Why corporate governance is key to China’s growth

chinese currency
By Mark Holmes and Dr Renfred Wong

13 July 2015

The makeup of boards, law enforcement practices and business culture all need to be examined if China is to sustain growth, argue Mark Holmes and Dr Renfred Wong.

Corporate governance can be seen as a set of mechanisms put in place to protect the value of investors' residual claims. In the past two decades, China has had one of the fastest growing economies globally.

For Chinese companies, some of the Anglo-American corporate governance practices may be relevant and applicable, while others may not be, because of its unique business climate that is subject to the influence of both capitalist and socialist views (Liu et al., 2011).

Board structure

As per the Code of Corporate Governance for Listed Companies in China (the Code), Chinese companies have a two-tier board structure, including a supervisory board and a board of directors.

So far, the supervisory board seems more decorative than functional (Huyghebaert and Wang, 2012), whereas the board of directors is supposedly accountable to shareholders and is tasked to safeguard the interests of various corporate stakeholders, among other duties. Any company board should have between five and 19 directors, one-third of whom should be independent directors.

According to the Code, an independent director is a person who does not hold any positions in the listed firm other than that of director and who does not have any affiliation or business relationships with the listed company and its major shareholder.

A study of the views of Chinese top managers reveals that executive age is important in determining firm performance.

A recent study suggests most outsiders in China are actually affiliated with the firm and are not likely to be strong mitigating factors of agency costs, at least not in the way suggested in extant literature (Liu et al., 2011).

Further, there seems to be no stipulation in China as to who can nominate or propose directors. Independent directors are often chosen by controlling shareholders, while boards of Chinese companies are often dominated by insiders such as senior managers and representatives of major shareholders (Huyghebaert and Wang, 2012).

This leads to questions regarding the independence and the monitoring effectiveness of boards in Chinese companies.

Shanghai Image: Sean Pavone / Shutterstock.com

Other board characteristics may affect firms' financial performance. A study of the views of Chinese top managers reveals that executive age is important in determining firm performance (Wei et al., 2005). This is because age facilitates the forming of close relationships with government officials and the acculturation of complex Chinese business practices (Liu et al., 2011).

Judicial environment

Law enforcement in China varies considerably between regions, perhaps due to the fact that the Chinese judicial system is still seen to be part of the government's administrative system, with no official separation of executive and judicial powers (Huyghebaert and Wang, 2012).

Research has identified that conflicts between public and private interests have commonly been resolved in favour of the former (e.g. Jiang et al., 2010). The lack of impartiality in resolving legal disputes by an independent judiciary may not be reassuring to investors who are attuned to the Anglo-American business culture.

This uncertainty about the quality of boards, management and judicial environment typifies many problems for potential overseas investors in China. Issues related to Variable Interest Entities (VIEs) will be used to illustrate areas that are worth further consideration in China's corporate governance reforms.

Foreign ownership

One highly publicised corporate governance failure is Enron. Its management used Special Purpose Entities (SPEs), that is companies contractually controlled by Enron but owned by management, in this case by then CFO Andrew Fastow. Such arrangements were legal, but when accounting for them the principle of "substance over form" was not applied (nor required under US GAAP).

Enron used SPEs to hide losses and liabilities from investors. Following Enron's collapse, the Financial Accounting Standards Board issued FIN46 to ensure such entities, now called VIEs, would be consolidated in financial statements.

Since then some Chinese companies, most notably in the technology sector, have sought an IPO on the NYSE to raise capital (Gillis, 2013; Shi, 2014). Unfortunately, these businesses are in industries that Chinese authorities have long considered "sensitive" (Shi, 2014) and thus limiting foreign investment.

To circumvent this companies have used VIE by placing business ownership with a Chinese member of management and contracting control and rights to the listed parent. These arrangements upon consolidation appear to show assets owned by the parent company and, therefore, its investors; despite ownership remaining with the Chinese individual.

Corporate governance will be crucial to China's sustained growth. How quickly and successfully it is strengthened is worth watching.

Though foreign ownership in certain sectors is illegal under Chinese law, the central authorities have been sporadic in its enforcement, with individual departments or local governments often enforcing requirements flexibly (Dutton and Wu, 2011; Shi, 2014). 

Gigamedia

Gigamedia and Alibaba/Yahoo are used here to illustrate the current challenges, while no wrongdoing by any parties is implied. Gigamedia, a Taiwanese company, acquired T2CN and its subsidiaries through a VIE owned by T2CN's then CEO Wang Ji. Subsequently it tried to remove Ji as CEO. Ji was unhappy and, despite contractual control lying with Gigamedia, took possession of all the necessary paperwork and licences of said subsidiaries. As foreign ownership was technically illegal it was highly unlikely that the courts would enforce their contractual rights (DeNoble and Harris, 2011). Eventually, Gigamedia ended the dispute with Wang Ji and sold T2CN, incurring impairment losses of $23.6m.

Shanghai skyline 

Alibaba and Yahoo

The other example concerns Alibaba and Yahoo. In order for Alibaba's subsidiary, Alipay, to obtain a licence as a payment system from the banking authorities, it could not have foreign ownership. As such, Alipay's ownership was transferred to a company owned by Jack Ma (founder and then CEO of Alibaba and a Chinese citizen).

The VIE in place was ignored by authorities and considered foreign ownership. The VIE was then terminated without consulting the directors or shareholders and as such Alibaba and its shareholders lost their contractual control rights. Yahoo challenged the loss of assets and reached a settlement (Dutton & Wu, 2011). In both cases, shareholders who invested in businesses found their rights to the assets were stripped and they had an extremely limited ability to enforce such claims.

Key learnings

The Chinese authorities may wish to consider a further few issues. Firstly, the code has failed to achieve the intended outcome with respect to actual board independence or diversity, rather they remain connected to and/or appointed by large investors.

In both examples above, the directors failed to represent all shareholders. As such the authorities may need to enforce the code for listed companies more strongly, as it is unlikely that the corporate culture will change on its own.

To place this into context the Western "comply or explain" approach, based on principles, is deemed to work because shareholder protection is more firmly rooted in the culture at board level. Enforcement is needed until such time as it becomes the "norm" within a culture.

Secondly, with respect to VIEs, the Ministry of Commerce (MOFCOM) issued the Foreign Investment Law exposure draft in January 2015, which clarified some matters but raised new ones.

Its definition of control and approaches again allows ambiguity and inconsistency (Clarke, 2015; Gillis, 2015). MOFCOM should provide greater clarity in how it approaches VIEs and foreign ownership. 

Decisive action will bring greater certainty and transparency, and may change the often ambiguous business practices at board level. Corporate governance will be crucial to China's sustained growth. How quickly and successfully it is strengthened is worth watching.

This article first appeared in the July 2015 edition of The CA magazine.

About the authors

  • Mark Holmes is senior lecturer in accounting, Faculty of Business, Environment and Society, Coventry University.
  • Dr Renfred Wong is associate head of depeartment, Economics, Finance and Accounting, Coventry Business School.

Topics

  • CA Magazine

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