Corporate China Going Private

(i) issuance of stocked SOS at initial public offering (IPO);

(ii) issuance of stocked SOS at additional stock offering (ASO);

(iii) SOS placement;

(iv) oriented repurchase; and

(v) SOS transfers by agreement.

The issuance of stocked SOS at the IPO of listing companies or ASOs of already listed companies is designed as the main channel of State ownership divestiture for the purpose of the NSSF. The reduction is mandatory only at new financings, be they IPOs or ASOs, at a controlled pace ¨C 10% of the total amount to be raised in a single offering. Since both IPOs and ASOs mandate a certain profit track,2 the SOS will be divested first from those relatively profitable companies. If free to choose, a rational investor in the State's shoes would rather back off from those ill-performing firms. However, under the Provisional Measures, these firms are not obligated to retire their SOS. According to Article 14, these listed companies may adopt the SOS placement or oriented repurchase method, which is to be implemented only on a pilot basis. On the other hand, if a listed company takes the route of transfer by agreement as provided by Article 15, they only need to hand over a portion of the proceeds.

In principle, the method of market pricing shall govern the SOS reduction (Article 6). At least two questions arise: how will the price of the divested SOS be formulated? And will the divested SOS become freely alienable in secondary markets? Bearing in mind the IPO and ASO scenario in practice, it is necessary for the SOS to be priced at the same issue price of the particular offering, which will be formulated according to the market conditions. The financing need of a particular offering will essentially become 110% of the original amount, adding the 10% to divested SOS, a factor the market will take into account.

Since the divestiture is bundled with an IPO or ASO which is directed towards the general investment market without limitation as to the eligibility of investors, the divested shares will have to be liquid, identical to the other shares sold in the same offering.

Potential Troubles

However, there is a problematic clause in the main operational provision, Article 5. This clause seems to be saying that a joint stock company (JSC) transformed from a State-owned enterprise (SOE) less than three years ago and that is too young to be listed3, should now transfer a certain number of SOS to the Council of the NSSF, in a dollar amount equal to the cash proceeds that the NSSF would be entitled to at a later listing. This reading of the language, however, renders the clause inoperable and counter-intuitive.

For one thing, the JSC may not become listed at all. To list is the company's choice. Secondly, how many shares does the company transfer? The first part of the second sentence of Article 5 provides the calculation to be 10% of the new financing amount at IPO or ASO. How does a company know how much money it will need from an IPO some years later, if it lists at all? Thirdly, what about the JSCs that are older than three years and not yet listed? It does not seem sensible to require younger companies to make contributions to the NSSF now, while sparing the older ones.

There is a potential loophole for companies taking alternative financing routes such as convertible bonds. Under the Provisional Measures, neither the issue of convertible bonds, nor the conversion of these bonds into common stocks constitutes an event subject to mandatory SOS divestiture as provided in Article 5. Driven by the motive of keeping the proceeds of additional finance for themselves, listed companies may take the indirect route of convertible bond financing to avoid the mandatory SOS divestiture requirement.

Dilutive effect

The motive for companies to issue convertible bords would be to avoid divestiture thus retaining the proceeds mithout haning to submit funds to the NSSF.

The better performing companies are the primary targets of the SOS reduction because of their stronger financing abilities. Moreover, the issue of stocked SOS can generate the highest price as opposed to, for example, contractual transfers where the parties would bargain on a mutually acceptable price taking into account the illiquidity of the transferred SOS.

On the whole, the reduction seems to be an ad hoc measure to fund the NSSF with a limited reliance on improved corporate governance measures. The dominant State equity stake, which takes 55% of the total equities in 1,125 publicly listed companies as of April 2001, will not take a significant hit because Article 5 generally involves "new" SOS that are about to enter the securities market. The effect of the more dilute ASOs on State share ownership is largely offset by its relatively high eligibility requirements.

A New Institutional Investor ¨C The NSSF

Many have regarded the emergence of the NSSF as potentially the largest institutional investor in the Chinese stock market. The NSSF has had a reservoir of Rmb30 billion, primarily from fiscal placement and the overseas listing proceeds of former Chinese SOEs like PetroChina.5 Article 5 requires all cash proceeds from the issue of stocked SOS be turned over to the NSSF. In the case where the unlisted JSCs are younger than three years old, a portion of the SOS will be transferred to, and held by, the NSSF Council, which will cash out at future IPOs to apply to the Fund. The legal significance, if any, seems to be a legal right alienation from the agency exercising the shareholder interests on the State shareholder's behalf to the Fund, which would exercise the shareholder rights associated with the transferred SOS, at least during the period from the transfer to the IPO.

Under the Provisional Measures, the NSSF Council ¨C the managing agent of the Fund ¨C will assume the responsibilities, inter alia, to allocate funds in accordance with the joint instructions by the Ministry of Finance and the Ministry of Labour and Social Security, disclose the Fund's assets, earnings and cash flows to the public, and undertake other tasks assigned by the State Council. Most notably, the Council may entrust the managing function with both domestic and foreign professional investment-managing firms in order to preserve and increase the value of the fund.6 However, there is always the concern of how these commercially oriented money managers would work with their bureaucratic bosses whose motives are not always profit-driven.

Corporate Governance Issues

Chinese corporate governance has long suffered from multi-faceted, unclear, and even conflicting operation objectives. For instance, the stakeholder model holds management accountable to a variety of corporate stakeholders including shareholders, creditors, employees, society at large, and even "socialist spiritual civilization," which end up getting lost in the parade.

Whether the NSSF will qualify as a credible institutional investor observing market rules hinges on a successful workout between the professional managers and the Council, which is under the dispatch of the State Council. The key is that the money managers should not become over-burdened by non-monetary social goals that often detract value from the perspectives of the corporations.

Empirical evidence has shown that State share ownership has negative or insignificant effects on the value of a firm, while the concentration of legal person shares has a positive performance on a firm.7 In contrast to dispersed ownership characteristic of opportunistic investors, concentrated ownership by institutional investors helps to safeguard the long-term competitiveness of the corporations.8

It is therefore desirable to substitute the concentrated institutional ownership for the concentrated State share ownership to achieve better corporate performance. For this purpose, it is critical to continually pursue creative ways to divest SOS while at the same time replacing the State shareholder with new institutional and strategic investors who are large enough and financially sophisticated to conquer the problem of shareholder class action.However, politics will decide how much governing power the NSSF should have in influencing listed companies and in what manner and scale the NSSF should penetrate the capital market as an institutional investor.

Strong Future Regulations

The Provisional Measures kick off the institutionalization of State share ownership. However, considering China's still fledgling securities market, it is particularly important for the regulator, through strengthened regulation of the new institutional investors and their professional managing staff, to ensure the efficient operation of capital markets. The discipline and rewards of which provide all corporate constituents with sufficient incentives to behave in a responsible way.

Endnotes

1 State-owned shares include the shares directly owned by the government and the shares held by the State-owned legal persons. See Article 2.

2 Under the PRC,Company Law, to be listed (Article 152) or to issue new shares (Article 137), a company must have been continuously profitable for the past three years. .

3 The PRC, Company Law, article 152, a joint stock company
must have been incorporated for more than three years to qualify for listing.

4 See Article 4 of the Public Share Offerings by Listed Companies Operational Guidelines (Trial Implementation) (中国证券监督管理委员会上市公司向社会公开募集股份操作指引（试行）), CSRC, April 30 2000 Given the fact that there have already been over 100 companies on ASO agenda as of the end of June 2001 compared to only 24 companies in year 2000 that issued ASOs, the requirements seem not to be as stringently implemented as written.

5 See Shanghai Securities Journal, June 18 2001 (in Chinese).

6 The PRC, Trust Law (中华人民共和国信托法), promulgated by National People's Congress Standing Committee on April 28 2001, to be effective on October 1 2001, and the Administration of Trust and Investment Corporations Procedures, passed by the People's Bank of China on January 10 2001, effective the same day, introduced long desired trust asset management models.

7 Xiaonian Xu & Yan Wang, Ownership Structure, Corporate Governance, and Corporate Performance: The Case of Chinese Stock Companies, the World Bank Policy Research Working Paper 1794, June 1997, at 11.

8 See Robert A.G.Monks and Nell Minow, Corporate Governance, Blackwell Business (1995), at 163.