Towards Mature Corporate Governance Standards in China
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Mike Thompson is Professor of Management Practice, CEIBS Director of the Centre for Leadership and Responsibility (ECCLAR)
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n November 2011, the IMF published their first Financial System Stability Assessment report on the Chinese financial system. Although the report was primarily concerned in reporting on China’s banking system it made recommendations on the legal and governance system in the securities sector. The IMF noted that the Chinese Securities Regulatory Commission (CSRC) has taken “an active and strategic approach to regulate securities markets, the legal and regulatory system needs improvement.” The IMF specifically recommended that the CSRC should increase their efforts “to detect and deter unfair trading practices”, notably insider trading and market manipulation. These recommendations resonated with the findings of a group of CEIBS MBA students who formed a Corporate Governance Think Tank in February 2011 to discuss the particular challenges faced by Chinese investors. They were particularly keen to advance the case for better protection for small investors against the power of dominant shareholders.
Concerns expressed by the Think Tank were the lack of knowledge about corporate governance regulations by board members of Chinese listed companies and the consequential detriment to small-scale investors. They also pointed out that the gains possible by fraudulent accounting and insider trading were greater than the threat of being caught by the CSRC. In their report, the IMF recommended that the CSRC redouble its efforts at “investigating suspicious trading around events likely to involve it, like initial public offerings (IPOs) and merger announcements, and lowering the thresholds for investigating or making enquiries.” Both the CSRC and the media have responded positively to the IMF report.
The rapid development of the socialist market economy in China and the emergence of the two stock exchanges in Shanghai and Shenzhen have been accompanied by the significant regulatory and enforcement challenges most notably witnessed in cases of insider trading. Small investors in China, reflected in the membership of the CEIBS Corporate Governance Think Tank, believe that insider trading on the Shanghai stock exchange is prevalent. Market-making by fund managers has included unlawful affiliate transactions between funds and their corporate board directors and also their distributors. Personal trades made by a fund manager who trades for personal profits through advanced knowledge has become known as “rat-trading” which is widely regarded as common practice. However, the enforcement regime in China is being strengthened and under an amendment to the Criminal Law enacted in February 2009, the CSRC successfully prosecuted a Shenzhen fund manager in 2011 for making a 270,000-yuan profit through secretly trading the Jiufu Listed Open-Ended Fund. The fund manager was sentenced to one year in jail and fined 310,000 yuan.
Despite renewed efforts at tracking down rat-trading by fund managers, corporate governance and financial accounting practices in China have, in the view of the Think Tank, suffered from lax monitoring and non-existent enforcement leading to a decline in investor confidence by Chinese domestic investors and also by foreign investors in Chinese companies listed on foreign exchanges. According to the CEIBS Think Tank, many smaller investors are disadvantaged both in direct trading as well as through fund investments due to a lack of transparency in reporting and governance, a point noted by the IMF and reported in the China Daily . They particularly point out the lack of truly independent directors in listed companies to represent their interests at board level and to scrutinise potential insider trading transactions. The Company Law in China sets out international best practice standards for board appointments to listed companies with the following vital safeguards for investors.
• A two-tier board: executive board and a supervisory board.
• Directors’ appointments should not exceed three years subject to reappointment procedures for any extension to the term of office.
• Executive boards should have at least two independent directors and should anyway comprise a minimum of one-third of the overall board.
• At least one independent director should be a professional accountant.
The law defines independent directors as those “who hold no posts in the company other than the position of director, and who maintain no relations with the listed company and its major shareholder that might prevent them from making objective judgment independently.” However, it is widely believed that these standards of governance are not followed in actual practice by boards. The power of nominated independent directors is questioned and China is still coping with a first generation of board directors who may lack the training and experience required for their role. Without truly independent directors on the board, strategic and financial decisions can be made in the interests of the management which may result in financial disadvantage to investors. It is not uncommon for Chinese investor websites such as chinalawedu.com to call for improvements in the corporate governance law and stronger enforcement measures by the CSRC.
CEIBS MBA student, Ted Yang, formerly a CPA auditor at KPMG’s Shanghai office, makes the link between corporate governance weaknesses, investor confidence and the lack of best practice accounting standards in Chinese listed companies. According to Mr Yang, although only a small number of companies have been prosecuted for fraudulent financial statements, he believes that the practice by listed companies of reallocating expenses and revenues between different accounting periods to avoid showing consecutive losses is prevalent. This is particularly the case by companies under special treatment by the Shanghai and Shenzhen Stock Exchanges who are working to retain their listing. In 2006, the Ministry of Finance issued a new set of accounting principles called Accounting Standards for Business Enterprises (“new PRC GAAP”) which have substantially converged with the International Financial Reporting Standards (IFRS). Every company listed on the Shanghai and Shenzhen stock exchanges were required to apply the new PRC GAAP. However, Mr Yang believes that there is a higher risk of accounting estimation failure in China than in Europe because of a lack of understanding of the PRC GAAP requirements such as the fair value approach and even a lack of care by accounting information users.
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