or joint stock companies on paper, but in many respects, the restructured companies continue to function like SOEs. He Qinglian, in her book Xiandaihua de Xianjing(现代化的陷阱), refers to these companies as "Turn-Over-the-Sign" companies (fanpai gongsi )(翻牌公司).² A fanpai gongsi has all of the accoutrements of a modern company: a board of directors, a supervisory committee and a shareholders committee. But these bodies are dysfunctional: the chairman of the board is usually the former factory director (changzhang)(³§³¤) of the reincarnated SOE. Like SOE factory directors, the chairman of a fanpai gongsi is usually appointed by the relevant government authority administering the enterprise on the basis of loyalty rather than managerial competence. The directors are often former employees of the SOE beholden to the former factory director acting now as the chairman of the board. Although there are shareholders, most of the shares are held by Chinese government entities or government affiliated entities. Individual shareholders are usually too few, dispersed and lacking sufficient information regarding company operations to maintain any kind of supervisory role over management. The phenomenon of fanpai gongsi has been a topic of considerable debate in China in recent years.

DYSFUNCTIONAL SHARE CAPITAL STRUCTURE

The phenomenon of the fanpai gongsi relates to the capital structure of Chinese companies that perpetuates the lack of separation of government and enterprise administration. The bulk of share capital in Chinese companies consists of State shares held by Chinese government entities or legal person shares often held by government-affiliated entities. These shares relate to assets originally contributed by the State in the establishment of SOEs. When these SOEs are converted into joint stock companies, the share capital relating to State assets is converted into State shares. When these State shares are transferred to wholly State owned entities, they are converted into State legal person shares. When transferred to non-state entities with legal person status, they become legal person shares. State shares, State legal person shares and legal person shares are not freely tradable. Only a fraction of the share capital in most listed Chinese companies consists of freely tradable A shares (and B-shares) listed and traded on China's domestic stock exchanges.

That almost three-quarters of the share capital in Chinese companies cannot be traded has several deleterious consequences for Chinese companies. First, since State shares and legal person shares cannot be freely traded means that the actual market value of State shares and legal person shares is markedly lower than that of more fungible A shares. Second, since State shares may only be sold by State entities to other State entities (unless MOF approval is given to sell them to non-state entities) that are often strapped for cash, Chinese companies are deprived of an ability to tap into China's huge pool of private savings. Third, because Chinese companies are often forced to meet their financing needs by issuing new shares, the State's interest in Chinese companies as represented by State shares is progressively diluted over time. Finally, because the preponderance of share capital consists of State shares and legal person shares, there are no real private shareholders available to exercise control over company management. Although State shares are often held by government asset management holding companies for the purpose of husbanding State assets, in practise, these entities are the alter-egos of local governments that continue to intervene in company operations in many respects similar to their SOE predecessors. As a result, many companies continue to cater to the wishes of government bureaucrats and party cadres who are more interested in power than in profits.

ROLE OF THE TRUST INVESTMENT COMPANIES

China's central planners have made a broad policy decision to begin reducing the State's stake in various non-strategic sectors of the economy. In practise, this means that Chinese government entities will begin to sell their State shares. The purposes underlying this revolutionary policy decision are to:

a) effect a separation of government involvement in enterprise administration;

b) create a viable group of shareholders capable of supervising and enforcing discipline on company management;

c) tap into China's huge pool of private savings to finance corporate restructuring; and

d) raise funds to finance China's nascent social insurance scheme.

For several reasons, China cannot simply relax restrictions on the trading of State shares and legal person shares since to permit State shares to flow into private hands would permit the rise of an independent capitalist class in China. In addition, dumping shares en masse onto China's equity markets would disrupt China's fragile stock markets. On previous occasions when China dumped shares on the markets in 1993 and 1995, the sales triggered destabilising shocks to China's stock markets.³

China expects that institutional investors such as investment funds will absorb the large amount of share capital and assets introduced to the market. By transferring State shares to trusts that will be administered by the trust investment companies, State shares will be allowed to circulate without ostensibly creating a new capitalist class in China. The investment funds will be a vehicle for tapping China's huge domestic savings for restructuring Chinese companies.

THE POLISH AND CZECH MODELS

In devising its investment fund scheme, China has carefully studied similar experiments undertaken in Poland and the former Czechoslovakia.⁴ As former socialist planned economies saddled with under performing SOEs, the Polish and Czech programmes are particularly germane for China.

The Polish model involved the large-scale privatisation of SOEs via investment funds under the 1994 National Investment Fund Programme.⁵ Under this programme, the Polish government set up 15 investment funds to which it transferred 60% of the shares in 512 select large and medium-sized SOEs. Of the remaining 40% of the shares in these companies, the government retained a 25% stake while the remaining 15% where sold to company employees.

The share capital in these 512 restructured companies was dispersed among the 15 investment funds. Each investment fund was responsible for "directing" certain enterprises. These investment funds each took a 33% stake in such "guided enterprises" (zhudao qiye)(主导企业) and approximately a 1.9% interest in "non-guided enterprises" (fei zhudao qiye)(非主导企业). The resulting share capital in the 512 enterprises is reflected in the table below.

• Government 25%
• Guiding Investment Funds 33%
• Non-guiding Investment Funds 27%
• Employees 15%

The investment funds authorised a fund management company to manage them. Each fund management company had within its portfolio approximately 30 "guided enterprises" (zhudao qiye). The fund management company undertook to reform enterprise management and restructure the enterprise. All of the fund management companies were joint ventures with foreign companies, usually foreign investment banks.

A key feature of the Polish model is that the Polish government issued "share subscription certificates" to Polish citizens. Each share subscription certificate could purchase 15 shares in an investment fund.⁶

The Czech model is similar to the Polish model. The Czech programme involved the restructuring of approximately 6,000 SOEs.⁷ Approximately half of these SOEs consisted of small enterprises that were sold to the public. The remaining medium and large-size SOEs were privatised through the use of the investment fund mechanism. Under the Czech system, all adult Czech citizens were allowed to purchase 1000 "privatisation notes" for US$35 that could either be used to directly purchase State shares in privatised SOEs or entrusted to investment funds to invest and manage the State shares on behalf of the investor. Over a three-year period from 1992 until 1994, approximately 70% of the State shares in 2,500 medium and large size SOEs were transferred to investment funds while the remaining 30% of the government's interest in the SOEs was dispersed amongst the public. At present, 15 fund management companies in the former Czechoslovakia manage roughly 95% of the shares in the restructured former SOEs. The remaining 5% are dispersed among several hundred small fund management companies.⁸

CHINESE TRUST INVESTMENT COMPANIES

The Trust Investment Company Administration Measures (Measures) lay a legal foundation for investment funds in China by creating a legal framework for administering fund management companies. The three basic elements of investment funds (as in the case of unit trusts) are the trust (that is, the investment fund), the fund management company and the trustee. China has existing regulations governing the establishment of closed end funds, and on October 8 2000 issued the Pilot Projects for Open-ended Securities Investment Funds Procedures, which standardise open-ended investment funds in China. China's Investment Funds Law is currently being drafted by the National People's Congress Financial and Economic Committee Investment Fund Law Work Group.(全国人大财经委投资基金法工作组) Many observers anticipate that the draft Investment Funds Law will be submitted to the National People's Congress sometime this year. Provisions of the Investment Funds Law will supersede conflicting provisions of the prospective Trust Law, which has yet to be passed by the National People's Congress.

The role of investment funds in the restructuring of Chinese companies is reflected in the Measures. For example, Article 5 of the Measures provides that upon approval of the relevant regulatory authority, the trust estate may include assets whose circulation is restricted under laws and regulations. This provision could be applicable to State assets that may only be transferred to non-state entities with the approval of the PRC, Ministry of Finance. For over 15 years, the Chinese government has endeavoured to force Chinese government entities to divest themselves of their commercial operations, but has had only limited success in this effort. Perhaps, the investment funds and the trust investment companies will provide a vehicle to split government entities from their commercial arms. Government entities will no doubt resist such moves as government backed commercial enterprises provide a crucial source of funding to supplement government coffers.

Also instructive is Article 21, which sets forth the business scope of trust investment companies. Item 3 states that trust investment companies can undertake investment fund business. In addition, under Item 1, trust investment companies can manage, operate and dispose of funds that a settlor cannot management himself or relevant laws and regulations prohibit him from managing. This provision lays the foundation for a possible future State Council Directive ordering PRC government entities to divest themselves of State shares in Chinese companies. These State shares could then be transferred to funds administered by trust investment companies in trust for the State.

That the trust investment companies will play a key role in restructuring Chinese companies is apparent in other aspects of their business scope. For example, under Article 21, Item 2, trust investment companies can manage, operate and dispose of a wide range of movable and immovable assets, and intellectual property. Under Article 23, trust investment companies may manage assets in the trust estate by means of leasing, sale, loan, investment and inter-bank lending and borrowing. In addition, Article 21, Item 4 provides that trust investment companies can engage in enterprise asset restructuring, mergers and acquisitions, project finance and financial consulting. In short, the overall business scope of the trust investment companies contemplates a broad mandate to participate in the restructuring of Chinese companies along the lines of the Polish and Czech models.

ASSET MANAGMENT COMPANIES

The relationship between the trust investment companies and the investment funds, and China's four asset management companies (AMCs) is unclear. China's Ministry of Finance recently established four AMCs, Cinda, Huarong, Great Wall and China Orient, for the purpose of clearing the non-performing loan portfolios off the balance sheets of China's four large State banks and restructuring select SOEs into limited liability and joint stock companies under the PRC Company Law (中华人民共和国公司法). A principal function of the AMCs is to engage in debt-for-equity swaps (zhai zhuan gu)(债转股) with the restructured SOEs.

Since the AMCs are only expected to be in existence for roughly 10 years, it may be the case that China's central planners will use the investment funds as a mechanism for assuming the asset management functions of the AMCs and winding down the AMCs' operations. This would presumably entail the AMCs selling their asset portfolios including State legal person shares in restructured State companies to the investment funds.

FUNDAMENTAL RESTRUCTURING

China's trust investment companies will play an important role in restructuring Chinese government-subsidiary companies. As government entities or wholly State-owned companies sell their State shares and State legal person shares to the investment funds, Chinese government entities will be ostensibly ceding control over their commercial enterprises to the investment funds. Theoretically, this process will force government entities to withdraw from commercial activities and rationalise corporate governance. If this policy is to succeed, however, the investment funds will perforce have to actively exercise shareholders rights in the enterprises in their portfolio. Given China's convoluted political system and fluid politics, asking the investment funds to exercise shareholders rights may be easier said than done. As in the case of the AMCs, unless the investment funds have the power to supervise and direct companies with powerful bases of support in the Chinese government, it may be difficult for the investment funds to fundamentally restructure Chinese companies.

ENDNOTES

1 See Ma Junju, Zhubian, Xiandai Qiye Falu Zhidu Yanjiu Beijing: Falu Chubanshe, 2000, pp. 288-295.(马俊驹，主编，《现代企业法律制度研究》北京：法律出版社，2000，第288-295页)
2 He Qinglian, Xiandaihua de Xianjing Beijing: Jinri Zhongguo Chubanshe, 1998, p. 24.(何清涟，《现代化的陷阱》北京：今日中国出版社，1998，第24页)
3 Wang Haiping, Xu Gang, Zhubian Touzi Jijin Shiwu Beijing: Qiye Guanli Chubanshe, 1998, p. 57.(王海平，许纲，主编《投资基金实务》北京：企业管理出版社，1998第57页)
4 Ibid, p. 306.
5 Ibid, p. 306.
6 Ibid, p. 307.
7 Ibid, p. 312.
8 Ibid, p. 314.