Shortcomings in China's Corporate Governance Regime

China has a two-tier board governance structure for companies which is very similar to the German system, with a board of directors and a supervisory board. Unfortunately, in reality, supervisory boards in China usually just rubber-stamp decisions taken by the board of directors. This duplication in the system does not do any good except to create redundancy and increase administrative costs for companies. Also, although Chinese companies are required to have at least a third of their boards constitute independent directors, in practice these directors have very limited ability to influence how their companies are run.

Moreover, the financial disclosure requirements of Chinese listed companies are still weak compared to those of many developed jurisdictions. The continued uncertain reform of SOEs' share structures and the lack of good financial information make it extremely difficult for China's equity markets to grow and function properly.

The PRC government has been encouraging companies to improve their awareness of good corporate governance. One method adopted by the government has been to actively encourage local companies to list on the Hong Kong stock exchange, which has a more internationally-accepted corporate governance system for listed companies. However, this plan could backfire and hinder the development of China's equity markets, as it creates the perception that the local stock exchanges in Shanghai and Shenzhen - and the companies listed on them - are weaker and less professionally managed.

Another corporate governance problem for big PRC companies (most of which are majority government-owned) is of the government trying to exert a strong management influence on them. Many of the senior management of these majority stated-owned companies see their role as that of keeping the government happy at all costs. Clearly, there is plenty of room to improve China's corporate governance system.

Legislative efforts

Great efforts have been made to overhaul the corporate governance framework in China, particularly through recent revisions to the securities and company laws.

In the area of financial disclosure, limited liability companies are now required to have their financial and accounting reports audited by professional accounting firms. Previously, this requirement only applied to joint stock companies. The amendment has strengthened the terms upon which companies can engage and dismiss external auditors.

Formal procedures have also been established for entering into related-party transactions. Under the new procedures, it is mandatory for a resolution to be approved at a shareholders' meeting before a company can provide security to a shareholder or to the controlling shareholder. The shareholder in question or the shareholders under the controlling party must abstain from voting on related matters to avoid conflicts of interests.

Improvements have also been made to the position of minority shareholders, which have been given rights to make motions, convene and preside over shareholders' meetings, and to bring derivative suits against directors and senior management. Shareholders in joint stock companies have also been given greater powers: they are allowed to use a cumulative voting system to elect supervisors and directors. In addition, the information available to shareholders has been extended: they are now able to obtain articles of association, shareholders' meeting minutes, board resolutions, financial reports and accounting books.

The supervisory boards of companies have also benefited from the legislative amendments which give them increased powers and functions, making them less like rubber-stamping machines.

The functions and voting rights of board members have also been clarified. In addition, the powers of the board's chairman have been reduced: his/her right to exercise some of the powers of the board when it is not in session have been cancelled.

Corporate governance issues

Government influence on SOEs

Many large listed companies are still majority state-owned, which has created the problem of local and city governments continuing to impose an influence on SOEs' operations and management. This undesirable situation has created an environment in which senior managers in SOEs align almost always with the state (the majority shareholder), to the detriment of minority shareholders.

Moreover, due to the non-merit based promotion system in many SOEs, it is difficult for some SOEs to attract good managers, as they prefer to go to multinational companies where they have a better chance to advance. This poses a great problem for the future development of SOEs.

If SOEs are to survive in the increasingly competitive markets, senior management must learn to develop their independent decision-making skills based on market needs and not what the government asks them to do.

Traditionally, there has not been a culture of good corporate governance in many PRC companies. The government needs to put a greater emphasis on corporate governance awareness and adoption by introducing training programmes for managers, senior executives and directors.

Financial disclosure

Financial disclosure in the PRC remains weak compared to many advanced jurisdictions. This results in a hampering of the growth of efficient equity markets. A common complaint among investors in China is that financial information on company performance is either unavailable or, if provided, lacks reliability. The government is beginning to tackle this problem by establishing more open disclosure rules and adopting international financial reporting standards..

On February 15 2006, the Ministry of Finance formally issued 38 specific Basic Accounting Standards for Business Enterprises, which apply to all listed Chinese companies as of January 1 2007. The new standards will bring Chinese accounting practices largely in line with the International Financial Reporting Standards (IFRS), with some exceptions. It is hoped that the implementation of these standards will significantly improve this area of corporate governance in the PRC.

Board governance structure

On the surface, the board governance structure for companies in China is designed similar to the two-tier structure in Germany, in which a management board is responsible for running the company and a supervisory board supervises the management board. However, in reality Chinese companies have had muddled one-tier board structures, which has created redundancy and inefficiency.

Fortunately, this unsatisfactory situation has been dealt with in the recent revision to China's company law. The structure of the board of directors and supervisory board has now been improved and clarified through the following measures.

i. The board of directors of a company is styled after the board of directors in the Anglo-American model of corporate governance, where the board oversees and helps management's decision-making process. Similar to practices followed in the US and the UK, guidelines issued by the China Securities Regulatory Commission require that at least one-third of directors be independent.

However, the blending of the Anglo-American model and the German model of corporate governance dilutes the effectiveness of both the board of directors and the supervisory board of a company and duplicates administrative costs by increasing the overall number of directors in a company.

ii. The supervisory board of a company in the PRC is much smaller than the supervisory board of a company in Germany, and shares only a few similar responsibilities with its European counterpart.

iii. In the PRC, the board of directors is the main decision-making authority in a company, with the supervisory board designated with legal powers to overturn decisions taken by the board of directors. In practice, the supervisory board is only symbolic and any attempt to strengthen its role is likely to create further ambiguity in China's board structure.

Slow-growing capital markets

With reforms underway in the equity and banking sectors, China's government has temporarily suspended the issuance of new capital on local stock exchanges and the market has been dormant since 2005. Listed PRC companies cannot issue new shares on the Shanghai or Shenzhen stock exchanges until they convert all non-tradable shares to tradable shares. In the meantime, PRC companies looking to raise new capital can only do so in Hong Kong, New York or Singapore.

The PRC government is hoping that having domestic companies list outside of China will improve their standards of corporate governance on a long-term basis. However, this plan may unfortunately backfire, as investors may see companies being listed on China's stock exchanges as having weaker corporate governance models and less protection for their investments, which does not help the growth of the equity markets.

China's government must try very hard to educate both the public and company executives of the importance of corporate governance if it wants to improve the growth and development of the local equity markets.

Expanding abroad

Significant steps have been taken to improve China's corporate governance framework, particularly through amendments to the company and securities laws. Unfortunately, there is still a large amount of work that needs to be done in order to raise the standards to an international level.

Many Chinese companies have great ambitions to become multinational corporations. For example, Lenovo, which has taken over IBM's personal computer business is a classic show case. However, the poor corporate governance structure of PRC companies is halting the progress of their internationalization, especially during the bidding process of merger and acquisition deals.

It therefore pays for Chinese companies to improve their corporate governance systems. The PRC government should encourage companies to take an active role in implementing internationally-accepted governance standards so that they can move to the next phase of their growth and development in the international play field.

About the author

Johnny KW Cheung is the associate general counsel of American International Group (AIG) for the Asia-Pacific region. Prior to joining AIG, he was an in-house counsel at ExxonMobil and InterContinental Hotels Group. He was also previously an attorney at Linklaters & Paines and Clifford Chance and a management consultant at the Boston Consulting Group.