Steven Shi and Drake Weisert

an effective system. Both officials and academics were disappointed when most of these “modernized” enterprises failed to start earning profits. Beginning in 2001, a string of corporate scandals, most of which were spotted by accident (see p.42), not only put the buzz-words “corporate governance” (gongsi zhili) in newspaper headlines, but also prompted disillusioned investors to demand reform of the country’s corporate governance structure for listed companies to revitalize China’s sluggish stock market. CSRC issued a raft of new regulations and decrees and punished a number of listed companies, brokerages, accountants, and fund houses. The effect thus far on China’s stock market has been minimal, however, and stock prices have not risen significantly since the decline of mid-2001, when the government raised the possibility of flooding the market with a selloff of its large shareholdings.

The lack of profitability and corruption scandals stemmed from the prevalence of structural distortions among China’s listed companies, which have obstructed the development of a healthy corporate management system in China and have created an untrustworthy setting for long-term investors. The systemic problems among China?s listed companies include:

• Concentrated share ownership
  The largest shareholder stake in listed companies averages 44.9 percent, according to a July 2001 issue of China Securities. In contrast, the second-largest shareholder typically owns a mere 8.2 percent. Under such a scenario, majority shareholders can easily ignore minority investors and use information asymmetries?whereby board directors and senior managers have access to key information regarding a stock price before individual investors?to beautify the books and defraud new investors.


• Considerable non-tradable shares
  More than 60 percent of listed companies' shares (both A and B shares) in China are not in circulation, according to CSRC. The considerable amount of non-tradable shares in the market makes management indifferent to the fluctuations in stock prices and the rights of minority shareholders. Meanwhile, external supervision by government industry regulators, and the media, remains limited.


• The role of the state
  Since most listed firms emerged out of state-owned entities, the government in many cases owns more than half, and in some cases up to 80 percent, of a company's shares. Typically, however, the state does not exercise its rights as a shareholder to influence management effectively. In fact, majority government control of listed companies can make it difficult for systems managers to build healthy corporate governance systems and enhance profitability; state shares played a negative role in corporate governance among 434 firms surveyed in 2001 by Chen Chien-Hsun and Shih Hui-Tzu, research fellows at Taiwan's Chung-Hua Institution for Economic Research. For example, the Ministry of Agriculture, as the supervisory agency of Lantian Co. Ltd., was either unable or unwilling to point out the company's financial misconduct before it became public.

  The government appears to be aware of this problem. As mentioned, CSRC worked out a scheme last year to sell off some state-owned shares, but the proposal caused turbulence in the market and drove individual investors?fearing a crash in stock prices from a massive sale of state shares?out of stocks. To maintain market stability, CSRC announced in mid-2002 that it would put the plan on hold.



• A compromised regulator
  Though PRC regulations governing the relationship between the state and company management are adequate, they are not always implemented, in part because of inadequate resources. Listed companies in China report to multiple government institutions, with each institution exerting considerable influence over the company's management. For example, CSRC shared authority over Lantian with the Ministry of Agriculture and Hubei local authorities. CSRC also lacks independent enforcement authority; it must coordinate any effort to penalize rule breakers with the Ministry of Public Security.


• Absence of incentive mechanisms for management
  Most listed companies in China lack an incentive mechanism that ties the management team's performance to its compensation. In addition, the absence of solid accounting and prevalence of information asymmetries boosts management's autonomy. Unfortunately, China's lack of an accounting culture, coupled with the widespread practice of reporting only good news to higher-ups, make the organic development of a fair incentive mechanism unlikely in the near future.


• Lax screening for IPO selection
  Poor corporate governance in China begins before a company is approved for listing. Many analysts have highlighted the distortion caused by the government's role in selecting companies for listing. There is also a perception problem: the prevalent mindset among SOE managers is that capital raised from the financial markets is free money that can be squandered with impunity. This attitude has its roots in the era of the planned economy, when SOE managers would receive loans from state-owned banks with no obligation to repay them. In order to increase their chances to be selected for listing, companies have an incentive to inflate their figures and produce deceptive financial reports. Collusion with local governments and interest groups facilitates the circumvention of the minimal accounting rules China maintains.

  Companies such as Lantian and Zhengzhou Baiwen Co. Ltd. were, in effect, phony entities even before their IPOs. And government officials showered praise on the companies after the IPOs, obscuring the companies' faults.



• Underdeveloped capital market
  In many cases, stock prices in China do not reflect corporate performance or operational cycles because institutional investors, insiders, and the listed companies themselves manipulate figures. As a result, investor psychology is not that of "buy and hold" but rather "buy to trade." Chinese investors typically focus less on a company's basic performance when making investment decisions than on the names of the company's key institutional investors. Thus, managers in a Chinese listed company, unlike their Western counterparts, are under little pressure to improve performance and self-discipline.

Article continued below.

A chorus for reform
Chinese academics and senior officials have published numerous empirical studies in newspapers and academic journals on the subject of corporate governance. Some of their recommendations are clearly receiving consideration by PRC lawmakers. Wu Jinglian, chief economist with the State Council’s Development Research Center (DRC), has criticized excessive intervention from the government and parent SOEs and proposed that listed companies drop their state-owned stakes. Zhang Weiying, professor at Beijing University, has recommended that the government allow company shareholders to select corporate managers and that China privatize its state banks. Dai Yuanchen, an economist at the China Academy of Social Sciences (CASS), believes that more state industries should be opened to private investors.

The core of effective corporate governance lies in the creation of a fair and efficient competitive market environment, according to Lin Yifu, professor at Beijing University. Related to this, Zhang Weiying has emphasized the importance of property rights reform in future legislation. And CASS’s Wang and the World Bank’s Zhang believe that listed companies should replace stock issuances with bond issuances as primary sources of capital.

The Code of Corporate Governance
The corporate scandals and capital flight cases that emerged in mid-2001 prompted officials at CSRC and other state regulatory bodies to put corporate governance at the top of their list of priorities for 2002. Reflecting this commitment, in January 2002 CSRC issued the Code of Corporate Governance of Listed Companies in China.

The new code aims to introduce solid corporate governance in listed companies by elevating requirements on accounting procedures and information disclosure, introducing independent directors’ systems, and tightening the supervision of corporate management. CSRC officials who drafted the code, and other similar legislation in the past, used the US legal and regulatory systems as models. Though the code directly addresses many of the existing problems in China’s financial sector, it will only prove effective if company managers honestly implement—and CSRC strictly enforces—its provisions.

Yet these provisions are promising. For example, the code expands the rights of shareholders. Article 2 states that minority shareholders should have equal status with other shareholders and Article 4 gives shareholders the right to protect their interests through civil litigation and other legal approaches. Article 8 requires that listed companies make a genuine effort to use modern telecommunications technologies in shareholders’ general meetings to improve shareholder participation. And Article 11 gives institutional investors more weight in the decisionmaking process, including in the nomination of directors.

The code attempts to strengthen the roles of the boards of directors and supervisors. According to Articles 29 and 31, a listed company must establish transparent procedures to select the board of directors, and a listed company in which the controlling shareholder owns a stake in excess of 30 percent should adopt a cumulative voting mechanism to ensure the voting interests of minority

from providing financial collateral to related entities. Article 92 requires the listed company to promptly release detailed information on controlling shareholders. And Articles 25 and 27 require controlling shareholders to honor the independence of the listed company and to avoid interfering or directly competing with the listed entity.

Building trust
China’s officials and academics are clearly worried that weak corporate governance is endangering the country’s economic reforms. And the problem is not limited to public companies, though private companies are hidden from scrutiny because they are not obligated to publish their financial data. New laws have addressed a number of the issues of greatest concern, including information disclosure and financial fraud, but effective enforcement is by no means assured. China would do well to learn from its own experience, and that of the United States, and work to improve public trust in its companies.

China Business Review, Volume 29, Number 5, September-October 2002