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ADAPTATION AND CONVERGENCE IN CORPORATE GOVERNANCE: THE

CASE OF CHINESE LISTED COMPANIES


Iain MacNeilÂ

INTRODUCTION

Prior to 1978, private enterprise had been effectively eliminated in China as a result
of central (state) planning of the economy. Recent years have, however, seen a
transformation. The economic reform process, which began in 1978, has led to
fundamental changes in enterprise organisation, a re-definition of the role of the state
and recognition of a role for private capital and private enterprise. The main elements
of that process have been the introduction of company and securities law, conversion
of state-owned entities into companies and listing of these companies on the Stock
Exchanges. From this process, there has emerged a group of public listed
companies, which represent a substantial part of China’s economy. A more recent
development has been the introduction of Corporate Governance Guidelines for
listed companies.

The creation of the legal and institutional framework which supports listed companies
in China raises a number of interesting issues. First, as company and securities law
had to be created ab initio so as to allow for the participation of private capital in the
economy, China provides a real example of the choices available in the design of a
corporate governance framework. A number of basic issues had to be addressed.
One was definition of the rights of shareholders and other stakeholders. Another was
the structure of the legal rules and in particular the balance between mandatory and
default rules. The rights of minority shareholders were also an important
consideration if private capital was to participate in the newly formed stock
exchanges. Second, the Chinese experience in establishing a regulatory regime for
listed companies provides some indication of the extent to which convergence
towards international norms is a significant force in corporate governance. This is of
particular interest in China, in view of the stated objective of the company and
securities law of promoting a “socialist market economy”. In particular, the experience
in China may provide some guidance as to elements of the corporate governance

Â
The Law School, University of Aberdeen. Research for this article was undertaken during a term of
sabbatical leave spent in Hong Kong and China. I am grateful to the Leverhulme Trust for financial
support; to the Hong Kong Baptist University for the provision of research facilities; to Alex Lau of
HKBU for translating Chinese legal materials; and to the many LLM alumni of Aberdeen University
who provided valuable assistance, particularly Zhou Xinguo, my research assistant.

NewCGin PRC - 25/04/02 1


framework effectively mandated by global capital markets and the residual power left
to individual countries to pursue their own objectives. Third, the Chinese experience
provides an interesting example of the interaction of two alternative approaches to
corporate governance. One approach is to focus on the internal governance
mechanisms of the company, and in particular the role allocated by the company
constitution to the company’s organs of governance such as the board of directors
and shareholders’ meeting. Another approach is to focus on external regulation of the
company (either by courts or regulatory agencies) through rules relating to matters
such as employment contracts and environmental standards. The Chinese
experience provides an interesting perspective particularly in relation to external
regulation, which, unlike most countries in the west, has been pursued through
extensive state ownership of listed companies and intensive regulation of the
financial markets.

This paper aims to examine the emergence of listed companies in China from the
perspective of these issues. It begins by reviewing the current debate on comparative
corporate governance. This is followed by a short history of enterprise reform in
China and identification of the main features of the corporate and securities laws,
which were introduced as part of the reform process. The role envisaged for private
capital and shareholders in the Chinese system is then analysed. This leads on to a
discussion of the manner in which the state regulates the operation of financial
markets and directly influences listed companies through its role as controlling
shareholder. An important element of the state’s control over listed companies is the
legal framework for the operation of the board of directors, which is analysed from
the perspective of the structure, composition and role of the board of directors.
Finally, the paper considers the role of minority shareholders in Chinese listed
companies in the context of recent research demonstrating close links between
minority shareholders’ rights and the development of capital markets.

A. ADAPTATION AND CONVERGENCE IN CORPORATE GOVERNANCE

National systems of corporate governance can be placed at some point on an axis


between two extremes, the shareholder model and the stakeholder model. The
shareholder model takes the maximisation of shareholder wealth as the primary

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objective of the company.1 In this model corporate governance is characterised
largely as a set of solutions to the principal (shareholder)/agent (manager) problem
which arises from the separation of ownership and control in the modern company.
The essence of the principal/agent problem is that (a) the interests of the managers
may not always be aligned with that of the owners and (b) it is not possible ex ante
for the owners to specify the manner in which their capital should be employed (or
put another way, the principal/agent relationship in the corporate context is a classic
example of an incomplete contract). Corporate governance, as a set of solutions to
the principal/agent problem, has three main aspects. First, aligning the incentives of
managers with owners (e.g. through various forms of share ownership). Second,
protecting shareholders from expropriation by managers (e.g. through self-dealing).
Third, making managers accountable through mechanisms such as the market for
corporate control, which is assumed to make poorly performing companies
susceptible to takeover and the incumbent management susceptible to removal by a
successful bidder. The shareholder model is essentially a creation of market
expectation because it seems doubtful that there is (at least in the United Kingdom)
any legal duty imposed on directors to maximize shareholder value.2

The stakeholder model takes a broader view of a company in which it is viewed as


being responsible to a wider constituency. While this wider constituency may in the
past have been regarded as open-ended, the “new” stakeholder model adopts a
more restrictive approach, categorising stakeholders as those who have contributed
firm-specific assets3 or (in less technical terms) those who enter into long-term co-
operative relationships with the company.4 Employees are always regarded as falling
into the category of stakeholders, but customers and suppliers may or may not be
regarded as stakeholders depending on their relationship with the company. The
nature of a stakeholder’s interest in a company differs from that of a shareholder in
that (a) there is no convenient unit for measuring stakeholder interest analogous to

1
For a justification of such an approach see A. K. Sundaram and A.C. Inkpen, “The Corporate
Objective Revisited” at ssrn.com.
2
See S. Worthington, “Shares and shareholders: property, power and entitlement (part 2)” 22(2)
Company Lawyer 307 (2001).
3
See M. Blair, Ownership and control: rethinking corporate governance for the twenty-first century,
Brookings Institute, Washington DC (1995).
4
See J. Parkinson, “Company Law and Stakeholder Governance” p149 in G. Kelly, D. Kelly & A.
Gamble (eds.) Stakeholder Capitalism (Macmillan 1997). Parkinson’s proposals for reform of UK
Corporate Governance include (a) the reformulation of directors’ duties to accommodate stakeholders’
interests and (b) the introduction of a two-tier board to facilitate a stakeholder approach. See also G.
Kelly and J. Parkinson, “The Conceptual Foundations of the Company: a Pluralist Approach” in J.
Parkinson, A. Gamble & G. Kelly (eds.), The Political Economy of the Company, (Hart Publishing,
2000).

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the role performed by the company share (b) there is no presumption of equality
between different stakeholders. In common law legal systems, the tendency has
been for the shareholder model to predominate, but within that there have been, at
different stages in the history of the company, differing perceptions of the respective
roles of the shareholders and the board of directors.5

A number of influences have been identified in the development of national systems


of corporate governance, although it is not always clear whether these factors are the
cause or outcome of systems of corporate governance.6 Berle & Means identified
ownership structure as a key issue in 1931.7 The consequences, in their view, of the
widely-dispersed structure of share ownership which had emerged in the United
States was that directors’ powers had expanded to a point where they were virtually
in control of public companies, with shareholders being largely powerless. Berle &
Means classic analysis is now seen as having less relevance in a world in which
widely-dispersed share-ownership is the exception rather than the norm and in which
it is no longer apparent that widely-dispersed share-ownership will lead per se to
inferior monitoring of management by shareholders.8 The more recent focus on
ownership structure has been on two issues. First, to compare the operation of
market-based systems of corporate governance, in which share-ownership is
relatively dispersed and financial markets play a major role in monitoring company
performance, with “blockholder” systems, in which most public companies have a
controlling shareholder and banks play a more significant role in corporate
governance than financial markets.9 The main conclusion is that there no ideal model
of corporate governance. Both systems have advantages and disadvantages. The
market-based system emphasises disclosure of financial information so as to allow
shareholders to make informed decisions but tends to encourage a short-term focus
on performance and exit rather than voice. The blockholding system allows the
development of long-term relationships between shareholders and companies but

5
See J. Hill, “Visions and Revisions of the Shareholder” 68 Am Jnl Comp Law 39 (2000).
6
See generally, M. Bradley, C. Schipani, A. Sundaram and J. Walsh, “The Purposes and
Accountability of the Corporation in Contemporary Society: Corporate Governance at a CrossRoads”
62(3) (1999) Law and Contemporary Problems 9.
7
A Berle and G Means, The Modern Corporation and Private Property (Transaction Publishers NJ
1991)
8
See H. Demsetz and K. Lehn, “The Structure of Corporate Ownership: Causes and Consequences”,
93(6) Jnl Political Economy 1155 (1985).
9
See N. Dimsdale and M. Prevezer, Capital Markets and Corporate Governance (Clarendon Press,
1994) for an extensive discussion of the relative roles of banks and financial markets in the UK,
Germany and Japan. See M. Maher and T. Anderson, “Corporate Governance: Effects on Firm
Performance and Economic Growth” in Renneboog L., McCahery J., Moerland P. and Raaijmakers T.
(eds.) Convergence and Diversity of Corporate Governance Regimes and Capital Markets (OUP 2000).

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tends to suffer from lower standards of disclosure and the appropriation of private
benefits by controlling shareholders at the expense of minorities. Second, to explain
why the market-based system emerged in some countries and the blockholder
system in others. Several theories have been put forward. Easterbrook and Fischel10
have argued that efficiency considerations are the main factor in the evolution of
corporate governance structures: as the market prices the governance scheme,
companies are forced to adopt the most efficient structure or else suffer a competitive
disadvantage in the same was as if, for example, their raw materials were more
expensive than those of competitors.11 Roe has explained the evolution of the
American system of corporate finance, characterised by relatively widely dispersed
share ownership and reliance on the monitoring function of financial markets, as the
result of politically-driven regulation of the financial sector, which was intended to
prevent excessive economic power being concentrated in too few hands. Underlying
the process of regulation was fear of the power of large corporations and trusts, an
ideological bias in favour of small business and the influence of interest groups (such
as small banks) who favoured fragmentation of financial power.12 The evolution of
shareholder voting rights in the United States and Europe has also been promoted as
a significant influence in the development of national systems of corporate
governance.13 According to this view, the one-vote-per-share rule, adopted in
corporation charters from the mid-nineteenth century onwards so as to displace the
old common law default rule of one vote per member, combined with the emergence
of anti-trust law later in the same century, contributed to the emergence of tightly-
controlled and industrially-concentrated companies in the United States. In Europe,
the survival of graduated voting scales into the twentieth century, combined with a
lack of anti-trust law, resulted in a broader distribution of shareholder power and
more reliance on cartels than mergers. A very different explanation is offered by La
Porta, Lopez-de-Silanes, Shleifer and Vishny (hereafter “LLSV”) who link the
emergence of financial markets to the development of investor protection regimes in

10
F. Easterbrook and D. Fischel, The Economic Structure of Corporate Law (Cambridge MA, Harvard
University Press 1991).
11
In its most extreme form, the “Chicago school” explanation of corporate governance formulated by
Easterbrook and Fischel is an irrelevance theorem in which there is no need for the law to intervene in
corporate governance structures as market forces will require them to evolve to their most efficient
form. A milder version of this view is provided by Andrews, “Corporate Governance Eludes the Legal
Mind” 37 U Miami L. Rev. 213, 214-21 (1983).
12
See M J Roe, “A Political Theory of American Corporate Finance” 91 Colum L. Rev. 10 (1991).
13
See C A Dunlavy, “Corporate Governance in Late 19th Century Europe and the United States, The
Case of Shareholder Voting Rights” in Hopt, Konda, Roe, Wymeersch, Prigge (eds) Comparative
Corporate Governance (OUP, 1998).

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different countries and in particular to the protection given to minority shareholders.14
The essence of their thesis is that strong minority protection is necessary to
encourage an equity culture and that unless this occurs, shareholders can only
protect themselves through the accumulation of the power associated with
blockholding. Path-dependence has also been viewed as a significant factor in
determining national systems of corporate governance. One version of its role is that
the corporate structures at any point in time will depend on those that existed at the
outset, and that corporate rules affecting ownership will also depend on those initial
structures.15 Another is that differing national cultures and values can de directly
associated with characteristics of a system of corporate governance and are likely to
defeat attempts to import elements of governance systems from countries with
fundamentally different culture and values.16

The extent to which there is, or should be, convergence in national systems of
corporate governance towards one model is a matter of some dispute. Some
commentators have argued for the superiority of the “shareholder value” system of
corporate governance in the United States, pointing to its increasing acceptance
worldwide and predicting its eventual worldwide hegemony.17 Others have adopted a
much more cautious view of convergence, recognising that there are unique
institutional and cultural factors operating at the national level which preclude the
importation of foreign governance systems. Put another way, for convergence to
occur, features of corporate governance within one system must be detachable and
so capable of transfer from one system to another: the more they are embedded in a
unique institutional or cultural setting in one country the less detachable they will
be.18 To the extent that convergence is predicted, the main driving force identified is
efficiency in governance structure, at least as viewed by investors in the global
capital market in which the “shareholder value” model dominates. A broader view,
however, would regard convergence in corporate governance as a sub-set of a more

14
See LLSV, “Legal Determinants of External Finance” 52(3) Jnl of Finance 1131 (1997); “Law and
Finance” 106(6) Jnl of Political Economy 1113 (1998); “Investor Protection and Corporate
Governance” at ssrn.com (update reference).
15
See L.A. Bebchuk and MJ Roe, “A Theory of Path Dependence in Corporate Ownership and
Governance” Columbia Law School Center for Law and Economic Studies Working Paper no 131 at
ssrn.com.
16
See A N Licht, “The Mother of All Path Dependencies, Towards a Cross-Cultural Theory of
Corporate Governance Systems” at ssrn.com.
17
See H. Hansmann and R. Kraakman, “The End of History for Corporate Law” at ssrn.com.
18
See W. Bratton & J. McCahery, “Comparative Corporate Governance and the Theory of the Firm:
The Case against Global Cross Reference” 38 Colum. J. Transnat’l L. 213, who present a useful matrix
for comparative corporate governance analysis at p17. See also E B Rock, “America’s Shifting
Fascination with Comparative Corporate Governance” 74 Wash U.L.Q. 367.

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extensive process of convergence in the structure and operation of capitalist systems.
From this perspective, the main driving force is the speed of technological change,
which, by making production more capital-intensive, encourages the globalisation of
product and financial markets.19

If some degree of convergence can occur, what form will it take? Gilson provides a
useful categorisation of the different forms of convergence that occur in the field of
corporate regulation. Formal convergence involves change in the legal infrastructure
and therefore requires political support and resort to the legislative process. This type
of convergence is often associated with international harmonisation in the form of
treaties, conventions or legislation made by supranational bodies.20 The most
significant step in this direction to date has been the limited harmonisation of
company and securities law in the European Union although the proposals made by
IOSCO for International Disclosure Standards may well represent a more significant
future development for listed companies.21 Functional convergence occurs without
any formal legal change in circumstances in which the existing regulatory
mechanisms are sufficiently flexible to respond to new circumstances without the
need for formal change. The process by which the Combined Code of Corporate
Governance has been developed and implemented in the United Kingdom could be
cited as an example of such a process: the development occurred outside the formal
legal and regulatory framework and the Code itself is appended to but does not form
part of the UKLA Listing Rules. Contractual convergence occurs when the existing
regulatory framework lacks the flexibility to adapt to new circumstances without
formal changes and an ad hoc solution is adopted through the medium of contract.22
Contractual techniques can move relatively easily from country to country without any

19
See S. Strange, “The Future of Global Capitalism; or, will divergence persist forever?” in C. Crouch
& W. Streeck, Political Economy of Modern Capitalism, Mapping Convergence and Diversity (Sage
Publications 1997). Associated with the process of convergence, in Strange’s view, are (a) a decline in
state sovereignty (b) asymmetry of regulatory power among states (with the USA predominant) (c)
denationalization of firms, who adopt a multinational perspective (d) increased government reliance on
financial markets as a result of the latter’s role in funding current spending through government bond
issues.
20
Proposals for formal convergence can also emerge from private sources: see e.g. Black &
Kraakman’s proposal for a self-enforcing model of corporate law, developed from models adopted in
the privatization process in eastern Europe (B. Black and R. Kraakman, “A Self-Enforcing Model of
Corporate Law” 109 Harv. L. Rev. 1911). See also J. Coffee Jnr. “The Rise of Dispersed Ownership:
The Role of Law and the Separation of Ownership and Control” at ssrn.com.
21
The proposal aims to establish minimum international standards for listing particulars and
prospectuses, thereby making possible multiple listing based on a single document. See D W Arner,
“Globalization and Financial Markets: An International Passport for Securities Offerings?” ???
22
Gilson cites as an example the contract terms that are typically adopted in venture capital limited
partnerships providing for distribution of the proceeds of investments that become liquid and the
liquidation of the partnership after a fixed period.

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need for change in the legal or regulatory framework. On the one hand, widespread
usage of ad hoc contractual governance techniques may indicate a failure of formal
legal and regulatory techniques to deliver appropriate forms of governance
mechanism. On the other hand, such usage may indicate the superiority of
contractual techniques as a governance mechanism by comparison with regulation
(e.g. as a result of their inherent adaptability) and suggest a re-evaluation of the
extent to which regulation is appropriate. Such an assessment of the appropriate role
of regulation by comparison with private ordering through contract parallels the
debate in company law over the appropriate balance between mandatory and default
rules.23

Transposing this background to the context of corporate governance in Chinese


listed companies, a number of issues emerge. First the institutional and cultural
setting in China is quite different to the west and to the countries of the former Soviet
bloc. China has not, as was the case in the former Soviet-bloc countries, undergone
a rapid transition from a planned economy to a market economy. Market-based
reforms and adoption of the corporate form for enterprises were adopted in China as
a pragmatic solution to poor economic performance under state planning.24 They
were grafted onto an ideological position that remained essentially collectivist and
socialist in its outlook.25 Experimentation with the corporate form in China therefore
provides some indication of the inherent adaptability of the corporate form to
accommodate considerations wider than those dominating the “shareholder value”
model of corporate governance that is prevalent in the west. Second, Chinese listed
companies provide a practical example of the extent to which the global capital
market can drive convergence in corporate governance in an ideological environment
in which markets are regarded as means to end in a socialist society rather than an
end in themselves. This helps answer the question of the extent to which corporate
governance features are portable. It also provides some indication of how the overall
system of enterprise organisation can be structured within a socialist society so as to
accommodate global capitalism but allow the survival of other forms of organisation
that are more inherently socialist in their structure.

23
See J. Gordon, “The Mandatory Structure of Corporate Law” (1989) 89 Columbia Law Review 1549.
24
The inherent pragmatism of China’s reform process is typified by the analogy used by Deng
Xiaoping in 1962 to refer to reform of the system of production. He used a popular Sichuan saying, “It
does not matter if it is a yellow cat or a black cat as long as it catches mice.” While this may have
lacked resonance in the 1960’s (Deng was purged during the Cultural Revolution), it later came to
typify the post-1978 reform process. See Lan Cao, “The Cat that Catches Mice: China’s Challenge to
the Dominant Privatization Model” (1995) 21 Brook. J. Int’l L 97.

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B. ENTERPRISE REFORM IN CHINA

The process of economic liberalization in China, from which listed companies


eventually emerged, can be traced back to 1978 when the Communist Party resolved,
beginning in 1979, to focus the party's work on "socialist modernization".26 This
change in policy away from state control of the economy and the effective exclusion
of private enterprise, recognized that China's economy had under performed for
many years, a realisation made particularly clear by the close proximity of several
examples of strong economic performance, such as Taiwan, Korea, Hong Kong and
Singapore (the “four little dragons”). The most important aspect of the modernization
was the gradual recognition of the role of private enterprise.

Practical development occurred first in the form of authorisation being given for
individual businesses to engage a maximum of five employees.27 The 1982
Constitution recognized the role of individual business by providing for the protection
of its lawful interests. In association with reform of the rural economy, in which the
majority of the Chinese population is employed, the relaxation of state control
resulted in the emergence in the 1980’s of a new and rapidly growing non-state
sector in which Town and Village Enterprises (TVEs) 28 and joint ventures with foreign
capital participation played a significant role. By 1988, the acceptance of the role of
private business was sufficient to result in an amendment to the Constitution so as to
refer expressly to the role of the private economy as a complement to the socialist
economy.29 Later in 1988 the State Council30 provided a basis for the authorisation

25
For a review of the ideological context within which enterprise reform in China has been pursued,
see G. Crane, “Globalization in China” 4(2) New Political Economy (1995) 215.
26
See A W Connor, "To get Rich is Precarious: Regulation of Private Enterprise in the People's
Republic of China", Journal of Chinese Law, Spring 1991 1.
27
For a discussion of these regulations and more generally on the history of the emergence of private
business in China see W. Kraus, Private Business in China (University of Hawaii Press 1991).
28
TVEs are collective enterprises under the ownership and nominal control of governments at the local
township, provincial and village level. They emerged as the post-1978 reforms permitted local
governments to promote and engage in business. For an assessment of their significance to the Chinese
economy, see H G Broadman, “The Businesses of the Chinese State” at ssrn.com. On TVE ownership
structure, see H. Williams, “Property Rights and Legal Reform in Township and Village Enterprises in
China” 2 Asia-Pacific Law and Policy Jnl 227 (2001).
29
The relevant article (11) was subsequently amended in 1999 to provide greater emphasis to the
private sector. The words “The individual economy of urban and rural working people, operating
within the limits prescribed by law, is a complement to the Socialist public economy” was replaced by
the words “the non-public sector, including individual and private businesses, is an important
component to the socialist market economy”. See the Constitution of the PRC at
http://www.qis.net/chinalaw and J. Chen, Chinese Law, Towards an Understanding of Chinese Law Its
Nature and Development (Kluwer 1999) Chap 3 (Constitutional Law).

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and control of private businesses that employed more than eight people by issuing
the Preliminary Regulations for Private Business. In 1992, the Fourteenth National
Congress of the Communist Party of China adopted the policy of establishing a
socialist market system and gave priority to reforming State Owned Enterprises
(SOEs).31 The main focus was on separating SOEs from the government
bureaucracy within which they had operated in the past and consequently to allow
them to operate independently from the government.32

This policy was pursued in four different ways.33 First, the introduction of business
autonomy: the State Enterprise Law of 1988 recognised SOEs as legal persons
separate from the state and defined the operational spheres of autonomy of SOEs
while a "contract responsibility system" was introduced to enhance the accountability
of SOE management. 34 This was followed by the introduction of fourteen
autonomous rights for SOEs in 1992, intended to enhance the autonomy of SOE
managements. Second, the transformation of SOEs into shareholding companies, a
process generally referred to as “corporatization”. This policy was implemented by a
series of administrative measures which recognised and created mandatory standard
forms for two types of company: Limited Liability Companies, which are broadly
comparable to private companies in the UK and Joint Stock Companies which are
broadly comparable to public companies in the UK.35 Corporatization had the effect

30
The State Council is the executive body of the National People’s Congress (NPC), which is the
“supreme organ of state power” (article 57 of the PRC Constitution). It includes the Premier, Vice-
Premier and Ministers. As the NPC meets only once a year for several weeks, much of the detail of law
making is delegated to the State Council.
31
State-owned enterprises are those with at least 51% state ownership and annual sales of at least RMB
5m (US$0.6m approx). In principle, this definition can include listed companies but the term is most
commonly applied to state enterprises that have not been listed.
32
For a discussion of the problems which had in the past plagued SOEs and held back progress in the
Chinese economy see Mai Yinhua & F. Perkins, China's State Owned Enterprises, (EEAU Briefing
Paper No 7, Dept. of Foreign Affairs and Trade Australia 1997). For an assessment of the current
position of SOEs in the Chinese economy see H.G. Boardman, “The Business (es) of the Chinese
State” at ssrn.com.
33
See China's Management of Enterprise Assets: The State as Shareholder (World Bank Country
Report, 1997 Washington DC).
34
The contract responsibility system, which had already been introduced prior to widespread
corporatization with objective of improving accountability, improved SOE performance. See Groves,
Hong, McMillan & Naughton, "Autonomy and Incentives in Chinese State Enterprises" 109(1)
Quarterly Journal of Economics (1994). See also Lan Cao (above n24) for a discussion of the system
in rural reform.
35
The relevant measures were mainly (1) The Measures for Experimental Joint Stock Enterprises (May
15, 1992) issued jointly by the State Commission for the Restructuring of the Economic System, The
State Economic Planning Commission, the Ministry of Finance, the People’s Bank of China (The
Central Bank) and the Production Office of the State Council (2) The Opinions for the Standardization
of the Experimental Joint Stock Companies (May 15, 1992) issued by the State Commission for the
Restructuring of the Economic System (3) The Opinions for the Standardization of the Limited

NewCGin PRC - 25/04/02 10


of formalising the separation of state from SOEs, as the state became a shareholder
rather than the direct owner of productive assets. This resulted in state control having
to be directed through the mechanisms provided by corporate law rather than being a
simple emanation of state authority. It also provided a long-term strategy for
integrating the state-owned sector of the economy into the global capital market, a
necessary adjustment if China were to fully embrace the concept of a market-
economy. The more immediate reasons for the process of corporatization were,
however, the inability of state firms to remain self-financing and solvent and the
desire of the state to tap into a pool of private capital in the non-state sector outside
its control.36 The availability of a substantial pool of private capital, held primarily in
bank deposits37, made it possible for the state to envisage a re-organisation of SOEs
that involved a substantial injection of new capital and not simply a re-allocation of
ownership rights through privatization. The third element of the policy was
clarification of the role of the state as owner. The Supervision Regulations38
introduced in 1994 provide the legal basis for the system under which the state owns
and supervises companies. State ownership is organised through a network of
organisations at the national, provincial, municipal and district level. Ultimate
responsibility rests with the State Council, which, as representative of the people, is
the ultimate owner of the state shareholdings. The fourth element of the policy was
clarification of the role of the state as regulator. This was necessary because in the
past the role of the state as regulator and owner had been merged.39 The opening-up
of ownership in SOEs to the public, through shareholding, in principle required that
the role of the state as regulator and owner be separated, although, as noted later,
there remains some confusion between these roles.

Mass privatization, in the form pursued in Russia and other "eastern-bloc" countries40,
has not been a feature of the re-organization of state owned enterprises in China

Liability Companies (May 15, 1992) issued by the State Commission for the Restructuring of the
Economic System.
36
See Lan Cao (above n24).
37
By 1996, bank deposits represented 56% of GDP; see R Gordon and Wei Li, “Government as a
Discriminating Monopolist in the Financial Market: The Case of China” Darden Graduate School of
Business Administration, University of Virginia Working Paper No 01-20 at ssrn.com.
38
Regulations Governing the Supervision and Management of State-Owned Enterprises' Property
(1994).
39
The World Bank commented in 1997 (above n33 at p38) on the confusion of the role of government
as shareholder and regulator "Overall, in the absence of more substantive "separation", these
[ownership] structures face inherent internal contradictions between governmental and shareholder-
ownership incentives. In such circumstances, the scope of reform they can accomplish is very narrow."
40
See J. Nellis, “The World Bank, Privatization and Enterprise Reform in Transition Economies: A
Retrospective Analysis” (at ssrn.com), for an account of privatization in Poland, Czechoslovakia and
Russia. The rationale for such mass privatization is explained by Wardle and Towle as follows: ".. it

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even when those enterprises have been transformed into listed companies.
Corporatized SOEs have been listed on the Stock Exchanges and have raised new
capital but the state has generally retained a controlling shareholding. In effect, China
has rejected the conventional wisdom41 underlying privatization in Russia and
elsewhere, that fundamental changes in ownership rights are necessary to transform
the performance of inefficient state enterprises.42 The dominant model of privatization
was the big-bang approach in which there was a rapid change from state planning to
a market economy dominated by newly privatized companies. What emerged in
China differed in several important respects.43 First, enterprise reform left in place a
wholly state-owned but organisationally reformed sector, which still plays an
important, albeit reduced, role in the economy. Second, there emerged from the
ranks of SOEs a group of companies which were listed on the stock exchanges and
issued shares to the public, but in which the state was controlling shareholder. Third,
the reform process gave rise to a vibrant non-state sector, comprising listed
companies with no state interest, TVEs and joint ventures, which have enjoyed rapid
growth.44

C. CORPORATE GOVERNANCE: THE LEGAL FRAMEWORK IN CHINA

Two features of a particularly Chinese character were evident in the development of


shareholding companies. The first was that the formal legal framework, represented
by the company law, was put in place at a relatively late stage. By the time the

serves the political purpose of entrenching the break with the past by giving each citizen the
opportunity to have a personal stake in their country's income-producing assets, thereby reducing
support for any future attempts to nationalize. It also provides an expectant public with a tangible sign
of the political changes and compensation for past hardship and deprivation of individual rights" (D.
Wardle and N. Towle, "Global Privatization" in International Privatization p7 (eds. D. Campbell and B.
Hollywood, Kluwer, London 1996).
41
The conventional wisdom was evident in the approach of the World Bank and was supported by a
background of successful privatization in developed economies such as the UK Canada and New
Zealand as well as a growing academic literature linking privatization with improved financial
performance. See J. Nellis (above, note?) and S Djakov and P Murrell, “The Determinants of
Enterprise Restructuring in Transition Economies” World Bank. September 2000. (see p76 of Nellis
Article).
42
For a discussion of the potential effects of privatization on the economy, see A. Schipke, Why do
Governments Divest? The Macroeconomics Of Privatization (Springer-Verlag, Berlin-Heidelberg,
2001) and J.J. Laffont and J. Tirole, "Privatization and Incentives", 7 Journal of Law, Economics and
Organization 84-105.
43
For a general discussion see Lan Cao (above n24).
44
While SOE’s share of the output of Chinese industrial enterprises fell from 47% to 28% between
1993 and 1999, the share of individually owned enterprises rose from 8% to 18%, collectives
(including TVEs) from 34% to 35% and “others” (including companies with either a minority or no
state shareholding) from 11% to 26%. See H G Boardman (above n32).

NewCGin PRC - 25/04/02 12


Company Law45 became effective on 1 July 1994, many companies had already
been established and the process of corporatization of SOEs was well established.
The formation of companies had in fact even preceded the "Standard Opinions"46,
with several companies being formed in the 1980s47. This pattern of development
can be associated with the Chinese tendency to subordinate law to government (and
hence party) authority and to exercise detailed administrative control over economic
activities rather than permitting activity within a range defined by law. The need to
take account of the socialist structure into which the corporate form was being
introduced also delayed the passage of the Company Law. The second feature is the
experimental and localized manner in which the early forms of regulation of
shareholding companies was developed. Particularly significant in this respect were
the regulations48 adopted in Shanghai, which had strong pre-communist trading links
with the west, and Shenzhen, a recently established city designated as a "special
economic zone (SEZ)"49, occupying an important strategic position on the Pearl River
delta between Hong Kong and Guangzhou. This process reflected both the
considerable decentralization50 of government in China to the provincial level
(permitting provincial and city authorities to introduce such regulations) and also a
willingness to experiment with the corporate form at a local level before adopting a
national measure.

The Chinese Company Law has a number of distinctive features.

45
For an assessment of the company law see K.T. W. Ong and C.R. Baxter, "A comparative study of
the fundamental elements of Chinese and English Company Law" 48 ICLQ 88 (1999); N.C. Howson,
"China's Company Law: One Step Forward, Two Steps Back? A Modest Complaint" 11:1 Columbia
Journal of Asian Law 127 (1997); Png Cheong Ann, "Some concerns about Chinese company law",
17(7) Company Lawyer 199 (1996); Lawrence Liu, “Chinese Characteristics Compared: A Legal and
Policy Perspective of Corporate Finance and Governance in Taiwan and China” at ssrn.com.
46
These were the administrative regulations that preceded the Company Law. See footnote 35 above.
47
See Fang Liufang, “China’s Corporatization Experiment” (1995) 5 Duke J. Comp. & Int’l L. 149.
Companies created under ad hoc administrative measures in the 1980’s and the 1992 "Standard
Opinions" are the subject of a "grandfathering" provision in article 229 of the company law, which
provides that such companies shall continue to be recognized but are required to meet the requirements
of the company law within a timescale set by the State Council.
48
The Shanghai and Shenzhen Trial Measures (sometimes referred to as the Interim Measures).
49
Shenzhen was one of five SEZs, the others being Xiamen in Fujian Province, Zhuhau, Shantou in
Guangdong Province and (later) Hainan Island. The purpose of the SEZs was to facilitate interaction
with the global economy on a limited basis.
50
See S. Breslin, “Decentralization, Globalization and China’s Partial Re-engagement with the Global
Economy” 5(2) New Political Economy (2000) 205 for a discussion of this process.

NewCGin PRC - 25/04/02 13


(a) There is extensive state regulation of company formation. Approval
must be obtained from the relevant government departments in addition to
satisfying the requirements of the company law.51
(b) Two types of company can be formed with private capital. They bear
some resemblance to private and public companies in the UK but there
are some differences. A limited liability company (LLC) must have
between two and fifty shareholders and cannot offer its shares to the
public. Shareholders have pre-emption rights over any sale of shares by
another shareholder, resulting in a closed shareholding structure. Joint
Stock Companies (JSCs, sometimes referred to as companies limited by
shares) are designed to allow capital to be raised through public share
issues. JSCs can be formed either by the public subscription method or
the promotion method. The former requires no less than 35% of the
capital to be subscribed by the promoters (the remaining 65% being
offered to the public) whereas the latter involves the promoters taking up
100% of the shares. Formation by the promotion method does not in itself
require listing, but as a public offering normally follows formation by the
promotion method, it is normal for such JSCs to be listed.
(c) The Chinese concept of the legal personality of a company differs from
western models. This is most apparent in two areas. First, every company
must have a “legal representative”, who is the natural person authorised
to act on behalf of the company. The legal representative bears greater
liability than an ordinary director of a Chinese company (both in respect of
civil and criminal law) and also greater liability than a director in a UK
company.52 This qualifies the separate legal liability of the company by
interposing a human agent who acts as the personification of the
company. Second, the company law53 provides that the state assets of a
company belong to the State. This provision appears to have resulted
from confusion over the ownership rights of the state in former SOEs.
Following corporatization, the state exchanged direct property rights over
enterprise assets for a shareholding in a company that has separate legal
personality and owns the enterprise assets. By recognising continuing

51
See article 77 (approval) and article 73 (conditions) in respect of JSCs. The relevant government
departments are the State Administration of Industry and Commerce (SAIC) or the Ministry of Foreign
Trade and Economic Co-operation (MOFTEC) for foreign-owned companies.
52
See Ong and Baxter (above n45) p119.
53
Article 4.

NewCGin PRC - 25/04/02 14


state ownership over assets in companies, the company law creates
confusion over property rights.54
(d) There is more extensive reliance on mandatory rules in the structure of
Chinese company law than is the case in common law jurisdictions,
indicating a rejection of the contractarian model of company law.55 This is
evident both in the Company Law itself and in the mandatory nature of the
articles of association. The company law, for example, requires
administrative approval for the incorporation of a company and sets
financial conditions for companies issuing shares. Such controls
generally have no counterpart in the west. All Chinese listed companies
are required to adopt standard articles of association and changes are
subject to regulatory approval56, with the result that tailoring of the
governance structure to individual circumstances is limited. The standard
articles differ for domestic and overseas companies.57 There is also
extensive reliance on the criminal law to punish breaches of the company
law, rather than reliance on private action.
(e) Despite the rejection of a contractarian model of company law
apparent in the heavy reliance on mandatory rules, the Articles of
Association have a contractual status that appears to be even more
extensive than the concept of the articles as "statutory contract" in the UK.
The latter is a contract between the company and shareholders and
between shareholders inter se. The standard articles (both domestic and
overseas58) envisage a contract with the following pattern of enforcement:
company versus shareholder (and vice-versa); shareholder versus
shareholder; shareholder versus director, supervisor, manager or other

54
On this issue, and its implications for rights on winding-up, see Howson (above n45) p142 and Png
Cheong Ann, “Some Concerns about Chinese Company Law” (1996) 17(7) Co Law 199,200.
55
On models of company law and the structure of its rules see I MacNeil, “Company Law Rules: An
Assessment from the Perspective of Incomplete Contract Theory” 1 Jnl Corporate Law Studies 107
(2001). Greater use of mandatory rules in transition countries has been justified by reference to the
need to protect minority shareholders and creditors: see J. Avilov, “General Principles of Company
Law for Transition Economies” 24 J. Corp. L 196 (1999).
56
Article 11 of the Company Law.
57
The articles for companies listed on a domestic exchange are contained in the China Securities
Regulatory Commission (CSRC) measure “Guidance on the Articles of Association of domestic listed
companies” (16 Dec 1997). The overseas provisions are contained in measure “Mandatory Provisions
in Articles of Association of Companies Listed Overseas” (promulgated 27 Aug 1994 by the Securities
Committee of the State Council, reproduced in I A Tokley and T Ravn, Company and Securities law in
China, Sweet & Maxwell Asia 1998, p219).
58
Article 10 of the domestic articles and article 7 of the overseas articles.

NewCGin PRC - 25/04/02 15


senior management personnel.59 These rights are in addition to (a) article
111 of the company law which provides for shareholders to apply for an
injunction to prevent the implementation of resolutions of the
shareholders' meeting which violate law or administrative regulations (b)
article 118 which provides that directors shall be responsible for
resolutions which violate law, administrative regulations or the articles of
association and cause loss to the company.
(f) The roles of shareholders and board differ from western models in that
shareholders have more extensive control. This is discussed in more
detail in part G.
(g) Chinese companies are required to limit their business to that
described in the scope of business at the time of registration (or as
subsequently amended). Contracts outside the scope of business are
illegal contracts and therefore not enforceable. There are no provisions
that protect third parties who contract innocently with a company acting
outside its scope of business.60
(h) The participation of workers in companies is ensured through the
requirement for JSCs to have a supervisory board that includes employee
representatives.61 The board of directors is accountable to the supervisory
board, whose members are entitled to attend meeting of the board of
directors in a non-voting capacity. The Company Law also requires the
Board of Directors to consult employees and trade unions on matters
affecting their interests.62

The development of a system of securities law and regulation of securities markets


was a natural accompaniment to the development of corporate law because the
objective of transforming some of the (substantial) savings in the personal sector of
the economy into investment in (corporatized and organizationally transformed)
SOEs could only be met through the creation of securities markets. Another
consideration was that securities markets made it easier for the state to raise loans,
through the issue of bonds to domestic and international investors, to fund public

59
The potential difficulties arising from this provision are discussed by Tokley and Ravn (above n57 at
p100).
60
Howson (above n45), p150, notes that the 1992 Standard Opinion provided for liability for those
parties responsible for companies acting outside of their registered scope of business. The Company
Law has no such provision.
61
Article 124 of the Company Law.

NewCGin PRC - 25/04/02 16


spending. Shanghai and Shenzhen were selected as locations for experimentation in
the issue of shares and the first issue of shares occurred in Shanghai in 1984, with
trading in shares beginning in 1986. The same pattern evident in the development of
corporate law was repeated in respect of securities law and regulation. Thus, the
stock exchanges in Shanghai and Shenzhen were established and operating prior to
the adoption of national measures governing securities markets.63 At this stage,
regulation of the securities markets was in the hands of the Shenzhen municipality
and the provincial government in Shanghai. National measures were introduced in
May 1992 when The State Council promulgated the Share System Experimental
Procedure of the PRC64, which set out the general objectives for stock-issuing
enterprises and the principles by which the national securities markets were to be
governed.65 More detailed regulation followed in the form of the Provisional
Regulations on the Administration of Issuing and Trading of Shares, promulgated by
the State Council in April 1993. For share issues on the domestic stock exchanges,
the Provisional Regulations were the main source of law until the Securities Law
finally took effect on 1 July 1999.66

An examination of the securities law67 reveals much less in the way of adaptation to
Chinese circumstances than in the case of the company law. The extensive
regulation of the process of listing and issuing securities is the most obvious
difference between China and the west. While all countries regulate this process,

62
Article 121 of the Company Law. This represents a dilution of the power previously held by workers
in SOEs, such as the right to dismiss directors subject to government approval. See Ong and Baxter
(above n45) p114.
63
The Shanghai Stock Exchange (SSE) was established in 1984 and officially opened in December
1990. The Shenzhen Stock Exchange (SZE) was established in 1987 and officially opened on 3 July
1991. Lan Cao (above n24) notes that officials of the Shenzhen Special Economic Zone decided
unilaterally to open a Stock Exchange without Beijing’s approval. Beijing’s response was not to stop
the process but simply to delay the opening for a few months.
64
Two notices gave effect to the procedure. First, the Notice of the Central Office of the State Council
Concerning Problems in Share System Experiment Enterprises Issuing Stock to the Public, 1990,
stating that "Other than the two stock exchanges at Shanghai and Shenzhen which have already been
permitted to issue shares to society, all others which have been approved by local governments but
which have not been through the approval procedures of the concerned ministries and agencies of the
central government, must within the designated period report to the State Commission on Reform of
the Economic System, the State Bureau for the Management of State Property, and the People's Bank
of China to once again undertake approval procedures."
Second, the Notice of the State Commission on Reforming the Economic System Concerning
Renewed Approval for Share System Experiment Enterprises Issuing Shares to Society, reprinted
Collection of Policies, Laws and Regulations for Share System Experiments (Shanghai Office for
Reform of the Economic System ed., 1992).
65
See Fang Liufang, “China’s Corporatization Experiment” 5 Duke J. Comp. & Int’l L 149 (1995).
66
These regulations were not repealed following the introduction of the Securities Law and in practice
are still followed by securities lawyers.
67
See generally Zhu Sanzhu, Securities Regulation in China (Simmonds & Hill Publishing Ltd., 2000).

NewCGin PRC - 25/04/02 17


China is distinctive in that it has favoured regulation over market forces in respect of
a number of issues, discussed below in part E. The separation of regulation of the
main financial sectors in China is a feature of many other regulatory systems, despite
being recently abandoned in the United Kingdom. The China Securities Regulatory
Commission (CSRC) is designated as the regulator for securities activities.68 The
Securities Law provides wide-ranging powers to the CSRC in respect of authorisation,
rule making, investigation and enforcement of all aspects of the securities market.69
In the past, the Central Bank (the People's Bank of China) had been responsible for
the entire system of financial regulation. From 1998, following the east Asian financial
crisis, the government began to restructure the financial system and pursued a policy
of separation of regulation of the four main financial sectors - banking, securities,
insurance and trust70. This resulted in the emergence of the CSRC in its current form,
the creation of a new regulator for the insurance sector (the China Insurance
Regulatory Commission, CIRC) and the limitation of the regulatory role of the central
bank to banking and trust business. However, while each financial sector is
separately regulated, China has not required that ownership of enterprises operating
in these sectors be separated, as was the case in the USA for many years prior to
the repeal of the Glass-Steagall Act.71

In other respects, the Chinese securities law follows very closely the pattern of
western models. This characteristic may be inherent in the nature of securities law.
To the extent that it represents entry into the global capital market, there is less room
for adaptation than in the case of company law. The tendency towards convergence
with western models becomes even more apparent at the level of stock exchange
listing rules where convergence with international norms is even more evident.72 As
noted elsewhere73, there appears to be a pyramid structure in corporate regulation in
which there is some room for adaptation at the lowest level (company law) less in the

68
Article 7 of the Securities Law. On the constitutional position of the CSRC and SCSC, see Zhu
(above n67) chapter 3. The regulatory structure is complicated by the existence of local securities
commissions and the involvement in securities markets of the State Commission for Restructuring the
Economic System, the State Planning Commission and the State Bureau for the Administration of State
Assets.
69
See Chapter 10 of the Securities Law in Zhu Sanzhu, Securities Regulation in China (Transnational
Publishers, 2000).
70
Article 6 of the Securities Law now gives effect to the policy of separate regulation of each financial
sector.
71
An example of cross-ownership of different financial activities is the Pinan Group based in Shenzhen,
which operates in the trust, insurance and securities sectors.
72
See A Lau, “The new Shanghai Stock Exchange Listing Rules: an egg hatched or an egg within an
egg?” (1999) 20(7) Co Law 243.
73
See I MacNeil and A Lau, “International Corporate Regulation: Listing Rules and Overseas
Companies” 50(4) ICLQ 787 (2001).

NewCGin PRC - 25/04/02 18


intermediate level (securities law and regulation) and almost none at the top level
(listing rules).

The most recent development in the legal framework of corporate governance in


China is the promulgation by the CSRC of corporate governance guidelines for listed
companies.74 The guidelines contain 95 articles and, once implemented, will
represent a substantial modernisation of corporate governance in Chinese Listed
companies. The Guidelines have several notable characteristics. First, there is
considerable evidence of convergence with western models of corporate governance
as almost all the articles contained in the guidance have parallel provisions in the law
or codes of corporate governance of the United Kingdom or United States. Second,
there is a clear attempt to strengthen the independence of listed companies from
controlling shareholders. This represents a limitation of the role of the state as
controlling shareholder and shows willingness on the part of the state to subordinate
its own interests as shareholder to the introduction of an effective system of
corporate governance. This differs to the approach taken at the time of the
introduction of the company and securities law, when there was greater emphasis on
protecting the role of the state. Third, there is no clear demarcation between
corporate and securities law and administrative regulations introduced by the CSRC.
This is evident in the fact that several of the provisions of the Guidelines (e.g. the
requirement in article 31 to use cumulative voting to elect directors in companies with
a controlling shareholder)
represent changes to the company law, a point made clear by the preamble to the
Guidelines, which requires amendment of articles of association that do not comply
with the Guidelines. This confusion of the legal basis of rules is a retrograde step,
reminiscent of the period before the introduction of the company and securities laws,
when administrative regulations were the only basis for the organisation of
shareholding companies. It would be better if the company and securities law were
amended to contain those articles of the Guidelines in respect of which there is an
overlap, leaving the Guidelines to cover points not included in the company or
securities law.

D. PRIVATE CAPITAL AND SHAREHOLDING

74
The Notice Concerning the Announcement of Corporate Governance Guidelines for Listed
Companies, promulgated by the CSRC on 7 January 2002 and effective from that date.

NewCGin PRC - 25/04/02 19


While the notion of private property rights and the participation of private capital in
the enterprise system are taken for granted in the west, communist ideology and
constitutional provisions in China had largely eliminated them in the pre-reform era.
The means of production were exclusively owned by the state, with private property
rights being confined to personal possessions and private enterprise being confined
to a few very marginal activities. Once the ideological and constitutional issues
surrounding the recognition of private property and the role of private enterprise had
been resolved, attention shifted to devising the legal mechanisms for private capital
to participate in the economy. This was not a simple task in an environment in which
private property rights had largely been eliminated. Two observations can be made in
respect of the way the issue was handled in China. First, at the conceptual level, the
role allocated to private capital is very similar to that envisaged by the “shareholder
primacy” model of capitalism prevailing in the west.75 There has been no real
attempt to re-define the role of private capital through the recognition of strong
stakeholder interests76 or to re-define the rights of shareholders as residual owners of
the company. The recently introduced Corporate Governance Guidelines simply refer
to the shareholders as owners of the company, with ownership rights being those
derived from law, administrative regulations and the articles of association.77

As in the west, there is no legal obligation imposed on directors in Chinese listed


companies to run the company so as to maximise shareholder value. 78 The absence
of legal recognition of other stakeholder interests means, however, that directors, in
exercising their powers to manage the company, can be quite easily captured by
market expectations that they will prioritise the interests of shareholders above those
of other stakeholders. This is not to say that there are no distinctive Chinese
characteristics in the private sector in China, rather that they are found outside the
formal legal structure in, for example, the manner in which discretionary powers over

75
I refer to the role “allocated” to shareholders to so as to recognize the significance of law in defining
that role. For a discussion of this issue in the context of the historical development of the ownership
rights of shareholders in England see P. Ireland, “Company Law and The Myth of Shareholder
Ownership” 62(1) Modern Law Review 32 (1999).
76
It would be wrong to say that there is no recognition of stakeholder interests in China, as there are
formal mechanisms (discussed below) for the representation of employees. The point is that the limited
type of stakeholder interest recognized in China has already been operating in countries such as
Germany, which do not share the same objective of a “socialist market system” (in the Chinese sense).
77
Article 1 of the Guidelines.
78
See S Worthington (above n2).

NewCGin PRC - 25/04/02 20


business are exercised by local government officials and the significance of extended
family connections in business networks.79

Second, it is evident in the regulatory regimes for both domestic and foreign capital
that a primary concern was to protect the control of the state over the economy.80
The presence of the state as controlling shareholder in most listed companies in
China made the adoption of a “shareholder primacy” model of corporate governance
relatively attractive because it provided continuity with the previous system in which
the state directly owned and controlled SOEs. Perversely, and in contrast to the
historical developments from which it emerged in the United Kingdom, the
“shareholder primacy” model was a mechanism by which the state could pursue the
“socialist market objective” through its controlling interests in most listed companies.
It leaves open the question, however, if there will be any substance left to the
“socialist market objective” when (as seems likely) the state reduces or even
completely ends its direct ownership of shares in listed companies.81

For small unincorporated businesses, the introduction of private capital mainly


required the sanctioning of the employment of a limited number of workers, which
had generally not been possible under the stricter interpretation of Communist
principles that had previously prevailed. There were no issues here regarding
transfer of state assets. Corporatization of SOEs, however, was more complicated as
reform of the old enterprise system of necessity involved some change in the rights
over SOEs previously vested in the state. Without such a change it would not be
possible for the company form to be introduced as a method of business organisation.
Prior to corporatization, SOEs could be regarded as part of the state82 but once
corporatized they have a separate legal personality and therefore the role of the state
as shareholder/owner must be clarified and in particular it must be distinguished from
the role of the state as regulator.83 There were several reasons for this. First, there

79
See Teemu Ruskola, “Conceptualizing Corporations and Kinship: Comparative Law and
Development Theory in a Chinese Perspective” 52(6) Stanford Law Review (2000) 1599.
80
See the constitutional provisions discussed at note 29 above.
81
This is discussed in more detail below.
82
The State Enterprise Law of 1988 recognised SOEs as legal persons, but they were still at that stage
wholly owned by the state and had not yet been corporatized.
83
This was the conventional view articulated in Communist Party Policy and endorsed by international
advisers such as the World Bank. Others regarded the property rights issue as less significant. Simon
took a pessimistic view of the effect of corporatization on property rights (W H Simon, “The Legal
Structure of the Chinese ‘Socialist Market’ Enterprise 21 Iowa J. Corp L. 267). He argued that property
rights in the SOE and TVE structures of the 1980's were relatively clear, with managers and workers
having strong control and income rights but relatively weak capital rights, the latter being preserved for
the benefit of the society at large. He saw the main problem as that of enforcing the rights against, for

NewCGin PRC - 25/04/02 21


was a perceived need to ensure that the process of corporatization did not result in
the misappropriation or transfer at an undervalue of state assets.84 Second,
clarification of property rights was necessary to make possible the sale of shares in
SOEs to outside shareholders. In principle, that could only occur in an environment in
which the role of the state was re-defined in a manner in which the rights of new
shareholders were made clear. Third, the introduction of a market-based system
involved a recognition that enterprises would be formed in which the state had no
ownership interest and therefore it would no longer be possible for the state to
continue to act in relation to these enterprises in the mixed role of owner and
regulator. Fourth, although in principle all productive assets were owned by the state,
corporatization required identification of which government department or
ministry/agency was an investor in a particular SOE, so as to make clear to whom
property rights were being assigned.

While, in the main, the rights of shareholders are made clear by the company law,
there remain some problems. First, the ownership rights of the state in respect of
assets owned by SOEs that have been coporatized is not entirely clear. Article 4 of
the Company Law provides that “The State assets of a company belong to the State”.
Howson described this provision as “nonsense” and noted that there was no similar
provision in the Standard opinion that preceded the Company Law.85 It is difficult to
disagree with this conclusion as it does not seem possible for assets that belong to a
company, as a separate legal person, to be owned by another entity at the same time.
The provision confuses the direct ownership rights previously held by the state over
SOE assets with the ownership rights now held by the state in the form of
shareholding.86It does not, however, appear to have given rise to much practical

example, managers who abused their position. Simon argued that the western experience in developing
company law to facilitate the participation of many small investors in an enterprise was of little
relevance to China where the expectation is that the state will remain the controlling shareholder in
most listed companies. It was therefore not surprising that the rights of minority shareholders remained
weak and uncertain even after the introduction of the company law, as the main objective of the
company law was to reduce the state shareholding while still leaving the state in control. Lan Cao,
CAT article, (above n24) discussing TVEs, also argued that the clarification of property rights was not
a critical issue.
84
As discussed below, some of this concern was misplaced as it resulted from a failure to recognize the
fundamental change in ownership structure resulting from corporatization, which replaced direct state
ownership of assets with shareholdings.
85
See Howson fn p 142.
86
It is an explicit example in Chinese law of an implicit tendency noted by Ireland in respect of English
company law, whereby the conflating of shareholders’ ownership of capital paid into the company and
of the company’s assets has led to the emergence of the view that companies should be run exclusively
for the benefit of shareholders (see P. Ireland, above n75 at p49).

NewCGin PRC - 25/04/02 22


difficulty, although that might change if the state were no longer the controlling
shareholder in most listed companies.

Second, the system of landholding in the PRC does not allow private ownership of
land. Land users (including companies) can only acquire a land-use right for a
specific time period and there are limits on the transfer of such rights.87 The result is
that major assets of a company, represented by land and buildings, are not directly
owned by the company.

Third, the presence of the state as controlling shareholder creates some difficulty in
defining the rights of other shareholders. Two factors are relevant. The first is the
constitutional and ideological support for the role of the state as controlling
shareholder and the second is the regulation of marketability of shares.
While neither has a direct bearing on the rights of shareholders as defined in the
Company Law, they have important implications for corporate governance because
they effectively entrench the position of the state as controlling shareholder and
confine non-state shareholders to a minor role. This issue is discussed in more detail
in part E below.

The dominant role of the state is also evident in the development of the regulatory
regime in respect of foreign capital’s participation in Chinese business. It reflects the
concern that China's economy, especially in strategically important industries, should
not fall under the control of foreign investors.88 Foreign capital has been invested
mainly in joint-ventures, which can be organized either as limited liability companies
or contractual joint ventures.89 The main source of foreign capital has been Hong
Kong90 and it has been targeted mainly at cities on China’s eastern seaboard.91

87
See Png Cheong Ann, (above n45).
88
One commentator viewed the position as follows: "..the PRC struck a compromise which continues
to animate China's policy and laws respecting foreign investment and corporate law: China would
strive to absorb enough foreign capital to bring about desired developmental benefits, while at the same
time maintaining state control over the terms of such investment through a system of approval controls,
taxation policy, access to foreign exchange and production and distribution requirements": see N C
Howson, "China's Company Law: One Step Forward, Two Steps Back? A Modest Complaint" (11) 1
Columbia Journal of Asian Law 127,133.
89
See generally, Guiguo Wang, Business Law of China chapter 8 "Organizations with a foreign
interest" (Butterworths Asia, 1999). The shares of foreign direct investment into China represented by
different forms of business enterprise between 1979-1997 was as follows: equity joint ventures 46%;
contractual joint ventures 23%; wholly foreign-owned enterprises 30%; joint resource exploration 1%.
(Source: OECD Financial Market Trends No 77, pp105-121 October 2000).
90
On the role of Hong Kong as a bridge between global markets and China see D. Crawford,
“Globalization and Guanxi: The Ethos of Hong Kong Finance” 6(1) New Political Economy (2001) 45.
91
See S. Breslin (above note 50) pp212/13 for details.

NewCGin PRC - 25/04/02 23


Since 1986, it has been possible for wholly foreign-owned enterprises to be
established in China in the form of a LLC or JSC. The conditions to be met to gain
approval for establishing such an enterprise are more stringent than is the case for
joint ventures.92

Participation in listed companies accounts for a relatively small proportion of foreign


investment in China, and one reason for this is that the options for participating in
listed companies are quite limited.93 China has adopted a policy of restricting foreign
investors’ access to its capital market.94 They cannot own A shares, which represent
the majority of the marketable shares of listed companies.95 There are, however,
several ways in which foreign investors can participate in such companies. First,
through the purchase of B shares, which are denominated in RMB, listed in China
and traded in a foreign currency.96 Until recently, such shares were only open to
purchase by foreigners, but are now open to purchase by PRC residents.97 In
aggregate, B shares account for only 5% of the share capital of listed companies.
Second, foreign investors can buy foreign shares of Chinese companies, which are
listed and issued in an overseas market. Such shares are most commonly listed and
issued in Hong Kong( H Shares), the NYSE (N Shares) and London (L Shares). In
aggregate, they account for 5% of the capital of listed companies.98 Approval is
required from the CSRC for the issue of securities in an overseas market although
the issue of admission to listing is a matter for the overseas market to determine. As
discussed in more detail below, the Articles of Association of a company intending to
issue securities on an overseas market must be amended to include the Mandatory
Provisions for Articles of Association of Overseas Listed Companies. Third, since
1995 it has been possible for foreign investors to invest directly into a (listed) Foreign
Investment Company limited by Shares ("FICLB").99 This type of company is
essentially the same as a JSC established under the Company Law with three main
exceptions. First, it is also subject to the laws and regulations governing enterprises

92
See Wang pp258-261.
93
See Table 4 in the Appendix, which shows foreign equity capital and foreign bonds as a percentage
of total foreign investment in China.
94
On the rationale for this policy, see Gordon and Wei Li (above n37), who show that the Chinese
ownership restrictions are equivalent in their economic effects to taxes on income from equity.
95
See Table 1 in the Appendix.
96
B shares listed in Shanghai are denominated in US dollars, while B shares listed in Shenzhen are
denominated in HK dollars. The regulatory framework is contained in the "Listing of Foreign Firms in
China by a Company Limited by Shares Provisions". See Tokley and Ravn (above n57) p197.
97
The restrictions on domestic investors owning B shares were partially lifted in February 2001 and
completely removed in June 2001.
98
See Table 1 in the Appendix.

NewCGin PRC - 25/04/02 24


with foreign investment and in particular the requirement that at least 25% of the
shares must be held by the foreign investor. Second the establishment of a FICLB is
subject to a minimum registered capital requirement of RMB 30m compared to RMB
10m for a JSC established under the company law. Third, the establishment of this
type of company has been limited to the promotion ("private placement") method as
the CSRC has not authorised the listing and public issue by such companies.100
Finally foreign investors can participate in listed companies through the purchase of
bonds, although as shown in Table 4 of the Appendix this has been a relatively minor
part of total foreign investment in China.

E. FINANCIAL MARKETS

Financial markets, and in particular the legal and regulatory environment in which
they operate, are closely related to the development of national systems of corporate
governance.101 At the most basic level, there is a clear relationship between the
presence of strong investor protection and well-developed financial markets.102
Beyond that, there are more specific influences such as disclosure obligations for
major shareholdings, takeover regulation and ownership restrictions (e.g. on banks’
ownership of equity).The manner in which market participants are regulated is also
significant as it may influence the pattern of shareholding in a country.103 So too is
the relationship between ultimate investors and intermediaries (banks, fund
managers, pension funds) in respect of issues such as voting rights over shares held
by intermediaries.104

The transformation of the Chinese economy into a “socialist market system”105 is


evident in the rapid development of financial markets over the last ten years. As

99
See Wang (above n89) pp304-312 for a discussion of the enabling regulations contained in the "Joint
Stock Company with Foreign Investment Provisions".
100
Some change in this policy on the part of the CSRC seems likely in the near future. See "Foreign
firms gain rights to China listing" South China Morning Post 9-11-2001. On 11 January 2002, the
CSRC published on its website for public consultation rules governing information disclosure in a
prospectus relating to a FICLB.
101
See LLSV, “Legal determinants of external finance” 52 Jnl of Finance 1131-1150 (1997) and A.
Shleifer and R. Vishny, “A survey of corporate governance” 52(2) Jnl of Finance 737-783 (1997).
102
See LLSV, “Investor Protection and Corporate Governance” at ssrn.com (update reference).
103
See M Roe (above n12) arguing that (politically –driven) regulation in the USA has been the main
factor shaping the modern system of corporate finance. (Political roots etc article)
104
See R. Buxbaum, “Institutional Owners and Corporate Managers: A Comparative Perspective” 57
Brook. L. Rev. 1 (1991) for a comparison between the USA and Germany on this issue.
105
This term has been used extensively since its adoption in 1992 at the 14th National Congress of the
Chinese Communist Party.

NewCGin PRC - 25/04/02 25


shown in Table 3, the ratio of stockmarket capitalization to GDP now stands at over
50%, which places China ahead of most EU members other than the UK in terms of
the significance of the stockmarket to the economy.106 What is less clear is whether,
and if so how, the socialist character of the system has been preserved in the midst
of these developments. The key to that issue lies in the peculiar mix of regulation and
market forces that has been adopted in the operation of financial markets in China.
What has emerged is a system in which there is such extensive state control of the
financial markets that the role of market forces has been marginalized.

(I) Regulation of Markets and Marketability of Shares

Prior to the introduction of national measures, regulation of the stock exchanges in


Shanghai and Shenzhen was left to the respective provincial/municipal governments.
The re-organisation of financial regulation in 1998 resulted in the CSRC assuming
responsibility for the stock exchanges. The exchanges themselves have a significant
regulatory role in setting rules for the operation of the market, but ultimately its is the
State which is in control as the CSRC is appointed by the State Council. The
Securities Law also contains important provisions in respect of the exchanges,
providing that they should be non-profit organisations (article 95) with a mutual
ownership structure (article 98). The effect of these provisions, taken together with
the observation that exchange members (viz. Securities Companies, discussed
below) are generally controlled by the state, is that the state is ultimately the owner of
the exchanges, the regulatory authority and the controlling shareholder in most listed
companies.107

The confusion between the different roles of the state is also evident in the complex
manner in which marketability of shares is regulated. An examination of the
provisions of the Chinese company law relating to share types and transfer rights
suggests, at first glance, a relatively simple picture. Article 130 provides that the
conditions and price of shares issued as part of the same issue shall be the same
and article 143 provides that shares may be transferred in accordance with law.

106
For comparable data on the relative size of stockmarkets see Maher and Anderson, “Corporate
Governance: Effects on Firm Performance and Economic Growth” at ssrn.com. See also
www.FIBV.com, the website of the Federation International des Bourses de Valeurs.
107
The control of the state was reinforced when, in October 2001, Premier Zhu appointed two former
vice-chairs of the CSRC to head the national exchanges.

NewCGin PRC - 25/04/02 26


However, the effect of regulations108 made by the State Council, and state policy in
respect of its shareholdings, is that shares are classified into two groups: marketable
and non-marketable.109 Categories 1 to 6 in Table 1 in the Appendix are designated
as non-marketable shares.110 Categories 7 to 9 in Table 1 are designated as
marketable shares. The result is that the fraction of shares of Chinese listed
companies that is available for trading in the market (the "free float") is just over one
third of the total shares in issue.

The different types of share and shareholder require some explanation, as the rules
on transfer are formulated by reference to both. The concept of different share types
relates essentially to the marketability of shares held by different shareholders rather
than to different rights attaching to different types of share. Shares held by the state
(category 1) are held either by the state (through agents at the national, provincial or
local level) or by state legal persons. The latter are legal persons established with
state capital and directed by the State.111 Domestic promoter legal person shares
(category 2) are shares held by the promoter involved in the formation of a JSC
(either by way of promotion or by way of public offer for subscription). The "domestic"
descriptor distinguishes this type of promoter from a foreign promoter.112 It is possible
for shareholders in category 2 to be state legal persons and therefore such
shareholders can appear in either category.

The limits on marketability within these two categories are also more complex than
suggested by their designation as non-marketable . As discussed below113, state
shares can be transferred in several ways, an outcome referred to rather obliquely by
article 148 of the company law which simply refers to the possibility of state-owned
investment institutions selling state shares and buying shares held by others in
accordance with the law and administrative regulations. The non-marketable nature
of state shares is a matter of state policy regarding its ownership rather than an

108
The Provisional Regulations on the Administration of Issuing and Trading Shares (April 22, 1993)
and The Provisional Regulations on the Administration of State Equity in Companies Listed by Shares
(3 Nov, 1994).
109
The terms marketable and non-marketable refer to whether or not the relevant shares can be traded
through the stock exchanges in Shanghai or Shenzhen. Some authors use the terms transferable/non-
transferable or negotiable/non-negotiable to refer to the same distinction. However, as non-marketable
shares can be transferred outside the recognised exchanges, it is submitted that the more accurate
distinction is between marketable and non-marketable shares.
110
Title to shares is recorded in electronic form. Paper copies of the record distinguish transferable
from non-transferable shares.
111
See article 4 of the Opinion on the Implementation of the management of state-owned shareholdings
in experimental JSCs, March 11 1994, State Assets Administration Bureau.
112
Article 75 of the company law provides that half of the promoters must reside in the PRC

NewCGin PRC - 25/04/02 27


aspect of the rights attaching to shares. Even if state shares are sold by the state (by
one of the methods indicated below) they remain in principle non-marketable as it is
not possible for shares other than those issued to the public to become freely
marketable. Promoters are required to hold their shares for three years after the
establishment of a JSC and therefore the limit on the transfer of their shares is
temporary rather than permanent. However, even after transfer, promoter shares will
continue to be non-marketable.114

Overseas legal persons (category 3) can become holders of non-marketable shares


through share issues made overseas by Chinese incorporated companies. This type
of issue is less common than issues made to foreign investors of marketable shares.
It is possible to make such non-marketable issues as some foreign investors are
keen to hold equity in Chinese companies for the long-term, regardless of restrictions
on marketability, which might be eased or abolished in due course. Social legal
persons (category 4) are domestic legal persons other than those in which the state
has a majority shareholding. This category includes LLCs and JVCs as well as co-
operatives and TVEs.

There are three share types that are designated marketable. They differ only in
respect of the currency in which the shares are traded and who is entitled to hold
them as the rights attaching to the shares are the same. A shares are denominated
in RMB and can be held only by domestic investors. B shares are denominated in
RMB, traded in foreign currency and until recently could only be held by foreigners.
Recent changes to the regulations have permitted B shares to be held by domestic
investors.115 In overall terms, B shares represent a relatively small part of listed
companies' capital.116 H shares are shares issued by PRC incorporated JSCs to
foreign investors through a listing on a foreign market. The most common option is to
issue in Hong Kong (hence the H designation) although several issues have also
been made in other markets.

The implications of this system of regulation of the market and marketability are
considerable. The dual role of the state as regulator and controlling shareholder

113
See section F for further discussion of the state shareholding.
114
The restrictions on marketability are supported by the electronic systems in which legal title to
shares is recorded: non-marketable shares are identified as such and this is shown on paper versions of
the electronic record.
115
One result of the change in regulations was that the value of B shares rose sharply and is now closer
to that of A shares - see Table 5 in the Appendix.

NewCGin PRC - 25/04/02 28


provides incentives for the state to regulate the market so as to favour its own
position as controlling shareholder. This appears to have occurred in respect of the
policy of reduction in state shareholding, which is discussed in more detail below.
The limits on marketability of shares have important consequences for trading
liquidity, the role of stock exchanges in allocating capital efficiently between
competing uses and for the creation of a takeover market. Each of these issues is
discussed in more detail below. First, consideration is given to the state’s role in
regulating the raising of capital.

(ii) Raising Capital

Capital markets allow companies requiring capital to raise it from investors, or in


economic terms, they perform the function of financial intermediation. In return for
the privilege of having access to capital markets, companies are required to submit to
two forms of corporate regulation (securities law and listing rules) in addition to the
basic provisions of the company law.117 In the main, however, financial regulators in
the west do not have discretion over which companies can list or issue shares: the
conditions are normally set out in the securities law and listing/prospectus rules and
companies satisfying those rules are entitled to list or to issue securities.118 “Merit-
based” regulation of capital-raising, in which regulators review the merits of the
securities to be offered by a company to the public, has been largely abandoned in
favour of a policy of permitting securities to be offered subject to full disclosure. In
China, the position is different because the CSRC controls the formation of JSCs,
listing and public issues of securities. There is no right to form a JSC or to have
access to the financial markets.119

According to the Chinese company law, a JSC can be formed either by the promotion
or public subscription method. The promotion method involves the sale of all the

116
See column B in Table 4 in the Appendix for capital raised through B share issues.
117
On the structure of corporate regulation see I MacNeil and A Lau (above n73). The Shanghai and
Shenzhen exchanges each have their own listing rules, which are very similar. While the CSRC
controls admission to listing, the Stock Exchanges are the front-line supervisor for monitoring
compliance on the part of listed companies. The structure and content of these listing rules is similar to
western models. They include financial disclosure rules, shareholders' approval for major transactions,
overriding disclosure rule relating to "material information", restrictions on controlling shareholders
voting on related transactions, general duty of honesty imposed on directors: see A. Lau (above n72).
118
In the UK, a decision made by the UKLA to decline a listing application may be appealed to the
Financial Services and Markets Tribunal (s76 FSMA 2000). In Hong Kong an applicant can appeal a
refusal to grant a listing application to the Listing Appeals Committee.

NewCGin PRC - 25/04/02 29


shares in the company to promoters and does not, in itself, require the shares to be
listed. It therefore bears some resemblance to a “closed circle” offering under the EU
Public Offers Directive.120 Any subsequent public offer by a JSC formed by promotion
will be controlled by the CSRC and the promoters are prohibited from selling their
shares within three years of formation. The public subscription method requires that
there be at least five promoters121 who purchase at least 35% of the shares, with the
remainder being offered to the public. In the past, the CSRC operated a quota
system for listing. Companies satisfying the listing criteria could not approach a stock
exchange directly to gain a listing - approval had to be granted by the CSRC. In
practice, the system operated through the supervising ministry for different industries
being granted a quota for listing, allowing them to recommend companies under their
supervision.122 The quota system has now been officially abolished but anecdotal
evidence suggests that there are around 500 companies awaiting approval for listing.

Secondary shares issues (made subsequent to an initial public offering) are a


significant feature of the Chinese capital market123 and are also closely controlled by
the company law and the CSRC.124 Although shareholders in Chinese listed
companies do not have pre-emption rights comparable to those found in s89 of the
CA 1985 in the United Kingdom, most secondary issues are in the form of rights
issues.

Overseas listing125 cannot circumvent the control of the CSRC as, although the
overseas Stock Exchange controls admission to listing in these circumstances,

119
Zhu (above n67) at p181 comments “.. the criteria which determine which companies are allowed to
issue shares and to be listed are not always commercial criteria. Government priorities and political
considerations are often as relevant.”
120
Council Directive 89/298 [1989] OJ L124/8. Article 2 provides that the provisions of the Directive
do not apply “where transferable securities are offered to a restricted circle of persons”.
121
An exception is made in the case of SOEs converting to a JSC when only one promoter is required.
122
In the past the CSRC also set the listing price for IPOs according to a formula based on
price/earnings ratio (a P/E of 15.0 was adopted). This meant that irrespective of other aspects of a
company's financial position and record, the issue price was fixed according to this formula. An
examination of the average P/E ratio for the two markets over recent years shows clearly why new
issues generated such a frenzy of activity among investors: on average, it could be expected that when
a new issue commenced trading in the secondary market the price would at least double in order to
bring the valuation up to prevailing market levels. See Su D. and Flesiher B. “An empirical
investigation of underpricing in Chinese IPOs” 7 Pacific Basin Finance Journal 173-202 (1999), who
show that in a sample of 308 IPOs the mean one-day return was 948.6%.
123
See Table 6 in the Appendix, which shows that 27% of capital raised through public issues in 2000
was in the form of rights issues.
124
See Tokley and Ravn (above n57) par 5.16.
125
Generally on overseas listing see I. MacNeil “Competition and Convergence in Corporate
Regulation: The Case of Overseas Listed Companies” and J. Coffee “The Coming Competition among
Securities Markets”, both at ssrn.com.

NewCGin PRC - 25/04/02 30


approval is still required from the CSRC.126 Overseas listing is only possible in
jurisdictions where the CSRC has entered into an agreement relating to joint
supervision of listing and share issuing by Chinese companies. Hong Kong is the
most important location for overseas listing of Chinese companies, but there have
also been listings in the United States and the United Kingdom.127 Companies listing
overseas tend to do so in order to raise their international profile and become
integrated into the global capital market. The opportunity offered by an overseas
listing to raise capital in an overseas market is often not the main motivation for the
overseas listing: one reason for this is that the generally high valuations128 of shares
in the PRC domestic market mean that capital can be raised at a lower cost in the
PRC than in overseas markets. Companies intending to list overseas must amend
their Articles of Association to include the Mandatory Provisions for the Articles of
Association of Overseas Listed Companies. Included in these provisions are
limitations on the power of controlling shareholders that are not found in the
(standard) domestic articles of association or the company law.129 Article 47 limits the
power of a controlling shareholder (in most cases the state) to exercise its voting
rights to determine a number of issues. These are discussed in more detail below
under the title "minority shareholders' rights" as the effect of the article is to
strengthen the position of minority shareholders by comparison with the position of
companies with only a domestic listing. Article 47 results in controlling shareholders
in companies with an overseas listing limiting their voting rights in certain key areas.

Corporate bonds provide an alternative means for companies to raise finance


through the stock exchanges. The Company Law sets conditions for the issue of
bonds130 and approval must be obtained from the CSRC. The Company law does not
refer to the possibility of companies granting security for loans, but under the general
principles of the civil law and the provisions of the security law, a company has power
to do this. The floating charge, commonly used by companies in the UK as a security

126
Article 29 of the Securities Law. The regulatory regime for overseas listing is contained in the
Special Regulations of the State Council Concerning Share Offerings and Listings Outside the People’s
Republic of China of Joint Stock Limited Companies (August 4, 1994). These Regulations refer
specifically to issuing shares outside the PRC and there has been some doubt over their application to
foreign issues of bonds.
127
Chinese company listings on the NYSE and LSE are in the form of depositary receipts. This
involves a bank holding shares of the (foreign) issuer and issuing depositary receipts to local investors
in local currency. It avoids the more onerous listing requirements associated with a conventional
secondary listing of shares.
128
See Table 5 in the Appendix.
129
In particular Article 47 of the Mandatory Provisions, which are published in I A Tokley and T Ravn,
Company and Securities Law in China (Sweet and Maxwell Asia 1998).
130
See articles 161 and 162 of the Company Law.

NewCGin PRC - 25/04/02 31


device, is not recognised in China, but mortgages are recognised and can be created
over such assets as premises attached to land (which is owned by the state) and
land use rights.131 Guarantees given by third parties in respect of loans are also
commonly used.

It might be expected that in an environment in which private property rights are


relatively underdeveloped and the concept of shares is relatively new, corporate
bonds would provide a simple means of raising finance from the public but they have
not however been extensively used by Chinese listed companies. The value of
corporate bonds issued by Chinese listed companies is on a similar level with the
value of B Shares issued. Several reasons have been suggested for this: (a) bond-
coupon rates are low and set by the government (b) bonds have had a bad image as
interest payments are not always made according to schedule and (c) the legal rights
of bondholders are not adequately defined in the event of bankruptcy.132 The relative
underdevelopment of the bond market as a method of finance carries several
negative implications for corporate governance: first, the absence of sources of debt
other than (policy-based) loans from the four large state-owned banks; second, the
absence of the disciplining role (over managers) played by bond rating agencies; and
third, the absence of the disciplining effect of bondholders forcing a re-organisation in
the event of poor corporate performance.

(iii) Liquidity and Efficient Capital Allocation

In China, as elsewhere, the role of stockmarkets as providers of new capital for


industry is quite limited133: more significant is their role as a forum for trading in
securities. From a Cosean perspective, trading in securities is no different to trading
in any other legal rights: the ultimate outcome is that trading promotes efficiency by
ensuring that rights are traded to their most highly valued use (i.e. to the holders who
will pay the highest price). Trading also effectively determines the price at which a
company can raise new capital (by reference to the price of shares in issue) and
provides a benchmark for the valuation of new companies whose securities are to be

131
The ability to mortgage state-owned land is a significant step in the history of the PRC. Article 2 of
the 1988 Amendment to the Constitution permits the transfer of a land-use right. Before 1988, no
organization or individual could appropriate, buy, sell, lease or otherwise engage in the transfer of land.
See Guanghua Yu, "Towards a market economy: security devices in China" 8 Pacific Rim Law &
Policy Journal (1999) 1.
132
See Hung-Gay Fung and Wai Kin Leung, "Chinese Financial Liberalization, Implications for
Corporate Governance" 34(1) The Chinese Economy 5-14 (2001).
133
See Table 3 in the Appendix for data on China.

NewCGin PRC - 25/04/02 32


listed. The assumption underlying this model, and on which the efficiency claim in
capital allocation depends, is that rights (securities) can be traded to their most highly
valued use. Where that is not the case, the efficiency claim cannot be made. In the
context of China, the limits on marketability of shares severely limit the free trading of
shares (to around one third of the market capitalisation) and therefore the efficiency
claim is compromised. The allocative efficiency of the markets is limited by the
restrictions on marketability. Shares cannot be freely traded to the highest bidder and
so it can be expected that (a) valuations will differ from those in systems where that
is possible and (b) in aggregate, the allocative efficiency of the market will suffer.
Some support for the first conclusion is apparent in the valuations at which A shares
trade in the two stock exchanges. The price/earnings multiples at which A shares
trade is considerably higher than B shares (or H and N shares), indicating that
domestic Chinese investors value the same securities much more highly than their
counterparts in Hong Kong, the United States and the United Kingdom.134 It is more
difficult to provide evidence in support of the second conclusion, but the theoretical
implication of systematic over-valuation of A shares must be that that the limited pool
of capital available for equity investment is not being allocated efficiently, particularly
when it is borne in mind that access to that pool of capital is determined not by the
market by the regulatory control of the CSRC.135

(iv) Institutional shareholder monitoring

Institutional investment has become an important influence in corporate governance


in listed companies in the west. Institutions, by holding shares on behalf of individual
investors in the form of pensions funds, unit trusts and life assurance are able to
exercise greater influence over management than would be possible for small
shareholders acting individually. Studies have shown that (a) increased institutional
shareholding is associated with better performance136 and (b) the presence of
concentrated shareholding (whether in the form of a controlling shareholder or
institutional investor) is associated with superior performance137. Such results can be
explained by the incentive created by large shareholdings to monitor management

134
See Gordon and Wei (above n37) for historical data on the relative pricing of A and B shares.
135
See K M Wong, “Securities Regulations in China and their Corporate Finance Implications on State
Enterprise Reform” 65 Fordham Law Rev. 1221(1996).
136
See A Shleifer and M Vishny, “Large Shareholders and Corporate Control” 94 Jnl of Political
Economy (1986) 461-488 and D Leech and J Leahy, “Ownership Structure, Control Type,
Classification and the Performance of Large British Companies” Economic Journal vol 101 pp1418-
1437.
137
See M Maher and T Anderson (above n9).

NewCGin PRC - 25/04/02 33


and the difficulty arising from the alternative strategy of disposing of large
shareholdings in the market. The implication is that a well developed system of
institutional shareholding can help resolve the monitoring problems that arise when
shareholders are widely dispersed. On the other hand, the presence of institutional
shareholders introduces a new dimension to the classic agency problem as ultimate
investors have to monitor the institutions managing their investment.138

Institutional investment is relatively underdeveloped in China. There are two main


reasons. One is that the position of the state as the controlling shareholder in most
listed companies has limited the scope for the emergence of institutional investors.139
Second, the result of the regulatory structure is that the range of investment products
which offer exposure to the equity market is relatively small: state pension funds do
not hold equities, nor do company pension funds; the equity holdings of insurance
companies are limited to 10% of assets; and retail investment products are relatively
underdeveloped.140 The growth of open-ended investment funds and the life
assurance market in China should boost the role of institutional investment, but so
long as the state retains its controlling shareholding in most listed companies, the
role of institutional investors in China cannot replicate the position in the west. The
short-term nature of much of the stockmarket investment in China also presents a
barrier to the development of a more prominent monitoring role for institutional
investors. Table 5 in the Appendix shows that Shenzhen A shares were traded on
average almost four times during the year 2000, while for Shanghai A shares the
turnover rate was 5 times. The comparable figure for London is 0.5 times and for
New York 0.7 times.141 Moreover, anecdotal reports indicating that Chinese
institutional investors are the main protagonists in speculative trading are borne out
by stockmarket turnover figures that show that the proportion of turnover represented
by investment funds under professional management is much higher than the
proportion of total market capitalization that they represent.142

138
See R Buxbaum (above n104).
139
It has also, of course, limited the principal/agent problems that are more closely associated with
widely held systems of share-ownership than with systems in which controlling shareholders are
prevalent.
140
There is around RMB70bn (US$8.5bn) invested in closed-end investment funds and RMB11.7bn
(US$1.4bn) in open-ended investment funds, which have only recently been authorised by the CSRC.
(Year-end 2001 figures from CSRC).
141
Source: 2000 Yearbook of the China Securities Association.
142
Figures presented by the CSRC at the Conference “The PRC, Taiwan, and Hong Kong: Developing
the Greater China Corporate Governance Model” (Hong Kong University, 2&3 Nov. 2001), on file

NewCGin PRC - 25/04/02 34


(v) Intermediaries

Intermediaries in the Chinese financial markets, such as securities companies,


investment banks and trust companies, are generally state-owned entities. They are
controlled by the CSRC in respect of licensing, capital adequacy and conduct of
business. The policy of separation of the three pillars of the financial sector (banking,
securities and insurance) means that there is no functional integration of the different
types of business, but ownership links are permitted. The position is therefore quite
different to that in western markets, where the independent position of financial
intermediaries such as investment banks in principle allows them to attach their
reputation to transactions. Reputation works for an issuer by bringing to bear the
selling power of the intermediary and for the investor by attaching the intermediary's
seal of approval (and legal liability) to the prospectus. In aggregate, the presence of
intermediaries facilitates the operation of the market and the process by which
securities will be traded to their highest valued use (according to the Cosean model).
For this to occur, intermediaries must be independent of issuers and investors. In
China, this is not possible as intermediaries are controlled by the state, which is the
most regular issuer of securities and is also generally the controlling shareholder in
companies. It can therefore be expected that the efficiency introduced into western
markets by the presence of independent intermediaries will not be present in the
financial markets in China.

(vi) A market for corporate control

Financial markets occupy an important position in the corporate governance structure


by providing a market for corporate control. In some countries, such as the United
States and United Kingdom, this is an important technique for disciplining the
incumbent management because poor performance holds out the prospect of a
change in control, through the medium of a takeover offer, and the removal of the
incumbent management.143 For takeovers to operate in this manner requires the
presence of liquid stockmarkets, strict trading rules and adequate disclosure of
information to shareholders in a target company. Although takeovers are legally
possible in China, and are regulated by rules similar to the Takeover Code in the
United Kingdom, the presence of the state as controlling shareholder in most listed

with author. Investment funds represented 4.17% of year-end 1999 market capitalization but accounted
for 7.9% of turnover.

NewCGin PRC - 25/04/02 35


companies effectively removes the possibility of takeovers being a significant factor
in corporate governance.144

F. THE STATE AS CONTROLLING SHAREHOLDER

As shown in Table 1 in the Appendix, the state is the dominant shareholder in listed
companies in China.145 The state's shareholding is held in three ways. First, state
shares in listed companies are held by the Ministry of Finance or agents acting on its
behalf at the national, provincial or local level. Second, state legal person shares are
held by entities directed by the state (typically other listed companies). Both these
types of shareholding are included in category 1 in Table 1 in the Appendix. Third,
state-owned entities are included among domestic promoters (category 2) and social
legal persons (category 4). The former are involved in the initial establishment of
JSCs and are required to take up shares in companies they promote.146 The latter
are legal persons other than those in which the state has a majority shareholding:
they include LLCs and joint venture companies as well as co-operatives and TVEs.

The presence of a controlling shareholder in Chinese Listed companies puts China in


the mainstream as regards the worldwide pattern of share ownership. As noted by
LLSV, the widely-held company, which formed the basis of Berle & Means seminal
work and much subsequent analysis of corporate governance, is not common.147 The
more common pattern is for there to be a controlling (20% plus) shareholder, without
the presence of another large (10% plus) shareholder. This casts the corporate
governance agenda very much in terms of techniques appropriate for the control over
appropriation by controlling shareholders. What makes China distinctive within this
framework is that the state is the controlling shareholder and therefore has the

143
See Franks and Mayer, “Hostile takeover and the correction of managerial failure” 40 Jnl of
Financial Economics 163-181 (1996) and Maher and Anderson (above n9) at pp29-32.
144
The legal framework for takeovers in China is contained in the Provisional Regulations on the
Administration of Issuing and Trading of Shares (1993) and Chapter 4 of the Securities Law, which
largely follows the model of the UK Takeover Code. See B. Chun, “A Brief Comparison of the
Chinese and United States Securities Regulations Governing Corporate Takeovers” 12(1) Colum Jnl of
Asian Law (1998) 99.
145
The figures in Table 1 show the aggregate position for listed companies as a whole, but they disguise
the fact that there are a significant number of listed companies in which the role of the state is limited
to state legal person shares or in which the state has no shareholding whatsoever. At the end of 1999,
121 of the 484 companies listed on the Shanghai Stock Exchange had no state shareholding of any kind
(source: Shanghai Stock Exchange Statistics Annual 2000).
146
The shareholding they are required to take up under the Company Law varies according to how the
company is formed: if it is by the public subscription method, the prompters are required to take 35%
of the shares, whereas if it is by the promotion method they are required to take up 100% of the shares.
147
LLSV, “Corporate Ownership Around the World” 54(2) Jnl of Finance (1999) 471.

NewCGin PRC - 25/04/02 36


potential to structure the corporate governance system in its own interests. This
raises a problem not present elsewhere as, although controlling shareholders in other
countries can lobby for corporate governance measures, they cannot directly control
them. It also results in the presence of a variant of the “who monitors the monitor?”
agency problem which arises between ultimate investors and institutional investors in
the west. In China, as in the west, there is no obvious answer.

The effect of ownership structure on the ability of shareholders to monitor the Board
of Directors is more difficult to judge. At the theoretical level, the proposition that a
diversified shareholding structure would be negative for corporate performance (as a
result of inferior monitoring of management by comparison with a concentrated
shareholding structure) was implicit in Berle and Means analysis.148 This proposition
was later challenged by economic theory149 and by empirical studies showing a link
between concentrated ownership and superior firm performance.150 In respect of
Chinese listed companies, Xu and Wang found that firms' performance was positively
and significantly correlated with the fraction of shares held by legal persons but was
either negatively or uncorrelated with the fractions of state shares or (transferable) A-
shares.151 Concentrated shareholdings in hands other than the state therefore seem
to help performance. The disproportionate influence of the state on board
composition must therefore be regarded as a negative influence for corporate
governance in listed companies, because the state does not appear to be as
effective a monitor as the legal person. Reduction in state shareholding,
accompanied by a transfer of that shareholding into the hands of legal persons would
appear to be a positive move for Chinese listed companies.152 So too would a
limitation of the influence exerted by controlling shareholders, which is likely to result
from the recent introduction of Corporate Governance Guidelines for listed

148
See Berle & Means (above n7).
149
See H. Demsetz and K. Lehn, "The structure of Ownership: Causes and Consequences" 93(6)
Journal of Political Economy 1155 . The factors identified by Demsetz and Lehn as determining
ownership structure are (a) the value-maximizing size of the form (taking account of economies of
scale) (b) the degree of control required by reference to market conditions (stable markets require less
control) (c) the presence of regulation which provides subsidized monitoring and disciplining of
management (d) the amenity potential of control (non-financial considerations such as the power to
dictate strategy, prestige, media image).
150
See C. Holderness and D. Sheehan, "The Pole of Majority Shareholders in Publicly held
Corporations: An Exploratory Analysis" 20 Journal of Financial Economics 317-346 (1988); J.
McConnell and H. Servaes, "Additional Evidence on Equity Ownership and Corporate Value" 27
Journal of Financial Economics 595-612 (1990). See also Maher and Anderson (above n9) p24/25 for
a review of studies on this issue in a number of countries and industries.
151
See Xiaonan Xu and Yan Wang, “Ownership Structure, Corporate Governance and Firm
Performance: the case of Chinese Stock Companies” 10(1) China Economic Review 75-98 (1999).

NewCGin PRC - 25/04/02 37


companies. The Guidelines emphasise the independence of a listed company from
its controlling shareholder and prohibit a controlling shareholders from interfering in
major policy decisions or board appointments in a manner that limits the proper role
of the shareholders’ meeting.

As for the future, it is questionable, in view of the constitutional provisions discussed


earlier, whether, it is possible for the state to relinquish its role as owner of the main
form of productive assets. The trend does, however, seem to be towards a reduction
in the role of the state. Recent interpretation of the state’s role is that it can be
confined to strategic industries, with other industries left to private ownership.153
Moreover, the pragmatic manner in which China has accommodated private
enterprise and corporatization within its own version of communist ideology makes it
unlikely those ideological or constitutional issues would be a major obstacle to such
developments. The issue has been complicated by recent policy developments in
respect of state shareholdings. In July 2001, the Ministry of Finance introduced The
State Shareholding Reduction Interim Measure, which set out a policy of reducing the
state shareholding in listed companies. While, in principle, the non-marketable nature
of shares held by the state posed a problem for reducing state shareholdings, a
pragmatic solution was devised based on three techniques. First, the state could sell
shares to the public as part of the corporatization of SOEs (the formation of JSCs
involves a public issue), thereby reducing the state shareholding and raising money.
This simply represented an already established practice. Second, the state could
decline to subscribe for a new issue of shares made by a listed company. The scale
of share issues (generally in the form of rights issues154) made by listed companies
subsequent to their flotation is substantial (see Table 6 in the Appendix) and
therefore provided a mechanism by which the state could reduce its shareholding.
However, this did not provide any means for the state to raise new money and
therefore a practice was developed which allowed this to occur. Listed companies
which issued new shares were required to allocate an additional 10% of the issue to

152
This was the conclusion reached by Xu and Wang (above n 151) and the World Bank Report of
1997 (above n33).
153
See H. Boardman (above note 32) who quotes President Jiang Zemin’s stated position in autumn
1997 (“ even if the state-owned sector accounts for a smaller proportion of the economy, this will not
affect the socialist nature of the country”) and his later clarification of the position in summer 1998
(“without a state-owned industrial sector, there can be no socialism”). See also Lay Hong Tan, "The
Legal and Regulatory Framework of Securities Markets in the PRC" (1999) Asia Pacific Law Review
69.
154
New issues of capital made by listed companies in China are generally in the form of rights issues
despite there being no pre-emptive rights included in the Company Law or the (standard) Articles of
Association.

NewCGin PRC - 25/04/02 38


the state, so that when those shares were sold by the company to the public, the
state received the proceeds. In return for this payment, the state's existing
shareholding (of non-transferable shares) was reduced. Finally, state shares could
be sold through individual negotiation with interested parties provided that the sale
contract was agreed by the Ministry of Finance and registered with one of the two
official exchanges on which the seller is listed.

The result of the operation of these techniques was that, in effect, non-marketable
shares were being sold (albeit indirectly) in the market at the prevailing price for
transferable shares. The negative impact of this practice on the market was
confirmed when, on the day that the CSRC announced that the policy of reducing the
state shareholding (and the associated practices) would be suspended, both the SSE
and SZE rose sharply.155 A similar situation occurred in January 2002, when the
CSRC indicated that the state would not, for the time being, sell its shareholdings
and would in any event take account of market stability in structuring any future sale
programme.156 It remains to be seen what will happen in the future. There are two
separate issues. The first is the issue of marketability of shares. The possibility of
allowing all shares to become freely marketable is recognized as a long-term
possibility by the CSRC.157 Shorter-term there are two possibilities: (a) foreign
investors being permitted, following China’s entry to the WTO158, to invest in funds
which hold A shares and (b) the introduction of a qualified foreign investor scheme
which would allow certain foreign investors to buy A shares. The second issue is
what will happen to state shareholdings in an environment in which all shares are
freely transferable. That remains unclear. On the one hand, it can be argued that
ownership is not necessary for the state to exercise control over the corporate sector

155
Both markets rose by 10% in response to the announcement. Source: China Daily report, “Stock
Market Policy needs consistency”, 26 October 2001.
156
See South China Morning Post of 29 January 2002, quoting CSRC chairman Zhou Xiaochuan as
follows, “Any market reform measures can only be carried out based on market stability and the
protection of the rights of shareholders. We must correctly assess the importance of the securities
markets to the national economy, and protect and take care of these markets.” The report also refers to
Premier Zhu Rongji stating in December 2001 that Beijing should find a way to resolve the problem of
raising cash needed for key programmes such as social security and reducing the state’s role in the
market without jeopardizing the interests of shareholders.
157
Th economic rationale for such a change is considered by Gordon and Wei (above, n37). They view
the current situation as one in which the government extracts monopoly rents from domestic investors
(equivalent to taxes on income from equity) by restricting the supply of domestic shares and
prohibiting foreign investment. As state ownership of listed companies declines those rents are shared
with other investors and therefore there is an incentive to move towards a system of explicit taxes on
equity income (and abandon ownership restrictions).
158
See South China Morning Post, China Stockmarket Report of 2-11-2001 quoting Laura Cha Shih
May-lung, vice-chairman of the CSRC.

NewCGin PRC - 25/04/02 39


as other mechanisms can be devised to achieve the same objective.159 But, on the
other hand, the long-term objective of integrating the Chinese stockmarkets into the
global capital markets will not be easily achieved if the state continues to hold control
rights (in whatever form) over companies.

G. THE BOARD OF DIRECTORS

The consequences of the separation of ownership and control in companies have


been widely discussed in the United States and the United Kingdom. Principal/agent
theory160 identifies the concerns arising from this separation and attempts to resolve
them. The main concern lies in ensuring that the (extensive) powers given to the
Board of Directors are exercised in the interests of shareholders and not for the
personal benefit of directors. In China (as in other countries in which controlling
shareholders are common) the principal/agent issue is less significant because
controlling shareholders are often able to control the board of directors so as to
ensure that the company is run according to their wishes. In such countries, the more
pressing issue is the extent to which controlling shareholders are able to run the
company so as to extract private benefits at the expense of other shareholders. In
both instances, however, the legal and regulatory provisions governing the structure,
composition and role of the board of directors is an important consideration. Another
factor is the manner in which directors’ legal liabilities are formulated as this can be
expected to influence the actions and decisions of the board. These issues are now
considered in the Chinese context as they are important in explaining how the state,
with a shareholding typically below 50% in most listed companies, is able to control
the board of directors.

(i) Structure, Composition and Role of the Board

China has adopted a two-tier Board structure, in which the supervisory board is
mandated for JSCs and formally charged with supervision of the Board of Directors

159
See for example K. Reiserer and V. Boll's discussion of privatization in Germany in International
Privatization p7 (Eds. D. Campbell and B. Hollywood, Kluwer, London 1996) which classifies
privatization into four techniques: organizational, operational, asset and functional. The first and last
techniques allow ownership to remain with the state. The first corresponds to the "corporatization"
stage in China's reforms in which SOEs are transformed into companies wholly owned by the state
prior to a public offer of shares. The last refers to the execution of functions undertaken by government
being delegated to private organizations.
160
See M C Jensen and W H Meckling, "Theory of the Firm: Managerial Behaviour, Agency Costs and
Ownership Structure", Journal of Financial Economics 3, no 4 (1976): 305-360.

NewCGin PRC - 25/04/02 40


and the Manager. 161 The purpose of a two-tier board is to create a clear institutional
and personal separation of monitoring and management organs within a company.
The supervisory board comprises representatives of the shareholders and
employees and, at least formally, has extensive powers to supervise the Board of
Directors.162 In this respect, it closely resembles the German Supervisory Board.163
The Chairman of the Board of Directors is designated as the legal representative of
the company, meaning that in principle he or she must sign documents binding the
company.164 The potential difficulties created by this approach are mitigated by the
fact that the powers of the legal representative can be delegated unless prohibited by
the articles.165 The position of Manager (or General Manager) is distinct from that of
Director and is mandated for JSCs by the company law.166 The role of the Manager
described in the company law would generally in the United Kingdom be undertaken
by an executive director (who might also have the title general manager). The
general manager in a Chinese JSC, appointed by the Board of Directors, is
responsible for the day to day management of the company.167 Specialised board
committees have been introduced by the recent Corporate Governance Guidelines.
They require listed companies to establish such committees for strategy, audit,
nomination (of directors and senior managers), salary & examination. The audit,
nomination, salary & examination committees should have a majority of independent
directors.

The term “composition” is used here to refer to the interests that are represented by
members of the board, in recognition of the fact they may represent different interests.
Shareholders should be concerned to ensure that collectively, the Board prioritises
the interests of the company. The presence of independent directors168 on the board
can help to ensure this outcome.169 It also promotes a separation between the

161
See Article 126 of the Company Law and Yongxin Song, "Some Special Features of The Organs of
Governance of Chinese Business Corporations" 24 Cap. U.L. Rev. 207 (1995).
162
See article 126 of the company law.
163
For a discussion of the composition and role of German supervisory boards see K J Kopt, “The
German Two-Tier Board: Experience, Theories, Reforms” in Hopt, Konda, Roe, Wymeersch and
Prigge (eds) Comparative Corporate Governance (OUP, 1998).
164
See Company Law articles 113 and 22(9).
165
See Wang Business Law of China p273.
166
Article 119.
167
Meir-Schatz (below n169, p5) takes the view that the Chinese company law rules relating to the
manager perform the same function as delegation rules in western (enabling) systems of company law
by recognizing that in reality the board of directors is performing a supervisory function rather than the
managerial function envisaged by the traditional corporate governance model.
168
Provide definition of independent from the Cadbury Code.
169
For a review of the literature linking board composition with company performance see C. Weir, D.
Laing and P.J. McKnight, “An empirical analysis of the impact of corporate governance mechanisms

NewCGin PRC - 25/04/02 41


controlling organ of the company and the controlled management, although this is
less formalised than in a two-tier board structure. In countries with a diffuse
ownership structure independent directors can protect against self-interested action
on the part of directors. It is this function which independent directors in the United
Kingdom (generally referred to as “non-executive directors”) are assumed to perform,
by for example, monitoring executive remuneration.170 In countries in which
controlling shareholders are present, it is likely that the board of directors will be
dominated by their nominees.171 In such countries, the presence of independent
directors, who have no link to the controlling shareholder, can help to ensure that the
interests of minority shareholders are taken into account at Board level.172 The
monitoring function of such independent directors is also promoted by their concern
to maintain their reputation in the external labour market.173

As in the United Kingdom, there are no provisions in the Chinese Company Law
relating to the composition of the Board of Directors. Research shows that boards of
directors in Chinese listed companies have been dominated by representatives of
state and legal person shareholders, to the effective exclusion of representatives of
individual shareholders.174 Frequently, Board members of Chinese listed companies

on the performance of UK firms” at ssrn.com. Weir et al report that UK boards have an average of 42%
independent directors and USA boards 76%. See also Gompers et al, “Corporate Governance and
Equity Prices” at ssrn.com. For an account of the development of the role of the independent director in
the USA, UK, Germany and elsewhere see C J Meier-Schatz, “Corporate Governance and Legal Rules:
A Transnational Look at Concepts and Problems of Internal Management Control” 13 J. Corp. L. 431
(1998).
170
Part 2, Section 1, provision A.3.2 of the Combined Code provides that "the majority of non-
executive directors should be independent of management and free from any business or other
relationship which could materially interfere with the exercise of their independent judgment". For a
discussion of the structure and role of the board of directors in the UK see CA Riley, "The
juridification of corporate governance: is it inevitable? is it desirable?" {SPTL Company Law Section
paper Sept 2001, published yet?}
171
This risk becomes particularly real in countries such as China, where cumulative voting is not used
to elect directors. Cumulative voting can reduce the extent to which controlling shareholders can fill
the Board of Directors with their nominees. Shareholders are allocated votes in proportion to their
shareholding. A vote allocated to the election of one director reduces the total available for the election
of other directors. Minority shareholders can more easily elect directors under this system than under
the voting system used in the UK in which a majority shareholder can control the election of all
directors. For a discussion and examples of the operation of cumulative voting in the USA see R.W.
Hamilton, The Law of Corporations pp 263-70 (West Publishing, 2000). The recently introduced
Corporate Governance Guidelines in China will require the use of cumulative voting in listed
companies in which a single shareholder holds 30% or more of the shares. This will require a change in
the articles of association of such companies.
172
Of course, to the extent that all directors within a controlling-shareholder system are the
representatives of controlling shareholders, it is false to distinguish between independent and executive
directors.
173
See Fama and Jensen, “Separation of Ownership and Control” 26 Jnl Law & Econ 301-349 (1987).
174
See Xianonian Xu and Yan Wang, "Ownership Structure, Corporate Governance, and Firms'
Performance: The Case of Chinese Stock Companies" (above, note 151), who present data based on the
1995 annual reports of listed companies. At that time there were 323 companies listed on the two

NewCGin PRC - 25/04/02 42


are not executive directors in the United Kingdom sense of having operational
involvement in the company's business, but that does not imply that they are
independent.175 There has also been a strong "insider" element in the composition of
the board in the form of current or previous managers, and the presence of effective
control by the local branch of the communist party in the selection of Chairman and
CEO.176 In recognition of the problems inherent in this type of board composition, the
CSRC has recently mandated that listed companies appoint independent directors.177
Chinese companies listed in Hong Kong are already subject to the requirements of
the SEHK listing rules, which require that a company have two independent
directors.178

The composition of the supervisory board in Chinese listed companies is determined


by the company's Articles of Association, subject to the requirements of article 124 of
the company law it be comprised of representatives of shareholders and employees
and have a minimum number of three. Directors, managers and responsible persons
in charge of financial affairs of a company may not serve concurrently as supervisors.

The role of the Board of Directors in Chinese listed companies is generally more
limited than in their UK counterparts.179 One reason for this is that concern to protect
state property from appropriation by managers resulted in the real decision-making
power being located in the shareholders' meeting, with the Board of Director's

exchanges compared with 1088 at the end of 2000. For companies in which either the state or legal
persons were the largest shareholders, they held respectively over 70% of the board seats on average.
Government officials filled half of all board positions, a proportion significantly higher than the state's
shareholding (held in the form of state-owned shares). As noted by On Kit Tam (The Development of
Corporate Governance in China, Edward Elgar Publishing, 1999) p74, one of the obstacles facing
active participation by individual shareholders in electing directors is that many companies restrict
participation in the shareholders' meeting by reference to a minimum level of shareholding. See also P.
Mar and M.N.Young, "Corporate Governance In Transition Economies: A Case Study of Two Chinese
Airlines", 36(3) Journal of World Business (2001) 280.
175
See On Kit Tam (above n174) who categorizes executive positions held by directors in Shanghai
listed companies. The largest category (34%) held no executive position.
176
See On Kit Tam (above n174, pp79/80).
177
The CSRC currently requires that all listed companies have 2 independent directors. From 2003, one
third of the directors must be independent. See CSRC Notice 102 (2001) to all Listed Companies with
respect to the Announcement of the Guiding System Concerning the Establishment of an Independent
Directors’ System in Listed Companies. According to the notice an independent director means a
director who does not take up any other positions in the appointing company, and he does not have a
relationship, which may interfere with his reaching an independent objective judgment, with the listed
company that appoints him and its major shareholders. The Corporate Governance Guidelines will also
require a listed company to establish a system of independent directors.
178
See chapter 3 of the SEHK Listing Rules. If the size of the Board or other circumstances justifies it,
the SEHK may require more than two independent directors.
179
See CA Riley (above n170) re the role of the Board of Directors in United Kingdom companies.

NewCGin PRC - 25/04/02 43


powers being primarily implemental in nature.180 An examination of the powers given
to the Board by the Company Law181 and the standard Articles of Association182
support this view. Comparison of those powers with the powers given to the Board of
Directors by Article 70 of the standard articles in the United Kingdom183 show that
they have been very narrowly formulated. A similar conclusion can be reached from
an examination of the (extensive) powers given to the shareholders’ meeting by the
Company Law184 and directors' perceptions of their powers.185 Within the Board of
Directors, the role envisaged for independent directors is similar to that envisaged by
the Combined Code in the United Kingdom although the CSRC notice provides
considerably more detail as regards the role and powers of independent directors
than does the Combined Code. The role of the supervisory board, as envisaged by
the company law, is to monitor the board of directors and, to this end, supervisors are
entitled to attend board meetings in a non-voting capacity. However, it is widely
recognized that they are largely ineffective in performing their monitoring function.186
The recent Corporate Governance Guidelines attempt to reinforce the role of the
Supervisory Board by requiring companies to adopt procedures for securing
information and providing that the Supervisory Board’s records should be an
important basis for the evaluation of the performance records of directors and
managers.

(ii) Directors’ Legal Liabilities

Directors’ legal liabilities are significant for corporate governance because they can
be expected to affect the manner in which directors’ act. This should hold true in both

180
Yongxin Song, "Some special features of the organs of Governance of Chinese Business
Corporations", 24 Capital University Law Review 207 (1995).
181
See Article 112 of the Company Law.
182
All domestic-listed companies must adopt the standard articles contained in the CSRC’s “Guidance
on the Articles of Association of Domestic Listed Companies” (promulgated 16 December, 1997). The
Articles do not alter the powers of the Board of Directors contained in the Company Law.
183
See The Companies (Tables A to F) Regulations (SI 1985/805), reproduced in British Companies
Legislation (CCH 2001). Table A contains the standard articles for a public company.
184
See article 103 of the Company Law. The powers given to the Board of Directors appear to be
mandatory provisions, precluding variation in the articles. However, even if they are viewed as default
rules, the requirement that listed companies adopt standard articles effectively precludes variation of
the powers of the board of a listed company in the articles.
185
See On Kit Tam (above n174) chap 6.
186
For the composition of supervisory boards, see Xu and Wang p13. For a survey of the functioning of
supervisory boards, see On Kit Tam (p87) who found that 78% of supervisors were not prepared to
investigate company affairs. Interviews with lawyers and professional investors indicated that the
position has not changed since Tam's survey. This is in line with the experience of supervisory boards
in Germany, in respect of which Meir-Spatz comments “The supervisory council tends either to
become the extended lever of the dominant shareholder or to degenerate into an advisory body without
influence on the executive unit” (see above n169, p13).

NewCGin PRC - 25/04/02 44


concentrated and diffuse ownership structures: in the former, directors’ legal liabilities
can limit the extent to which private benefits can be channelled to controlling
shareholders and in the latter they can limit the extent to which directors can act in a
self-interested fashion.

The legal liabilities of directors (including independent directors187) in China, as in


other civil law jurisdictions, are formulated without reference to the wide-ranging
concept of fiduciary duty found in common law jurisdictions.188 That consideration, in
itself, does not have very significant implications because the detailed provisions in
the Chinese Company Law and standard Articles encompass almost all the aspects
of fiduciary duty.189 For example, reference is made to the faithful performance of
duties and upholding the interests of the company. There are prohibitions against
using the position of director for personal gain, accepting bribes, misappropriating or
lending company funds, using company property as collateral for personal debts,
competing with the company, entering into contracts not authorised by the Articles or
a shareholders' resolution and disclosing company secrets.190 In the case of
overseas listed companies, the mandatory articles specify additional duties for
directors.191 One notable omission (in respect of both domestic and overseas listed
companies) is an express prohibition against misappropriation of corporate
opportunity. It is difficult to fit this into any of the general duties outlined above, not
least because such conduct often occurs after a director has resigned so as to
pursue the relevant opportunity.192 This omission is not however, inherent in the

187
Chinese company law (as is the case in the United Kingdom) makes no distinction between
executive and non-executive (or independent) directors for the purposes of legal duties and liabilities.
The CSRC notice on independent directors (article 2) emphasizes that an independent director owes a
fiduciary duty and due diligence duty towards its listed company and all shareholders.
188
Fiduciary duty in the common law context imposes three main obligations on directors: (I) to act in
good faith for the benefit of the company (ii) to exercise their powers of office only for proper purposes
(iii) to avoid possible conflicts of personal and company interests. Howson (above n45) notes that the
Standard Opinion that preceded the Company Law did refer specifically to a concept of fiduciary duty
(Chengxin Zeren). This resulted from the Hong Kong securities authorities insisting that directors of
companies making ‘H’ share offerings be bound by some credible notion of fiduciary duty. Zhu Sanzhu
(above n67, p150) notes that this concept was specifically incorporated into the Articles of Association
of the first nine PRC companies that made H share offerings in Hong Kong. The new Corporate
Governance Guidelines refer to independent directors owing a fiduciary duty towards the company and
all shareholders.
189
See M I Nikkel, “Chinese Characteristics in Corporate Clothing: Questions of Fiduciary Duty in
China’s Company Law” 80 Minn. L. Rev. 503.
190
See articles 59 to 63 of the Company law.
191
See articles 112-116 of the MPs.
192
See Yongxin Song, “Some Special Features of the Organs of Governance of Chinese Business
Corporations” 24 Cap U.L. Rev 207, who takes the view that the absence of any relevant provisions is
a "serious loophole of the corporate law" (p10). However, interviews indicated that it is common for
directors' service contract to contain restrictive covenants which limit competition with the company

NewCGin PRC - 25/04/02 45


Chinese or civil law approach towards the definition of directors’ duties – in principle
there is no reason why such a prohibition should be excluded, and there would seem
to be no clear reason why it could not be introduced in the future.

Another consideration is the absence from the company law or domestic articles of
association193 of any standard required from directors in the performance of their
duties. While it is true that this does not form part of the Companies Act in the United
Kingdom it is made clear (albeit in an unsatisfactory manner) by the common law
relating to the duty of care and skill.194 The articles for overseas listed companies do
include a provision (article 115), which is quite similar in its formulation to the
common law position in the UK.

The provisions of the Chinese Company Law relating to directors’ liabilities are
formulated very narrowly. Article 63 refers to directors being liable to the company if,
in performing their duties, they violate the law, administrative regulations or the
articles of association. Article 118 refers to directors being liable for resolutions
passed by the board, which violate the law, administrative regulations or the articles,
subject to the proviso that a director whose objection to the resolution is recorded in
the minutes of the board meeting may be exempted from liability. Thus, it can be
concluded that the duty of care is limited to illegal acts and resolutions and does not
require directors to meet the standard of a reasonable person or to exercise the
standard of care required by the "business judgment rule" in the United States.195

H. MINORITY SHAREHOLDERS’ RIGHTS

Minority shareholders' rights have featured prominently in recent research on links


between legal systems, investor protection and capital markets presented by LLSV
who demonstrate a link between legal rules (both as regards formulation and

should the director resign. Articles 80-91 of the standard articles for domestic-listed companies also
deal with the performance of directors' duties but do not refer to misappropriation of opportunity.
193
The CSRC Notice "Guidance on the Articles of Association of Domestic Listed Companies" (16
December 1997) sets out mandatory provisions to be contained in the Articles of companies with a
listing in China. Companies that adopt the "Mandatory Provisions in Articles of Association of
Overseas Listed Companies" (CSRC Notice of August 27 1994) are exempt from the domestic
requirements.
194
The Company Law Review Steering Group in the UK has proposed a statutory statement of
directors’ duties incorporating an objective standard of liability. See Modern Company Law for a
Competitive Economy: Developing the Framework (London, DTI, March 2000). See also CA Riley
(above n?).

NewCGin PRC - 25/04/02 46


enforcement) originating in different legal traditions (civil and common law) and the
development of capital markets.196 The implication is that civil law systems are in
general less friendly towards investors and therefore less conducive to the growth in
capital markets.197 In particular, the weak protection of minority rights associated with
civil law jurisdictions is seen as limiting the ability of companies to raise external
finance because the potential providers of that finance do not have adequate legal
rights.198 The analysis has been developed further by research showing that good
enforcement of law is critical for investor protection in transition economies: it is not
enough to transplant the “law on the books” from more developed countries.199
Aspects of the LLSV theory have been challenged by Roe200 (who disputes the
causal links claimed by LLSV) and Coffee201 (who claims that LLSV overstate the
significance of corporate law and understate the significance of securities regulation
and listing rules). Nevertheless, the underlying significance of minority rights as an
element of corporate governance is widely accepted. In the Chinese context, the
issue is of particular interest because of the presence of a controlling shareholder, in
the form of the state, in most listed companies. Private investors in China (institutions
or individuals) therefore have a particular interest in the rights of minority
shareholders, because in reality, this is what defines their rights as shareholders.

The discussion here is focussed on a broad view of minority shareholders’ rights.


Legal provisions protecting minority shareholders from expropriation of private
benefits on the part of controlling shareholders can take a variety of forms. The most
obvious is a specific remedy available to minorities, such as that provided by s459 of
the Companies Act 1985 in the United Kingdom or the common law “derivative
action”. Minority protection can, however, also be integrated into other rules (listing
rules as well as company law) such as those relating to voting requirements202,
directors’ legal liabilities and rules governing voting by controlling shareholders.

195
This is the conclusion reached by Yongxin Song (above n?), p11.
196
See LLSV, “Legal Determinants of External Finance” 52(3) Jnl of Finance 1131 (1997).
197
See LLSV, “Law and Finance” 106(6) Jnl of Political Economy 1113 (1998).
198
See LLSV “Investor Protection and Corporate Governance” at ssrn.com.
199
See K. Pistor, M. Raiser and S. Gelfer “Law and finance in transition economies” 8(2) Economics of
Transition 325-368 (2000).
200
See M J Roe “The Quality of Corporate Law Argument and its Limits” Columbia Law School
Center for Law and Economic Studies Working Paper No 186 at ssrn.com.
201
Coffee “Privatization and CG: The Lessons from Securities Market Failure” 25 J. Corp. L. 1
202
See Howson (above n45, p147) who refers to the absence in the Chinese Company Law of (a) a
quorum requirement for the general meeting of shareholders and (b) any differentiation between
general and special resolutions. He regards this as evidence of a lack of concern for minority
shareholders on the part of the drafters of the Company Law. The Standard Opinion preceding the
Company law had contained such provisions. See Avilov (above n55) for a discussion of rules that can
be adopted in the company law of transition economies to promote minority shareholders’ rights.

NewCGin PRC - 25/04/02 47


China does not have a minority protection provision comparable to s459 or the
common law “derivative action”203 but the standard Articles of Association for
domestic listed companies do require controlling shareholders to take account of the
interests of the company and other shareholders when exercise their voting rights.204
As is the case with the line of common law authority in the United Kingdom that
developed the concept of shareholders casting their vote in the best interests of the
company as a whole205, it is difficult to apply such a provision in practice. Even more
problematic is the statement in article 19 of the new Corporate Governance
Guidelines that a controlling shareholder owes a fiduciary duty to other shareholders.
Taken literally, this would prohibit a controlling shareholder acting in any way
contrary to the interests of minority shareholders.

As a civil law jurisdiction, China would be expected to fall into the investor-unfriendly
category of countries identified by LLSV.206 An examination of the components of
LLSV’s "antidirector rights index" shows this to be the case. The index 207 is intended
to act as an indicator of the level of minority protection in different countries and is
calculated by adding one when each of the following occurs (the actual value for
China being shown in brackets, based on the position of domestic listed companies)
(a) Shareholders can mail their vote to the company (China, zero).
(b) Shareholders are not required to deposit their shares prior to the AGM (China +1).
(c) Cumulative voting or proportional representation of minorities in the board of
directors is allowed (China, zero).
(d) An oppressed minorities mechanism is in place (China, zero).
(e) The minimum percentage of capital that is necessary for shareholders to call an
EGM is equal to or less than 10% (China, +1).
(f) Shareholders have pre-emptive rights that can only be waived by a shareholders
vote (China, zero).208

203
The point has been made, however, that Article 111 of the Chinese Company law may serve a
similar purpose to a derivative action. It allows shareholders to seek a court injunction preventing
implementation of a resolution (of the shareholders’ meeting or board of directors) that violates laws,
regulations or shareholders’ legitimate interests. See Lawrence Liu (above note 45) at p46.
204
Article 40 of the Standard Articles for domestic listed companies.
205
For a review of these cases see I. MacNeil, “Shareholders’ Pre-Emptive Rights” 2002 JBL 78.
206
China is not included in the extensive analysis in LLSV, "Legal Determinants of External Finance",
52(3) Journal of Finance 1131(1997). In principle, China would fall into the German-origin civil law
jurisdictions in that analysis.
207
See La Porta et al, "Law and Finance", Journal of Political Economy 106, 1113-1155. For a
lawyer’s critique of the index see M J Roe, “The Quality of Corporate Law Argument and its Limits”
Columbia Law School Center for Law and Economic Studies Working Paper No 186 at ssrn.com. For
an alternative view of essential minority protections, see Avilov (above n55, p8).
208
The reference here is to pre-emptive rights over new issues of shares by the company. The position
in respect of shareholders' pre-emptive rights is that they are not recognized by the company law in

NewCGin PRC - 25/04/02 48


China's grand total of two compares with a world average of 3.0 and an average for
common law jurisdictions of 4.0. Although the index may be insensitive to a number
of factors relevant to minority protection, it is difficult to avoid the broad conclusion
that China's company law has been formulated without much weight being given to
minority protection. This is consistent with the protection of state interests and state
property being the primary consideration in the drafting of the Company Law. The
difficulty of enforcing minority shareholders’ rights in courts also supports this view.209
The first reported case involved minority shareholders suing directors for fabricating
profits. Prior to the local court delivering its verdict, the Supreme Court issued a
notice210 suspending the action on the basis that it could lead to a deluge of similar
actions, which the court lacked the necessary expertise to judge. The Supreme
Court has now issued a notice211 permitting lawsuits in respect of false information
only, subject to a prima facie case having been established by a CSRC
investigation.212

The legal position of minority shareholders changes when one looks at overseas
listed companies and takes into account the articles of association that are mandated
for those companies. The mandatory provisions for overseas listed companies
comprise 166 articles (compared to 230 for the company law and 194 for the
standard domestic articles), which must be incorporated into the articles of
association prior to an overseas listing. Two of the provisions relevant to minority
protection are contained in both the mandatory provisions for overseas companies
and the standard articles for domestic companies. They are:
(a) Shareholders representing 5% or more of the company's voting rights may
propose motions for discussion at the AGM (article 54 of the articles for overseas
companies and 42 for domestic companies).

respect of JSCs, but can be included in the Articles. They are not included in the standard articles
although article 22 provides that the shareholders’ meeting can decide that a new share issue can be in
the form of a rights issue. For an alternative to LLSV’s view of the centrality of pre-emption rights to
the protection of minorities, arguing that shareholders pre-emptive rights are not are inherent element
of shareholders’ ownership rights, see I. MacNeil, “Shareholders Pre-Emptive Rights” 2002 JBL 78.
209
See generally Donald C Clarke “Power and Politics in the Chinese Court System: the Enforcement
of Civil Judgments” 10(1) Columbia Jnl of Asian Law (1996).
210
Notice Concerning Suspension of lawsuits for civil compensation related to Securities, Sep 21 2001,
Famingchaun [2001] No. 406. The notice requires any claim of wrongdoing to be based on evidence
provided by the CSRC’s investigation of the matter.
211
Dated 15 Jan 2002.
212
The South China Morning Post of 29 January 2002 reported three such cases being filed against
Shanghai-listed companies.

NewCGin PRC - 25/04/02 49


(b) Shareholders representing 10% or more of voting shares have the right to
organise an EGM if the board of directors fail to organise a meeting at their
request (article 72 for overseas companies, article 44 for domestic companies ).
The Company Law (article 104) provides for shareholders holding 10% or more
of the shares to request an EGM but does not authorise them to organise one.

However, there are also important provisions contained in the mandatory provisions
for overseas companies that are not contained in the standard domestic articles.
They are:
(a) Shareholders have enhanced rights to information and disclosure of the financial
position of the company (article 45).
(b) The duties of directors are formulated in greater detail (articles 114-118). There is
an additional provision (article 118) relating to the obligations of directors subsequent
to their term in office.213
(c ) Controlling shareholders voting rights are restricted (article 47)214. There are
three restrictions. A controlling shareholder cannot exercise its voting rights to (I)
relieve a director/supervisor from his/her responsibility on the basis that it is in the
best interests of the company (ii) to approve that a director or supervisor expropriate
company property using any means including any commercial opportunity which is
open to the company215 (iii) to approve that a resolution or action of a director or
supervisor divests any other shareholder of their individual rights and interests
including any right to dividend and voting rights (other than under a company
reorganisation approved by the shareholders' meeting in accordance with the
articles).

213
The substance of this provision is not entirely clear. The prohibition against disclosing confidential
information subsequent to the term in office is clear enough but the provisions relating to the duration
of other obligations is rather obscure. It states "The duration of other obligations shall be determined in
accordance with the principle of fairness and shall depend on the length of time between the occurrence
of an event and the time such post is terminated and on the circumstances under which such director,
supervisor, manager and other senior management personnel ended their relationship with the
company."
214
A controlling shareholder is defined in article 48 of the Mandatory Provisions as (1) a shareholder
who can elect a majority of directors either in its own right or when acting in concert with others (2) a
shareholder who can exercise more than 30% of the company's voting rights either in its own right or
when acting in concert with others (3) a shareholder who holds more than 30% of the company's issued
shares either in its own right or when acting in concert with others (4) a shareholder who can exercise
actual control of the company in any other way either in its own right or when acting in concert with
others.
215
The presence of this provision in the Mandatory Provisions supports Song's argument (above n180)
that the company law does not prohibit that misappropriation of corporate opportunity. If it did, there
would be no need for this provision in the Mandatory Provisions.

NewCGin PRC - 25/04/02 50


These provisions considerably enhance the position of minority shareholders, even
though there is no change to China’s score on the LLSV index.216 However,
enforcement of these rights by shareholders remains problematic. While in principle
all shareholders are entitled to enforce the (amended) articles, it is not clear if courts
in China will treat shareholders in overseas listed companies any differently from
shareholders in domestic companies, who do not have such extensive rights. There
are also problems for foreign shareholders, at least those outside Hong Kong. The
MPs require that in respect of disputes concerning foreign capital shares listed in
Hong Kong, disputes must be referred to arbitration.217 No such provision is made in
respect of disputes involving foreign capital shares listed elsewhere .

Amendment of the articles of association in line with the Mandatory Provisions does
not appear to generate any systematic response in the share price of the relevant
companies.218 This runs contrary to the conventional wisdom embodied in the recent
law and finance research, which regards the governance structure as a significant
factor in the pricing of shares, by markets.219 It also runs contrary to the "bonding"
thesis in respect of overseas listing, which holds that overseas listing in jurisdictions
with higher regulatory standards than the home country will generate a positive
response in share price.220 The amendment of the articles to correspond with the
MPs should be viewed as a considerable enhancement of the governance structure
by comparison with domestic-only listed Chinese companies. However, the closed
nature of the Chinese A-share market, combined with the low percentage of
marketable shares makes it difficult to reach conclusions. Shares in the A Share
market generally trade at levels significantly higher than foreign capital shares
(issued by the same company and carrying the same rights) traded in overseas
markets.221 Moreover, there is at present no linkage between shares traded in the A
share market in China and those traded in overseas markets.222

216
This tends to support Roe’s argument that the index is a very crude measure of minority rights.
217
See article 163, which provides for the dispute to be referred to the China International Economic
and Foreign Trade Arbitration Commission or the Hong Kong Arbitration Centre. The laws of the PRC
apply to the arbitration unless otherwise stipulated in relevant laws and regulations.
218
The observation is based on responses generated by interviews with fund managers, lawyers and
regulators, as the author has not been able to carry out event studies on relevant companies share prices
before and after amendment of the articles.
219
For the general theoretical background see Easterbrook and Fischel, The Economic Structure of
Corporate Law.
220
See I. MacNeil "Competition and Convergence in Corporate Regulation: The Case of Overseas
Listed Companies" at ssrn.com.
221
Data on the relationship between share prices in the A and H share markets can be found in
Xiaoqing Eleanor Wu, "Market Structure, Volatility, and Performance of H Shares", 34(1) The Chinese
Economy. This shows that for the 17 Chinese companies which had issued both A and H shares by the
end of 1997, the average discount of the H to the A shares had moved to 85%. The most significant

NewCGin PRC - 25/04/02 51


CONCLUSIONS

The Chinese experience in developing the legal and institutional framework of


corporate governance for listed companies has been characterised by a number of
features. It forms part of a gradual transition to a market-based system, unlike the
rapid transition pursued in countries of the former Soviet-bloc. The adoption of
corporate and securities law has featured experimentation and ad hoc measures
prior to the introduction of national measures. In the main, there has been no
fundamental re-working of western models of corporate governance so as to take
account of the objective of establishing a “socialist market economy”. Perhaps
perversely, China falls into the “shareholder primacy” model of corporate governance.
The “socialist market” objective is pursued not through internal governance structures
mandated by the law but through extensive state regulation of financial markets and
direct ownership of shares in listed companies. Considerable effort has been made to
bring China rapidly into line with international regulatory standards, as evidenced by
the recent introduction of a system of independent directors and Corporate
Governance Guidelines for Listed Companies.

State control of the capital markets has involved the substitution of regulation for
market forces in several areas of the capital market. The most obvious example is
state regulation of listing and share issuance, which has moderated in recent years
but is still much more extensive than in the west. The result is that, while there
appears to be reliance on the market to allocate capital between competing uses, the
reality is that the state is still very much in control. This raises the basic question of
the function of the financial markets in China. They were developed primarily to
assist in the re-structuring of SOEs, through the introduction of private capital, but
have not yet developed an extensive role as a forum for trading shares in private
enterprises. For that to occur, two developments are necessary. First, there needs to

movement was between 1994/95 when H shares moved from a premium of 15% to a discount of 47%
relative to the corresponding A shares as international investors reacted negatively to the PRC
government's austerity programme.
222
Wu (above n222) shows that there is strong intraday transmission of information between B shares,
H shares and Hong Kong shares and weak contemporaneous transmission between A and H shares.
This is in line with previous research (prior to the opening of the B share market to domestic investors)
on the relationship between the A and B share markets which had found segmentation and limited
information transmission between A and B shares, with B shares being more sensitive to the listed
company's fundamental profitability (see HG Fung, W Lee and W.K. Leung, "Segmentation of the A
and B Share Equity Markets", 23 Journal of Financial Research 179-95 (2000)).

NewCGin PRC - 25/04/02 52


be an increase in the proportion of the market capitalisation represented by
marketable shares. Second, regulatory controls over listing need to be eased so as
to allow listing of companies in which there is no state shareholding.

Disposal of the state shareholdings in listed companies now seems likely in the
medium term. Ideological or constitutional constraints on the withdrawal of the state
from a key ownership role in the economy have been overcome in the same
pragmatic manner evident in the whole reform process in China. Attention is now
focused on the more practical problem of how to dispose of large state shareholdings
without depressing the values of the relatively small proportion of shares currently
held by the public. Underlying this process is a more fundamental concern on the
part of regulators and policy makers that it is essential to preserve confidence in the
operation of the capital market in the early stages of its operation.

The legal framework relating to the board of directors and minority shareholders’
rights facilitates state control of listed companies, through shareholdings typically
below 50%. Boards lack real decision-making power, which is located in the
shareholders’ meeting. The absence of cumulative voting provides disproportionate
power to major shareholders in electing the board. Supervisory boards, which in
principle might dilute the interests of the state through promotion of the interests of
employees, are generally weak. The introduction of independent directors will help to
limit the control over board decisions by major shareholders. Minority shareholders
enjoy relatively little protection in China, although the position does improve in the
case of those companies who list overseas and are then required to incorporate
additional minority protection into their articles.

Finally, from the perspective of comparative corporate governance, the Chinese


experience suggests that convergence is a strong force. This is particularly
noticeable at the level of securities law and CSRC regulatory rules and less so at the
level of Company Law, which has some distinctive features. While unique, the
Chinese experience tends to support the view that listed companies are converging
towards a single global model of regulation.

NewCGin PRC - 25/04/02 53


APPENDIX

Table 1 - Distribution of Shareholdings in Chinese Listed Companies (%)223

Share type 1995 1996 1997 1998 1999

(1) State 39 35 32 34 36
(2) Domestic promoter
Legal Person 16 18 23 21 19
(3) Overseas legal person 1 1 1 1 1
(4) Social legal person 7 8 7 6 6
(5) Staff (employee) 0 1 2 2 1
(6) Other (convertible) 1 1 1 1 1

Total Non-Marketable
Shares 64 65 65 66 65

(7) A Share 21 22 23 24 26
(8) B Share 7 6 6 5 5
(9) H Share 8 7 6 5 4

Marketable Total 36 35 35 34 35

Table 2 Profile of Chinese Securities Market

Year 1996 1997 1998 1999 2000


Total Listed Companies 530 745 851 949 1088
B-Share Listings 85 101 106 108 114
H-Share Listings 25 42 43 46 52

Shanghai Composite Index 917.01 1194.10 1146.70 1366.58 2073.48


Shenzhen Composite Index 327.45 381.29 343.85 402.18 635.73

Number of Securities
Investment Funds 0 0 6 23 34

223
Source: CSRC. Social legal persons include securities companies who hold shares as principals,
other companies who hold shares and organisations such as co-operatives. Shares held by institutional
investors on behalf of the individual domestic investors (e.g. through investment funds managed by a
professional manager) are shown in category 7 (marketable A shares).

NewCGin PRC - 25/04/02 54


Table 3 Ratio of Market Capitalization to GDP and Domestic raised Capital to
Newly-Increased Fixed Asset Investment224

Year GDP Market % Negot. % New f-a Dom


Cap. GDP Market Cap GDP Inv. Cap225 %226

1995 58478.1 3474.0 5.94 937.94 1.60 20300.5 85.51 0.42


1996 67884.6 9842.37 14.50 2867.03 4.22 23336.1 294.34 1.26
1997 74772.4 17529.23 23.44 5204.43 6.96 25154.2 856.06 3.40
1998 79552.8 19505.64 24.52 5745.59 7.22 27630.8 778.02 2.82
1999 82054.0 26471.17 31.82 8213.97 9.87 29475.2 896.83 3.04
2000 89404.0 48090.94 53.79 16087.52 17.99 n/a 1498.52 n/a

Table 4 Role of securities markets in foreign investment in China227

Year Total Foreign Foreign Equity Foreign Bonds % %


Investment (A) Capital raised (B) Issued (C) B/A C/A
1995 3995.04 64.81 78.06 1.62 1.95
1996 4548.73 130.74 143.39 2.87 3.15
1997 5345.86 469.53 35.37 8.78 0.66
1998 4860.23 63.50 83.0 1.31 1.71
1999 3338.33 47.17 0 1.41 -
2000 3376.17 576.21 n/a 17.07 n/a

Table 5 P/E Ratios and Turnover Rates in the Chinese Stockmarkets228

Year Shenzhen A Shenzhen B Shanghai A Shanghai B


P/E Turnover P/E Turnover P/E Turnover P/E Turnover
1995 9.39 309.56 5.86 30.9 13.66 519.41 8.00 56.26
1996 38.52 949.68 12.54 96.85 31.13 760.05 14.04 61.58
1997 42.38 662.32 10.71 131.32 42.44 534.99 11.99 74.60
1998 32.18 411.14 5.82 45.88 33.66 355.3 6.04 57.30
1999 38.28 371.61 10.39 95.40 36.59 421.55 10.05 92.59
2000 59.62 396.47 13.50 89.09 58.63 504.07 25.23 151.24

224
Figures are in RMB 100m.
225
Includes initial and subsequent issues.
226
This column shows the ratio of domestic raised capital to newly increased fixed asset investment. It
provides an indicator of the significance of the stockmarkets in providing finance for new investment.
227
Figures are in RMB100m. Source: China Securities and Futures Statistical Yearbook. Foreign
equity capital comprises the proceeds of B, H and N share issues. The sharp rise in foreign capital
raised in 2000 is due to tenfold increase over 1999 in the number of H and N shares issued. Figures for
foreign issued bonds in 2000 are not available.
228
For negotiable shares. Source : China Securities and Futures Statistical Yearbook. Turnover is
calculated as the annual value of turnover over year-end market capitalization.

NewCGin PRC - 25/04/02 55


Table 6 Shares Issued and Capital Raised by Category

1996 1997 1998 1999 2000


A-Share
Number (bn) 38.29 105.65 86.30 98.11 145.68
Value (RMB 100m) 224.45 655.06 412.59 512.88 840.87
H & N Shares
Number (bn) 31.77 136.88 12.86 23.05 7.10
Value (RMB100m) 83.56 360.00 37.95 47.17 562.21
B-Share
Number (bn) 16.05 25.10 9.90 1.77 359.25
Value (RMB 100m) 47.18 80.76 25.55 3.79 13.99

A and B Share Rights


Issue value (RMB 100m) 69.89 198.00 334.97 320.97 519.46

Total capital raised (RMB100m) 425.08 1293.8 811.06 884.8 1936.53

Table 7 Overseas Listings by Chinese Companies229

Total overseas listings 56

H share issue only (i.e. no domestic issue) 34


A shares and H shares issued 22

Listed only in
Hong Kong 42
NYSE 1
LSE 1
Singapore 1

Dual listing in
USA and UK 10
Hong Kong and UK 3

229
Source: CSRC

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