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Steven Shi and Drake Weisert


Chinese officials are
addressing the
widespread problem of
ineffective and corrupt
management and
accounting in Chinese
public companies
China, like the United States, has weathered a number of its own financial scandals over the last year. As a result, PRC officials are examining more closely than ever the issue of corporate governance—the means by which various corporate participants, including managers, shareholders, and banks, share rights and responsibilities. Legislation has tackled many problems in recent years, including lack of transparent information disclosure, the need to separate enterprise from government control, and the need for independent board directors. This year the PRC government announced that local regulators would crack down on corporate and securities
law violations, focusing on the relationship between listed and parent companies, the use of capital raised from markets, and the accuracy of financial data. Such initiatives, however well-intentioned, demonstrate that China’s corporate culture is not yet entirely successful in fostering professional managerial behavior.

Early reform
Chinese officials have been studying corporate governance ever since they launched the Shanghai and Shenzhen stock exchanges in December 1990 and April 1991, respectively. Officials hoped the stock markets would put household savings to use as financing for listed companies, most of which were?and still are?profitable parts of state-owned enterprise (SOE) parents. They were also interested in separating SOE management from government. As China's capital market developed and SOE reform progressed, a string of SOEs were restructured into "shareholding" firms?a new structure for PRC enterprises?in the early 1990s. Some of these shareholding enterprises undertook initial public offerings (IPOs) and listed on the Shanghai and Shenzhen exchanges. To date, more than 1,100 companies have listed on the exchanges, according to China’s regulatory body, the China Securities Regulatory Commission (CSRC), and numerous unlisted SOEs have turned into shareholding or limited liability entities.

PRC authorities that supported these economic reforms initially hoped the existence of capital markets could facilitate the introduction of a modern enterprise management system based on efficiency and transparency. They also hoped reforms would help overhaul ailing state-owned businesses without the social turbulence that they feared would result from massive bankruptcy in the SOE segment of the economy. Authorities focused on how to allocate controlling rights among corporate leaders and prevent excessive control by management; how to ensure that management maximizes investors’ interests; and how to design and implement incentive mechanisms.

Current legal framework
The current legal framework for corporate governance is based primarily on the following national laws and regulations: the Certified Accountant Law (issued in 1993), Audit Law (1994), Company Law (1994), People’s Bank of China Law (1995), Commercial Bank Law (1995), Securities Law (1998), and Accounting Law (1999). The key regulatory bodies involved in the lawmaking process are CSRC, the State Economic and Trade Commission, the Ministry of Finance, and the People’s Bank of China.

According to the Company Law, there are three tiers of control over a company’s operations: the shareholders’ general meeting, the boards of directors and supervisors, and management. The general shareholders’ meeting has final say over the key issues of the company, such as approval of the management strategy, the financial budget and key investment plans, and the nomination of the boards of directors and supervisors. The board of directors makes key investment plans and the board of supervisors oversees the decisionmaking process and performance of senior management and directors. And management is responsible for day-to-day operations and for implementing the decisions of the board of directors.

Problems from the outset
In practice, key managers sometimes gain control over the shareholders’ general meeting so it functions mainly as a rubber stamp, giving green lights to decisions already made by senior management. Insiders have also occasionally won dominant positions on the boards of directors and supervisors and placed their cronies in board positions. In such cases, the boards of directors and supervisors merely serve the demands of controlling parties and their representatives. In some instances, managers diverted money from state and company coffers into their own pockets—actions that clearly ran counter to the goal of increasing the value of shareholders’ investments.

Government and company efforts to build a corporate governance system during the 1990s thus existed largely on paper and ultimately contributed little toward

  A string of corporate
scandals, most of which
were spotted by accident,
not only put the
buzzwords “corporate
governance” (gongsi zhili)
in newspaper headlines,
but also prompted
disillusioned investors to
demand reform.

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.

China's Enrons

Since late July 2001, the China Securities Regulatory Commission (CSRC) has reprimanded a number of listed companies for violating provisions relating to financial reporting and management. A few of the highest-profile cases include:

Guangxia (Yinchuan) Industry Co. Ltd.
Guangxia, a listed pharmaceutical company, falsified profits for several years to present itself as a fast-growing entity with sophisticated, state-of-the-art technologies. The company fabricated sales contracts and export figures and exaggerated its financial statements, reportedly inflating net profits by ¥745 million ($90 million). CSRC initiated an extensive probe of the company in August 2001, and the Ministry of Finance eventually stripped the accounting license of its longstanding auditor, leading observers to nickname Guangxia the “Chinese Enron.”

Sanjiu Pharmaceutical Co.
CSRC uncovered Sanjiu’s troubles in mid-2001. The listed company, which was reportedly China’s largest pharmaceutical group, had misappropriated ¥2.5 billion ($302 million) on behalf of a few major shareholders and related business partners without the consent of other shareholders or the public. These diversions amounted to 96 percent of the company’s net assets, posing considerable threat to the company’s operations.

CSRC reprimanded the senior principals, headed by former military serviceman Zhao Xinxian, and fined the company ¥150 million ($18.1 million). Major shareholders and related business partners had repaid ¥349 million ($42.2


million) to Sanjiu by March 2002. Zhao remains the company’s legal representative and the company continues to operate, publishing a quarterly report for the first quarter of 2002.

Lantian Co. Ltd.
Lantian listed on the Shanghai stock exchange in 1996 and was hailed as the first publicly listed Chinese ecological agricultural company. Immediately after its IPO, however, investors grew suspicious of the company’s soaring share price and incredibly strong profit growth because its business lines, lake fisheries and lotus processing, were unlikely to generate profits at that level. In 2000, the company had reported ¥1.84 billion ($222 million) in sales income but only ¥8.5 million ($1 million) in accounts receivable—an impossible gap for a legitimate company. Lantian said that it had settled most of its transactions with cash. Analysts have estimated that the company fabricated 2000 net profits of up to ¥500 million ($60 million).

Liu Shuwei, a researcher at the Central University of Finance and Economics in Beijing, wrote a research paper in October 2001 questioning the company’s financial safety and sent warnings to state bank officials urging them to reconsider their lending programs to Lantian. Banks stopped extending new loans to Lantian and the company’s major creditors, Citic Industrial Bank and China Minsheng Banking Corp., filed lawsuits against the company. CSRC also launched an investigation of the company’s connected transactions, suspicious accounts receivables, and inflated earnings.


Zhengzhou Baiwen Co. Ltd.
Henan-based Baiwen, a state-owned retail firm, listed on the Shanghai Stock Exchange in April 1996. Exactly three years later it became one of the first companies that CSRC temporarily delisted, after it reported losses of ¥957 ($116 million) in 1999—the largest one-year loss by a listed PRC company. CSRC later found that the company had inflated profits by ¥19 million ($2.3 million) before its listing and by ¥144 million ($17.4 million) in the three years that it was listed. The company was reportedly found guilty of insider trading and publishing misleading annual reports. CSRC also fined Baiwen’s accountants for falsifying audits. In mid-2002, leather products firm Sanlian Group finalized a purchase of 50 percent of the company.

Macat Optics and Electronics Co., Ltd.
Guangdong-based Macat, a motorcycle and camera parts manufacturer, listed in Shenzhen in July 2000. CSRC began investigating the company in November 2000 and in September 2001 announced that the company had fabricated fixed assets of HK$91 million ($12 million) by falsifying imported capital equipment lease contracts; had inflated sales revenue by HK$301 million ($39 million) by issuing fake foreign trade receipts and forging sales contracts and customs documents and seals; and had exaggerated net profits by HK$93 million ($12 million). In January 2002, the local procuratory office indicted senior company executives, the external auditor, and the company’s underwriter and asset appraisal agency for implication in fraud activities.

—Steven Shi and Drake Weisert

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 prevalent mindset
among SOE managers
is that capital raised
from the financial
markets is free money
that can be squandered
with impunity.
Wu and CSRC Chairman Zhou Xiaochuan have stated that a crucial obstacle to successful corporate governance of listed companies is “insider control.” Wang Guogang, vice director of CASS’s Financial Research Institute, has recommended that companies move toward an institutionalized management system to alleviate undue influence by individuals. Wu and Dai proposed the introduction of independent board directorships to monitor the management of listed companies. And Zhang Chunlin, an economist at the World Bank, believes China should set up financial institutions to replace government agencies to monitor enterprise management.

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

shareholders. Article 49 requires listed companies to introduce independent directors who do not hold any other positions within the company. Articles 60 and 61 state that members of the board of supervisors must be permitted access to information related to operational status and be allowed to hire independent intermediary agencies for professional consultation, without interference from other company employees.

Finally, the code includes specific provisions on information disclosure. Articles 88 and 89 require the listed company to disclose promptly any information that may have a substantial impact on the decisionmaking of shareholders or associated parties. Articles 13 and 14 require the listed company to fully disclose prices of related party transactions and prohibit it

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.

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.

  Steven Shi is a senior consultant at PricewaterhouseCoopers.
Drake Weisert is an assistant editor of The CBR.


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

Copyright 2002 by The China Business Review
All rights reserved.

Last Updated: 29-Aug-02