A Brief Review of Corporate Governance Issues in the People's Republic of China

1. A Brief Review of Corporate Governance Issues in the People's Republic of China Michael E. Burke, Honorary Fellow, Asian Institute of International Financial Law, Hong Kong University 2003 U.S.-China Legal Exchange

2. Defining Objective Corporate Governance Standards • Defining corporate governance: • Corporate governance relates to the internal means by which corporations are operated and controlled. • Objective standards: • The corporate governance principles promulgated by the Organization for Economic Cooperation and Development (OECD), available at the OECD’s website (www.oecd.org) are recognized as an influential, objective set of corporate governance principles and represent the first initiative by an inter-governmental organization to develop the core elements of a good corporate governance regime. • The Principles can be used as a benchmark by governments as they evaluate and improve their laws and regulations. They also can be used by private sector parties that have a role in developing corporate governance systems and best practices. 2003 U.S.-China Legal Exchange

3. OECD Principles • The Principles are divided into five (5) themes: • The corporate governance framework should protect shareholders’ rights. • The corporate governance framework should ensure the equitable treatment of all shareholders, including minority and foreign shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights. • The corporate governance framework should recognize the rights of stakeholders as established by law and encourage active co-operation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises. 2003 U.S.-China Legal Exchange

4. OECD Principles, Cont’d • The corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company. • The corporate governance framework should ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and the shareholders. 2003 U.S.-China Legal Exchange

5. General Observations About Corporate Governance in China: • Much has been accomplished but there is still much to do; in some areas, Chinese regulation predates similar U.S. regulation. • Corporate governance has moved to the center stage of Chinese enterprise reform: • The Fourth Plenum of the Chinese Communist Party's 15th Central Committee held in September 1999 adopted a decision that identifies corporate governance as the core of the modern enterprise system. • Commitments under the World Trade Organization add some urgency to tackle corporate governance issues in a comprehensive and systematic manner. 2003 U.S.-China Legal Exchange

6. General Observations About Corporate Governance in China: • legal framework has limited shareholder protection; • corporations with concentrated ownership predominate; • small shareholders are inactive in company oversight; • government influences management appointment and corporation operations; • too much power is concentrated in the hands of a few shareholders; and • at times, a lack of accountability for corporate actions or omissions. 2003 U.S.-China Legal Exchange

7. Concentrated Ownership • Three largest shareholders held, on average, about 58% of total shares in listed Chinese companies. • Average shareholding of the largest shareholders is about 47%. • In almost 49% of sample firms, the three largest shareholders accounted for 60 to 80% of all shares. • In PRC listed companies, the largest shareholder accounts for slightly less than 50% of all shares but controls more than 50% of board seats. • Directly or indirectly, the State selects almost 70% of all directors of all PRC listed companies. 2003 U.S.-China Legal Exchange

8. Concentrated Ownership, Cont’d • Other jurisdictions recognize the duty of fair dealing by majority shareholders in relation to minority shareholders. • Fiduciary duties of controlling shareholders are not stipulated in relevant law, their liabilities in relation to losses incurred by minority shareholders are not clear. • Recent PRC regulations implicitly introduce this principle without, however, spelling out liabilities, penalties, and procedures. • Documented abuses by controlling shareholders: • soft loans from listed companies on a long-term basis; • use of listed companies as guarantors for bank loans; and • the sale of assets at unfair prices, usually without an appraisal by an independent evaluator. 2003 U.S.-China Legal Exchange

9. Board Issues • Directors’ incentives may not be linked to their companies' return on equity or earnings per share growth. • Directors can not be dismissed (prior to the expiration of their term) without "cause," although such concept is not defined. • Directors owe the duties of good faith and due diligence and care towards the listed company and all the shareholders, although relevant law does not define these concepts further or create an enforcement mechanism. 2003 U.S.-China Legal Exchange

10. Board Issues, Cont’d • Compared with practices in other markets, Chinese boards have less decision-making power within the existing legislative framework, while government ministries and commissions and securities regulatory authorities have substantial decision-making power. • The Company Law does not stipulate any disclosure obligation on the part of directors or any specific liabilities assumed by directors who fail to perform their obligations. • Chinese corporations still lack nominating committees for directors and corporate governance committees and listed companies do not disclose their procedures for nominating directors or their corporate governance principles. 2003 U.S.-China Legal Exchange

11. Board Issues, Cont’d • A 1999 survey showed that only 3.1% of all directors had some degree of independence; in 2003, average listed company has 3 independent directors. • On August 16, 2001 the China Securities Regulatory Commission (CSRC) issued the Establishment of Independent Director Systems by Listed Companies Guiding Opinion (the Guiding Opinion), requiring 1/3 of Board directors to be independent. • Most listed companies do not have a system in place for establishing board committees. • Only 5.4% of surveyed listed Chinese companies have established any committee under the board of directors, and only 14% plan to set up such committees. • In those companies that do have committees, the committees are usually an investment or finance committee, an audit committee, a financial management committee, and/or a strategy committee. • The main functions of the committees focus on decisions concerning major investment projects, while their supervisory and auditing functions are at an early stage of development. 2003 U.S.-China Legal Exchange

12. Shareholders’ Issues • The Company Law requires every company to establish a shareholders' general meeting. • While every shareholder may attend a shareholders' general meeting, recent data indicates that most attendees are state representative and representatives of legal persons. • Not all companies have established a shareholders' general meeting, and there are indications that some boards of directors simply ignore the meeting's decisions. • Shareholders' general meeting sometimes will vet proposed actions with the Board before taking action. • Only about 20% of company actions are voted on at the shareholders' general meeting. 2003 U.S.-China Legal Exchange

13. Shareholder Protection Issues • The Supreme People's Court allows courts to hear only a very limited class of securities-related claims. • The remedy the Company Law provides to minority shareholders is that they may apply to the courts to prevent the continuation of unlawful conduct by directors and majority shareholders. • Existing laws and regulations do not specify penalties for corporations and officers that obstruct shareholders’ rights to access information. • Securities Law is unclear as to whether investors can take civil action against directors and investment professionals for false or negligent disclosures that resulted in losses. 2003 U.S.-China Legal Exchange

14. Shareholder Protection Issues • On January 9, 2003, the PRC Supreme People's Court (the SPC) promulgated the Trial of Civil Damages Cases Arising from Misrepresentation in the Securities Market Several Provisions (the Provisions), which entered into effect on February 1, 2003. The Provisions extend the Questions Concerning the Acceptance of Civil Tort Dispute Cases Arising from Misrepresentation in the Securities Market Circular (the Circular) issued and effective January 15, 2002. • The Provisions discuss acceptance of cases and jurisdictions, methods of bringing lawsuits, determination of misrepresentation, liabilities determination and exemption, joint tort liability, calculation of loss and miscellaneous. As defined in the Provisions, misrepresentation can include fraudulent records, misleading statements, material omissions and improper disclosure. • The Provisions deal only with misrepresentation made by public companies and not share price manipulation or insider trading. • The Provisions exclude a class action litigation as a permitted channel for investors to bring a lawsuit. 2003 U.S.-China Legal Exchange

15. Disclosure Issues • Financial reporting, accounting practices, and disclosure are oriented toward satisfying the information needs of taxation authorities. • Separate reporting for tax and accounting purposes does not exist. • Inadequate disclosure of related party transactions, line segment information, accounting policies, impact of extraordinary items, contingencies, capital commitments, and effects of changes in government policies. • The regulations do not require the distribution of annual reports to shareholders. 2003 U.S.-China Legal Exchange

16. Disclosure Issues, Cont’d • Disclosure in annual reports is governed by detailed requirements that focus on short-term rather than long-term objectives and strategies, do not sufficiently emphasize business opportunities and risks, are lenient on segment reporting and corporate governance, and discourage the use of projections. • Multiple bases for preparing and auditing financial statements also affects the quality of information. • Some companies follow IAS, others use U.S. GAAP, and still others follow domestic standards. • Variable quality of audits by certified public accountants. 2003 U.S.-China Legal Exchange