VOLUME 26 | NUMBER 3 | SUMMER 2014
Journal of APPLIED CORPORATE FINANCE
In This Issue: China’s Capital Markets and Corporate Governance
Was Deng Xiaoping Right? An Overview of China’s Equity Markets 8 Carl E. Walter
Corporate Governance in China 20 Randall Morck, University of Alberta, and Bernard Yeung, National University of Singapore
Presentations at the CARE Conference, Hong Kong Polytechnic University
Challenges for China—Beyond Minority Listing of SOEs 43 David Webb, Webb-site.com
Asian Corporate Governance—and the Case of Dual-Class Shares 50 K.C. Chan, Secretary for Financial Services and the Treasury, Hong Kong
Financial Reporting Practices of China’s Listed Firms 53 Joseph D. Piotroski, Stanford University Graduate School of Business
Son of Enron: Investors Weigh the Risks of Chinese Variable Interest Entities 61 Paul Gillis, Peking University, and Michelle René Lowry, University of Hong Kong
The State of Asian Corporate Governance 67 Jamie Allen, Secretary General, Asia Corporate Governance Association
Equity Financing for Early-Stage Companies in China 71 Ning Jia, Tsinghua University
The State of Sustainability in China 76 Peijun Duan, China Central Party School, and Robert G. Eccles, Harvard Business School
Politically Connected CEOs, Corporate Governance, and the 85 Joseph P. H. Fan, T.J. Wong, and Tianyu Zhang, Post-IPO Performance of China’s Partially Privatized Firms The Chinese University of Hong Kong
The Composition and Effectiveness of Audit Committees in the 96 Re-Jin Guo, University of Illinois at Chicago and Presence of Large Controlling Shareholders Yin-Hua Yeh, National Chiao Tung University VOLUME 26 | NUMBER 3 | SUMMER 2014
In This Issue: China’s Capital Markets and Corporate Governance
A Message from the Editor 2 Executive Summaries 4
Was Deng Xiaoping Right? An Overview of China’s Equity Markets 8 Carl E. Walter
Corporate Governance in China 20 Randall Morck, University of Alberta, and Bernard Yeung, National University of Singapore
Presentations at the CARE Conference, Hong Kong Polytechnic University June 9-10, 2014
Challenges for China—Beyond Minority Listing of SOEs 43 David Webb, Webb-site.com
Asian Corporate Governance—and the Case of Dual-Class Shares 50 K.C. Chan, Secretary for Financial Services and the Treasury, Hong Kong
Financial Reporting Practices of China’s Listed Firms 53 Joseph D. Piotroski, Stanford University Graduate School of Business
Son of Enron: Investors Weigh the Risks of Chinese Variable Interest Entities 61 Paul Gillis, Peking University, and Michelle René Lowry, University of Hong Kong
The State of Asian Corporate Governance 67 Jamie Allen, Secretary General, Asia Corporate Governance Association
Equity Financing for Early-Stage Companies in China 71 Ning Jia, Tsinghua University
The State of Sustainability in China 76 Peijun Duan, China Central Party School, and Robert G. Eccles, Harvard Business School
Politically Connected CEOs, Corporate Governance, and the 85 Post-IPO Performance of China’s Partially Privatized Firms Joseph P. H. Fan, T.J. Wong, and Tianyu Zhang, The Chinese University of Hong Kong
The Composition and Effectiveness of Audit Committees in the 96 Presence of Large Controlling Shareholders Re-Jin Guo, University of Illinois at Chicago and Yin-Hua Yeh, National Chiao Tung University A Message from the Editor
Since the death of Mao and the return to and Taipei, he moved in 1992 to Beijing, largely an illusion created and maintained power of Deng Xiaoping in the late 1970s, where he lived and worked for the next by (1) government-granted monopolies the Chinese government has succeeded 20 years. During that time, he played a and protection against foreign competi- in engineering what two contributors to leading role in China’s first IPO, Brilliance tors and (2) a seemingly endless supply this issue—Randall Morck and Bernard China Automotive, which was launched of cheap capital provided in large part by Yeung—describe as “the greatest economic in October 1992. Then, after establishing China’s state-owned banks (whose main feat in the history of the world—the lifting Credit Suisse First Boston’s China office, mandate is to promote domestic growth, of hundreds of millions of people out of he helped lead-manage in August 1994 full employment, and the financial stability the abject poverty of a pre-industrial soci- the first listing of a state-owned enterprise, of the SOEs). And so, as Walter sums up ety.” “No other government,” Morck and Shandong Huaneng Power, on the New the current state of affairs, Yeung go on to say, “has achieved anything York Stock Exchange. And after joining remotely comparable.” Morgan Stanley in 1999, Walter became For the most part China’s National How was this feat accomplished? Was a member of the Management Committee Champions remain state-controlled enter- it the willingness of Deng and the Chi- of China International Capital Corpo- prises and act like them. Beijing plays every nese Communist Party to adopt Western ration (CICC), China’s first and most role from issuer, to underwriter, to regulator, market capitalism? The answer offered by successful joint venture investment bank. to controlling investor and manager of the the collection of articles and CARE con- In that role, he not only supported debt exchanges. The state in its many guises still ference presentations in this issue is yes and stock offerings by Chinese companies, owns nearly two-thirds of domestically listed and no. (CARE, for those unfamiliar with but participated in numerous financial company shares. it, is Notre Dame’s Center for Account- reforms over the years. ing Research and Education; and the In 2010 Walter drew on these experi- Thus it’s not surprising that the Chinese presentations in this issue took place at a ences to publish (with co-author Fraser government’s conception of the role and conference hosted in June by Hong Kong Howie) a book called Red Capitalism: The rights of shareholders has turned out to be Polytechnic University and organized by Fragile Financial Foundation of China’s very different from that in most Western CARE’s director Peter Easton of Notre Extraordinary Rise. The main argument of economies. Whereas the shareholders of Dame together with Joe Piotroski of Stan- the book—which was recognized by The companies in the West—and even some ford and Gary Biddle of the University of Economist and Bloomberg as “A Best Book parts of Asia—play an important role in Hong Kong.) of the Year”—is that despite the inten- disciplining the managements of underper- Let’s begin with a look at our lead tions of its reformers, China has ended up forming firms, the minority shareholders article. Its author, Carl Walter, is a Stan- adopting the forms, but not the substance, of Chinese SOEs are viewed in Beijing as ford Ph.D. in Political Science who was of Western capital markets. With consider- a powerless and voiceless source of inex- among the first American graduate stu- able help from U.S. investment banks like pensive capital. Most Chinese managers, dents to study in China after the collapse Goldman Sachs and Morgan Stanley, the as Walter reports, view equity as a form of Maoist revolution at the end of the Chinese government succeeded in repli- of bank loan with “optional” payments of 1970s. Fluent in Mandarin, Walter was cating the entire panoply of institutions interest called dividends. able gather enough material during his that support public capital markets, from That said, it’s also not hard to see why first stay in Beijing—which ended with his stock exchanges to regulators and audi- the interest of most Western institutional acquiring a certificate in “advanced study” tors to listed companies large enough to investors in Chinese companies—the from Peking University—to complete his justify the costs of raising public equity recent case of Alibaba notwithstanding— Ph.D. dissertation on China’s central bank capital. But, as Walter makes clear, the has been falling steadily since the flurry of back at Stanford in 1981. But instead of profitability and values of most of China’s successful banking IPOs in the mid-2000s becoming an academic, Walter became a publicly traded companies—virtually all and the series of governance scandals in banker; and after several years in Tokyo of them state-owned enterprises—are recent years. For as Walter points out,
2 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 with the state still holding a clear majority After noting the aptness of the Com- Second, and more important, although of domestically listed shares, “Outsiders munist Party’s official name for its the “Big Push” has raised China to the cannot help suspecting that state entities approach—“market socialism with Chi- middle ranks of the world’s economies, largely control the share price movements nese characteristics”—Morck and Yeung the odds are against its success in taking of even Hong Kong-listed Chinese com- go on to show its affinity with the writings China to the next level. China’s per capita panies.” And this means that for overseas of Paul Rosenstein-Rodan, a mid-20th GDP, at about $6,000, is now about the investors looking at Chinese companies, century development economist cred- same as Peru’s—as compared to $50,000 there are two main sources of uncertainty ited with designing the World Bank. In or more for the U.S., U.K., and other that are likely to prevent their stock prices this economist’s view, the main challenge “high-income” countries. Recent economic from reflecting fundamental values: (1) for most of today’s developing economies history is full of rapid ascents by develop- uncertainty about who’s buying the stock: is finding a way to overcome “coordina- ing countries (like Brazil and Argentina) are there large inflows of government tion failure”—that is, to create networks that, with almost predictable regularity, capital ready to prop up the values when of suppliers and manufacturers necessary become mired in what economists now call useful or expedient? and (2) uncertainty for large-scale production where there “the middle income trap.” After discuss- about the fundamentals themselves: will are none or few. The solution to this ing the main contributor to this trap—the the government continue to protect the problem—and Rosenstein-Rodan’s main tendency of well-entrenched “elites” to monopolies and favored access to public contribution to development econom- suppress competition—Morck and Yeung assets on which much of the value of such ics—is what he calls the “Big Push,” a close by expressing strong doubt that companies depends? government-orchestrated effort to plan China will continue its rise into the world’s But if Walter is right and China’s leaders and carry out the simultaneous develop- economic upper ranks until it adopts the have retreated from their initial commit- ment of networks of companies across a substance as well as the form of those ment to market capitalism, then how range of industries. And the best illustra- “missing institutions” that are “the only account for the country’s extraordinary tion of the “Big Push” in action, according well-marked path to high-income status.” growth? In the article that follows Walter’s, to Morck and Yeung, may well be China’s This prescription is reinforced by the the above-mentioned Randall Morck, a recent growth. What’s more, given the CARE presentations that provide much chaired professor of finance at the Univer- country’s desperate circumstances in the of the material for the rest of this issue. sity of Alberta, and Bernard Yeung, Dean late ’70s, it may have been the only way of In an especially memorable one, British- of the National University of Singapore’s accomplishing the goal in such short order. born David Webb, one of Hong Kong’s NUS Business School, begin with the pro- But after praising China’s leaders for leading investor activists and authorities on vocative statement, “Economics surely has pulling off this “greatest economic feat in Chinese corporate governance, urges the more to learn from China than China has history,” Morck and Yeung go on to express Chinese government to follow the example ever learned from economics.” two major reservations about the theory of the U.K. government under Margaret The conventional wisdom of econo- and workings of the “Big Push.” First, such Thatcher and reduce its massive holdings mists is that institutions like the rule of law, initiatives don’t have to be planned or car- of SOEs “to zero” while providing the well-defined property rights, and well-func- ried out by governments. Indeed, research greatest possible encouragement for for- tioning capital markets provide the most on Japan and Korea (much of it their own) eign investors and banks to expand their reliable—if not indeed the only—path provides compelling evidence that private- participation in China’s capital markets. for nations intent on achieving long-run sector coordination—by networks of firms The next three issues of theJACF will growth and prosperity. But, as Morck and called zaibatsu in the case of Japan, and be devoted to (1) corporate investment Yeung argue persuasively, China’s transfor- chaebol in Korea—has generally proved and payout policy; (2) risk management; mation into a modern industrial economy to be more effective than central planning and (3) value-adding sustainability pro- may well have been hastened by suppress- in building an industrial economy and grams. Manuscripts should be sent to me ing the development of such institutions. national wealth. at [email protected]. —DHC
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 3 Executive Summaries
Was Deng Xiaoping Right? ing that non-state investors have become the Communist Party, continues to con- An Overview of China’s Equity Markets motivated more by speculative opportu- trol the careers of SOEs’ senior executives, Carl E. Walter nities than by investment fundamentals. regulators, and government officials, and But a quarter of a century is a short retains “options” to intervene in a large In the western world, stock markets time in any country’s development and, variety of financial and corporate affairs arose from the search by privately owned for all their shortcomings, the markets in as well as judicial processes and decisions. companies for capital to build their busi- mainland China and Hong Kong have Chinese history underpins the system nesses. Over time, the markets became played a significant role raising capital in the sense that the Party is, at least in places where ownership interests and even for China. It may be too early, perhaps, some respects, a genuine meritocracy entire companies were bought and sold. to suggest that China’s equity markets reminiscent of the imperial civil service In China, the complete opposite has hap- have failed to accomplish what they were of past eras. And the authors raise the pos- pened. The markets arose out of the need intended to do. sibility that the Party’s Leading Role has for capital by bankrupt state-owned enter- actually contributed to China’s extraordi- prises operating in an economy with no nary growth not only by fostering such a history of private property. Deng Xiaop- Corporate Governance in China meritocracy, but by initiating and presid- ing, China’s last emperor, gave the green Randall Morck and Bernard Yeung ing over what development economists light for the stock market experiment in describe as a “Big Push,” a coordinated early 1992 more with the hope of encour- Since the death of Mao Tse Tung in simultaneous development of many firms aging reform and efficiency than from any 1976, China has achieved unprecedented in multiple industries that was necessary conviction that stock markets were the economic growth. Per capita GDP has to transform a subsistence agricultural next sure thing. increased from one of the lowest in the economy into a modern industrial one. Now, after more than 20 years of world to a level that is firmly in the middle But for all the effectiveness of China’s experimentation with domestic and inter- of the international ranks. But can China “Big Push,” the authors close by expressing national listings, it appears evident that continue on the growth path of the last doubt that China can continue to rise into stock markets whose primary function is four decades? The question arises because the world’s economic upper ranks until it to trade minority interests in government- of the tendency of developing economies, adopts the substance as well as the form controlled companies have not achieved having achieved periods of “catch-up” of those missing institutions that, they the goal of improving enterprise per- growth, to become mired in a “middle- argue, are the only well-marked path to formance, as China’s leaders originally income trap” that appears to stem from a high-income status. hoped. Instead, the combination of state variety of factors, including the tendency monopolies with Wall Street expertise and for elites and oligarchs to protect their own international capital has led to the creation interests by blocking competition. Challenges for China— of national companies that represent little China’s success to date has come with- Beyond Minority Listing of SOEs more than the incorporation of China’s out many of the key institutions—notably, A Presentation by David Webb old Soviet-style industrial ministries. As private property rights, shareholder- for the markets, the government’s deter- centered corporate governance, and a Transitioning from outright communism mination to prevent real privatization has well-functioning impartial legal system— and central planning, China has already produced separate classes of shares that are that most Western economists believe plucked the low-hanging fruits of mar- defined almost entirely by one thing: the essential to long-term success. China’s ketization. Reforms have stalled well short shareholder’s relationship to the govern- description of its system as “market of a free economy. In this transcript of a ment. And with all aspects of stock market socialism with Chinese characteristics” is recent presentation, a widely recognized activity regulated, managed, and owned an accurate one. Markets, not decrees, set authority on Chinese corporate gover- by various state agencies, it is not surpris- most prices, while the state, in the form of nance recommends necessary steps for an
4 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 enlightened Chinese leadership if they are Financial Reporting Practices and shareholders, while increasing the abil- to avoid economic stagnation or a crisis Incentives of China’s Listed Firms ity of accounting to serve a contracting that could undermine social stability. Even Joseph D. Piotroski function and the demand for timely infor- in a one-party state without an electoral The long-term success of financial markets mation for valuation purposes. mandate, you can govern only with the depends on the widespread availability of consent of the people. reasonably detailed and reliable finan- cial information. Individual investors Son of Enron: Investors Weigh the Risks depend critically upon companies’ regu- of Chinese Variable Interest Entities Asian Corporate Governance— latory filings and voluntary disclosures to Paul Gillis and Michelle René Lowry the Case of Dual-Class Shares assess their long-run risks, payoffs, and, A Presentation by K. C. Chan ultimately, their intrinsic values. How- Investors are heading back to China after ever, a recent string of accounting frauds ending a buyers’ strike in response to The case of the Alibaba IPO illustrates the involving Chinese firms listed on over- numerous accounting scandals and corpo- divergence of corporate governance stan- seas markets has drawn attention to the rate governance failures. There have been dards between the United States and many accounting and governance risks associ- several successful IPOs in recent months, other markets, and reopens the debate on ated with investing in Chinese firms. and the market is awaiting the listing of the one-share one-vote principle. Since This article provides a brief overview of the internet giant The Alibaba Group. corporate governance standards develop the information environment of Chinese The Alibaba IPO has focused inves- in ways that reflect the history and legal capital markets and the primary forces tor attention on the use of the variable and political environments of different that affect the incentives of Chinese listed interest entity (or VIE) structure by other countries, we should not expect to see a companies to provide timely and accurate overseas listed Chinese companies as well global convergence of these standards— financial reports. The evidence reviewed as Alibaba. The VIE structure allows out- nor is it generally desirable to transplant here indicates that the adoption of world- side investors some measure of influence policies from one market to another class standards and regulation, although or control over Chinese operations that without understanding their historical necessary, is not sufficient to generate is exercised through contracts instead of backgrounds. incentives for transparency. The long- actual equity ownership. By using such Nevertheless, the U.S. approach to term health of China’s capital markets contracts, companies are able to circum- regulation raises the concern that com- will also depend upon other reforms that vent Chinese laws that severely restrict petition among exchanges will cause are designed to accomplish the following: ownership in many industries, including issuers to “shop around” and tempt the (1) improve the protection of investor the internet sector. exchanges to relax their standards in a race rights through an effective, independent The contracts attempt to replicate to the bottom. While market participants judiciary court system that promotes civil the benefits of direct ownership, but do and regulators outside of the U.S. debate lawsuits, and through credible regulatory so imperfectly. The biggest concern over whether and how to modify the one-share, enforcement; (2) strengthen market devel- the VIE structure is the enforceability of one-vote rule, they face challenges in com- opment activity, especially with respect to the contracts. China has a law that invali- ing up with new rules that strike the right foreign investors; and (3) limit political dates contracts that attempt to do what balance between effective corporate gov- rent-seeking behavior and deter politicized is illegal through legal means. One court ernance and market development. business decisions, especially in China’s case involving a VIE-like structure led state-owned enterprises. Together, such China’s Supreme Court to rule that the reforms have the potential to improve contracts were unenforceable, and arbitra- corporate governance in China and better tors reached the same decision. align the incentives of the state and major- The biggest nightmare of investors in ity shareholders with those of minority Chinese VIE structures is that the Chinese
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 5 Executive Summaries Continued
owner of the operating company could nance, it is expected to remain limited, companies out into the IPO market choose to abrogate the contracts and take particularly in the functioning of boards as early as they can—and thus possibly ownership of the VIE. The highest profile and internal governance. prematurely—to establish a track record example of this took place in 2011, when As for the case of China, there was and facilitate future fundraising. This Alipay faced increased regulatory scrutiny such a flurry of rule-making in the early explanation is supported by the under- and Jack Ma responded by extracting it 2000s—a national Code of Corporate performance of Chinese VC-backed IPOs from the Alibaba Group. Governance in 2002, and a Directive on that has been documented by the author’s The fix for China’s VIE problem has Quarterly Reports in 2003—that people recent research. to come from Chinese regulators, and in Hong Kong used to enjoy saying that Although they continue to offer signif- reforms to foreign investment rules that China’s corporate governance standards icant opportunities for global investors, have been proposed may make the VIE were higher than Hong Kong’s. But if that China’s VC and PE markets still face structure obsolete. But until then, inves- may have been true on paper, the reality many challenges. The supervisory sys- tors have to weigh the unusual risk of has been quite different. tem and legal environment need further investing in companies that they do not improvement, and Chinese funds need to own. find a way to attract more institutional Equity Financing for Early-Stage investors—a goal that can and likely Companies in China will be promoted through government The State of Corporate Governance Ning Jia inducements. in Asia Jamie Allen Many of the smaller private-sector Chi- nese companies in their entrepreneurial The State of Sustainability in China Since the 1998 Asian financial crisis, growth stage are now being funded by Peijun Duan and Robert Eccles there has been considerable corporate Chinese venture capital (VC) and private governance reform in the region. But equity (PE) firms. In contrast to western China has experienced remarkable eco- such reform has proceeded on two tracks. VC markets, where institutional investors nomic growth since the reforms of Deng On one track, international rules are such as pension funds and endowments Xiaoping in the late 1970s. This growth dominant, and common accounting and have been the main providers of capital, has come at a significant environmental financial reporting standards are essen- in China most capital for domestic funds and social cost, raising the question of tially accepted as necessary for trade and has come from private business owners whether the country needs to focus more investment. On the second track, however, and high net worth individuals. As rela- on sustainable development than on eco- local cultural norms continue to exert a tively new players in the market who are nomic growth for its own sake. strong influence on the functioning of the less accustomed to entrusting their capi- Moreover, there is growing recogni- boards, the quality of dialogue with share- tal to fund managers for a lengthy period tion in China that more attention needs holders, and the way they manage related of time, Chinese VCs and their investors to be paid to achieving environmental and party transactions and capital raising. As have shown a shorter investment horizon social as well as economic goals. This rec- a consequence, in these matters of inter- and demanded a faster return of capital ognition has come in the form of changes nal governance—where legacy issues and and profits. in public policy, in pronouncements by culture, and not international standards, In an attempt to explain this behavior, Party leaders, and in the research and continue to be the main driving force Paul Gompers and Josh Lerner of writings of academics, think tanks, and behind governance—there continue to Harvard Business School have offered industry associations. be significant differences among Asian a “grandstanding hypothesis” that As the authors also point out, sus- countries. And thus even as convergence focuses on the incentives of younger, less tainable development on a global scale is is occurring in certain aspects of gover- established VCs to push their portfolio now as dependent on the actions of large
6 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 corporations as on government policies. cally connected CEOs on the corporate finds a strong positive correlation between And one way of assessing China’s com- performance and governance of publicly the “cash flow” ownership (as opposed to mitment to sustainability is to compare listed companies in China. Newly listed just the voting rights) of large sharehold- the behavior of its largest 100 companies Chinese companies with politically con- ers and the percentage of independent to that of the largest 100 corporations in nected CEOs are more likely to have audit committee members. The study the United States. In making this com- boards that are populated by current or also reports a strong positive correlation parison, the authors use two, admittedly former government bureaucrats, and that between the “cash flow” ownership of large imperfect, indicators of sustainability that generally exhibit low degrees of profes- shareholders and the percentage of audit suggest that the extent of the commitment sionalism, as indicated by fewer directors committee members with financial exper- to sustainability is roughly comparable in with relevant professional backgrounds. At tise and experience. both countries. the same time, the operating and stock- This finding is consistent with the The first of the two indicators is mem- return performance of such firms has failed hypothesis that larger cash flow ownership bership in the UN Global Compact. to match that of their politically uncon- provides large shareholders with strong On that score, the authors report that nected counterparts. incentives for more effective governance. exactly 15 of the top 100 companies in Thus, the authors’ study provides more Conversely, the lower percentages of inde- both China and the U.S. have formally support for the argument that bureau- pendent or professional audit directors at endorsed its ten principles regarding crats and politicians extract resources companies with large disparities between human rights, labor, the environment, from listed SOEs under their control to cash ownership and voting rights is con- and anticorruption. The second indica- fulfill objectives that are not consistent sistent with the authors’ hypothesis that tor is the percentage of the largest 100 with firm value maximization. Expressed entrenched large shareholders prefer infe- companies that produce a sustainability in more general terms, the main find- rior governance structures that pose fewer report based on the guidelines of the ing of the study is that the constraints obstacles to their tendency to exploit the Global Reporting Initiative. Using that on property rights faced by Chinese wealth of minority shareholders. measure, the authors report that about SOEs—namely the non-transferability Furthermore, the authors find higher half of China’s largest companies produce of state ownership and the right of the valuations (market-to-book ratios) for a sustainability report based on the GRI government to appoint CEOs—appear companies with audit committees that guidelines. Although that percentage is to have significantly negative effects on consist entirely of independent directors smaller than the two-thirds of U.S. com- firm performance as well as board pro- and have larger percentage of members panies that now provide such reports, the fessionalism and governance. Removing with financial expertise. And when viewed authors are encouraged by the trend, and these constraints will likely have to be a as a whole, the authors’ findings provide by the pattern of adoption in which larger critical part of any future reforms that support for the argument that ownership companies are clearly leading way. aim to improve the productivity of listed structure affects the composition of audit Chinese companies. committees, and that independent and professional audit committees can help Politically Connected CEOs, Corporate increase firm value. Governance, and the Post-IPO Audit Committee Composition and Performance of China’s Newly Partially Effectiveness in Presence of Large Privatized Firms Controlling Shareholders Joseph P. H. Fan, T.J. Wong, and Re-Jin Guo and Yin-Hua Yeh Tianyu Zhang The authors’ study of audit committees in The authors’ study provides suggestive 450 large East Asian companies (150 each evidence of the negative effects of politi- in Hong Kong, Singapore, and Malaysia)
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 7 Was Deng Xiaoping Right? An Overview of China’s Equity Markets* by Carl E. Walter
n Shenzhen in late January 1992, Deng Xiaop- In a Centrally Planned, State-controlled Economy, ing, perhaps China’s last emperor, was asked Why Stock Markets? I about stock markets. He famously replied, “Are Given China’s centrally planned economy of the 1980s, it such things as stock markets good or not? Do might seem strange that its stock markets developed more these things exist only in capitalist countries or can socialist rapidly than its debt markets. Although the government did ones use them too? It is permitted to try them out… If they issue bonds in the 1950s, the practice ceased as the country work out… then we will open up.” His words provided the became entangled in the political struggles of the following political cover for a group centered around Zhu Rongji, then two decades. Issuance resumed in 1981 but market devel- Vice-Premier in charge of economics and finance, to make opment was severely limited by a lack of investor capital. use of China’s recently opened, but moribund stock exchanges Although China’s economy appears to have grown rapidly in Shanghai and Shenzhen. Perhaps equally important, Zhu over the three decades following the 1949 revolution, this followed up on an idea presented by the Stock Exchange of growth did not trickle down to the population. As a conse- Hong Kong (SEHK) to list several state enterprises on the quence, in the 1980s the government was forced to rely on SEHK as an experiment. Zhu agreed with the Exchange’s state enterprises to buy its bonds. Massive “patriotic” bond reasoning that overseas listings would subject state enterprises drives sought to mobilize retail funds, but required months to additional regulatory and investor oversight, raise capital to complete. Moreover, since the government prohibited the outside of the awkward joint venture framework, and promote trading or even sale of the securities, bonds turned out to be greater enterprise efficiency. just a form of taxation by another name. Late in the decade, So Tsingtao Beer became the first state enterprise to state enterprises were allowed to issue debt, but this first wave list in Hong Kong in June 1993, but not the first to list of corporate debt resulted in widespread defaults and the overseas. Brilliance China Automotive achieved that honor corporate bond experiment was abandoned. in October 1992 with a blow-out listing on the New York As for shares, no one in the early 1980s—neither the Stock Exchange. These early transactions put China on the government, the issuers, nor the presumed “investors”—really map of global capital. What came after in the 1990s was understood what the securities represented. After their disap- Beijing’s wholesale adoption of the Western capital markets’ pearance in the 1950s and an absence of 30 years—and, of approach to reforming state enterprises. course, much political demagoguing about “capital” during How has Beijing made use of stock markets and what that time—the equity shares that reappeared in tiny trans- changes has it made when adapting them to China’s still socialist actions in remote areas of the economy were viewed as little economy? Has the dual approach to listing companies domesti- different from debt securities. Like debt, these shares were cally and internationally promoted economic competitiveness described as paying interest, not dividends, and there was and improved corporate governance? How do China’s markets no secondary market where they could be readily bought value issuers in the primary and secondary markets? Are China’s and sold. Nevertheless, far-flung but very small local enter- markets really dominated by retail investors? prises began to raise funds by selling pieces of paper called With nearly a quarter century of history to look back on, “shares” to their employees and others; and by 1988 some this overview of the restoration of China’s capital markets seeks 9,000 entities had issued such securities (see Figure 1). to identify its distinctive characteristics and accomplishments But everything changed in 1988 when Shenzhen Devel- while also considering the major challenges confronting what opment Bank—at the time the largest state enterprise must still be viewed as an experiment, a work in progress to have carried out an IPO—declared a stock split and a whose success and sustainability remain uncertain. huge dividend. Suddenly everyone understood the concept
*The research findings cited in this paper were first published in either Privatizing China: Inside China’s Stock Markets (Wiley; 2005) or Red Capitalism: The Fragile Fi- nancial Foundation of China’s Extraordinary Rise (Wiley; 2012) both by Carl E. Walter and Fraser J.T. Howie.
8 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Figure 1 By 1988 over 9,000 entities had issued shares
10,000
9,000
8,000
7,000
6,000
5,000
4,000
3,000 Number of companies issuing shares
2,000
1,000
0 1984 1985 1986 1987 1988
Sources: Liu Hongru, People’s Daily, June 23, 1992, p.5 of capital appreciation, and what became known as “share This decision, which was taken by Zhu Rongji in the spring fever” was ignited. Even the June 4 events elsewhere in China of 1992, had the effect of internationalizing China’s experi- failed to dampen speculation, and it was with great difficulty ment with shares and placed the development of the two that the government closed down the completely unregulated mainland exchanges in a subordinate position, where they “curb” markets that had sprung up all over China. remain today; for Chinese policymakers, it was better to export any potential social risk. Creating a Framework for Securities Markets, 1988-1991 The Impact of the “Standard Opinion” Efforts to create a regulatory framework for stock markets on China’s Stock Markets had actually begun as early as 1984 in Shanghai and The Standard Opinion codified the restructuring of state gained momentum in 1988 when Zhu Rongji became the assets into companies limited by shares. The corporatiza- city’s mayor and party secretary. But Shanghai was by no tion of state-owned enterprises (SOE) in and of itself has means alone; Shenzhen, Wuhan, Chengdu, and Shenyang had a huge impact on China’s economic landscape, as will be all encouraged the development of securities markets at this discussed later. The most immediate effect of the Opinion, time. In Beijing a working group composed of several return- however, was the very awkward approach it took when adapt- ees from graduate study in the United States put together a ing equity shares to a political environment that was hostile recommendation for China’s State Council. to the idea of privatization of state assets. Beijing understood Although this proposal was shelved after the June 1989 at once that turning an SOE into a company with distributed events, it was revived in 1990 as a means of bringing the share ownership effectively turned that SOE into a commod- booming curb markets under government control. And even ity that could be sold off. though the Shanghai and Shenzhen stock exchanges opened To prevent this, the Opinion created various classes of in late 1990, they were both moribund until Deng Xiaop- shares (as shown in Figure 2) based primarily on the relation- ing’s Southern Journey in early 1992 gave them the needed ship of the shareholder to the State. For example, on the political cachet. incorporation of a state enterprise, assets originally funded Supporters of the exchanges moved rapidly. On the heels by a state agency became “state shares.” Other assets that of Deng’s trip south, China’s first corporate law, known as were funded by the profit of the enterprise group forming the the “Standard Opinion,” was enacted. This law gave form to new company were called “state legal person shares.” None China’s particular approach to the design of equity shares. of these shares owned directly or indirectly by the state were A specialized market regulator, the China Securities Regula- deemed tradable. tory Commission (CSRC), was established in October 1992. In contrast, shares purchased by retail and other investors At the same time, the government announced a list of nine with cash could be listed and traded on the stock exchanges; large state enterprises as candidates for listing on the SEHK. their cash had never been a “state asset,” and their shares,
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 9 Figure 2 The incorporation of a state enterprise Figure 3 Incorporation of Red Chips and National Champions
State Agency
Unincorporated Board of Directors State Enterprise Group Holding Company State Agency
Company limited 100% Parent Groups, by shares SOEs, Local Gov’ts
Share Investors Board of Directors
Company limited by shares called “A shares,” were therefore not state property. To erase any trace of privatizing state property, these A shares were all new shares; the state was diluted down, not selling out. And, finally, the various classes of state shares could not be its products, and so on. Relatively speaking, these enterprises diluted below an absolute controlling majority ownership of were all small middle market companies by sales revenue. 51 percent. The composition of the board of directors would Moreover, the fact is that no one knew whether these compa- reflect the overall state control of the company. nies made money or, more importantly, could be structured In short, Beijing corporatized its SOEs in an effort to so as to make money. In fact, few of these enterprises even recapitalize them with other peoples’ money. As the authors knew the value of the assets they claimed to own. wrote in a book published in 1999 to celebrate the 50th Getting clarity on these questions depended on the anniversary of the People’s Republic, “Looking at the current completion of a draft audit, after which bankers working with situation in our country, no matter whether the regulators, accountants began to “slice and dice” the SOE—its assets, government departments, or the listed companies, all treat obligations, and employees—into a listing candidate (the public offerings and listing of shares as a cheap source of “ListCo”) that could show a profit for the past three years. But funding.”1 Little has changed since then. half of the time, no matter how the furniture was rearranged, the outcome was still negative. And even for those proto-Listco Implications of the Corporatization of Chinese State- companies that on paper were profitable in the past, this was owned Enterprises no guarantee that they would be so in the future. After all, The impact of this incorporation process in changing the the managers of these enterprises had never managed to a face of China has been perhaps farther reaching than the bottom line based on international generally accepted account- more than $1 trillion in capital raised. China’s corporatiza- ing principles—nor had they been forced to respond to the tion process combined China’s best state companies with the concerns of minority investors outside the country. best capitalist expertise of Wall Street. Working together with Once SOE management and its state owners had agreed the Chinese authorities, Wall Street bankers, accountants, on the general corporate framework of the new listing candi- and lawyers transformed unprofitable and uncompetitive date, the issue became exactly who owned how much of the SOEs into listable companies and, almost at once, the listable new company. It was always surprising to see how hard the companies became Fortune Global 500 behemoths. How was various parts of what many had presumed to be a monolithic this done? State fought over their share of the new company. Generally At the start Beijing deliberately selected China’s best state speaking, if the assets to be contributed to the ListCo had enterprises to list overseas, primarily in Hong Kong. Over been financed by the state’s budget, whether central or local, the first five years, a total of 86 companies were selected as then the equivalent value in shares became “State shares.” candidates, but less than half succeeded. Why the high failure If the SOE had invested in assets using its own retained rate? When Beijing selected an SOE, it did so based on its earnings, the shares were known as “Legal Person shares” (or own criteria—the size of the enterprise, the importance of “Domestic Legal Person shares”).
1. Shang Ming, Editor, XinZhongguo jinrong 50 shinian (50 years of New China’s banking), (Beijing, Zhongguo caizheng jingji chubanshe, 1999), p. 307.
10 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Figure 4 China Telecom: China’s First National Champion
Ministry of Posts and Telecommunications Guangdong Mobile Zhejiang Mobile Jiangsu Mobile China Mobile Fujian Mobile Communications Corp. Henan Mobile Onshore Hainan Mobile 100% Offshore China Mobile Hong Kong Group 100% China-Mobile-BVI
US $4.5 bn in cash US $6.6 bn in appraised asset value 75% Guangdong BVI Zhejiang BVI Jiangsu BVI NYSE/HKSE 25% China Mobile Fujian BVI Listed-Shares (HK) Co. Ltd. Henan BVI 100% Hainan BVI
By 1996 most of the possible SOE candidates for restruc- additional provincial telecoms bureaus and “injected” them turing had been identified and an effort made to list them. At into the holding company, it used secondary offerings to raise that point, central government ministries and local govern- tens of billions of dollars for Beijing. And this paved the way ments were very hard pressed to locate enterprises that, after for other ministries to build similar corporate empires, giving repackaging as a shareholding company, could raise large rise to PetroChina, Sinopec, China Aluminum, and so on. amounts of capital. But up to this point the government had In effect, these new monopolies were simply the corpora- been looking at relatively simple enterprises that made a single tization of the old industrial ministry systems. That ministry product like cars or steel. officials rapidly adopted this form was not a coincidence, since Beijing Enterprises changed all that. Operating within Zhu Rongji on becoming the Premier in 1998 had begun to a structure like the one shown in Figure 3, Beijing Enter- eliminate these ministries as bureaucratic obstacles to China’s prises was a conglomeration of unrelated assets with a single reform efforts. The new National Champions produced by owner, the Beijing municipal government, including the this corporatization process were China’s first companies airport expressway, the Badaling section of the Great Wall, with the scale to match overseas rivals and place high on the a dairy, and so on. There was no coherent story relating any Fortune Global 500. of these assets or enterprises other than shared ownership. At the time of their listing, however, these National The equity story in such cases became, “Share the wealth as Champions were by no means integrated companies operat- Beijing grows.” Each of these assets was duly incorporated, ing under a single management team; they were artificial with Beijing Enterprises itself serving as the holding company. confections adapted to the Chinese situation in a way that The importance of this case was not in the frenzy that was believed by their Western investment bankers to be most it touched off as bankers and local governments across attractive to global investors. And the question of whether China sought to do copycat deals. Its importance was that these entities have become serious competitors to global it represented the first application in China of the holding companies remains as vexing and unresolved today as it did company concept. Central ministries that own assets spread when they were listed a decade or so ago. geographically across China quickly grasped the potential uses of this organizational form. The telecommunications The Evolution of China’s “Segmented” Markets ministry moved the fastest, and in late 1997 China Telecom Having defined shares in terms of the nature of the share- was successfully listed in Hong Kong and New York, raising holders, Beijing had perhaps unwittingly created classes of over US $4 billion (see Figure 4). And thus began the days shares even though the Standard Opinion and the Company of China’s block-buster IPOs. Law, passed two years later in 1994, made no provision for China Telecom, now known as China Mobile, became, such differences; all shares were supposed to be equal. As the at least on paper, China’s first truly national corporation experiment evolved, three broad classes of shares emerged. with operations spanning the country. As it incorporated The largest class consisted of the RMB-denominated
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 11 Figure 5 The share structure of China’s stock markets, FY1990 – 2001
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 State Domestic LP Other ABH
Source: China Securities Regulatory Commission state and legal person shares that are owned by the origi- Figure 6 China’s segmented markets: many markets, nal promoters of the listed companies. Then there were the many regulators, same stock domestically listed “A” shares held by cash investors, either retail or institutional. Third and last was a variety of foreign Market capitalization = HK listed shares only currency-denominated shares that were listed either domes- Auction Houses, HKSE/NYSE Negotiated tically (the now moribund B-shares) or abroad (the H-shares, HKSE/SFC transfers N-shares, Red Chips and so on). SEC/NYSE SAMB H Shares & LP Shares With everyone else trading shares, it is easy to understand offshore B why the original SOE promoters were the first to complain; Legend: markets D as originally conceived their shares could not be traded or A: QFII A C B: Cross border M&A even sold! Where was the much-needed liquidity that stock C&D: Privatization A-share State Shares E markets were meant to supply? How could an SOE manager E: State share sale markets optimize the structure of his company if he could not sell or spin off unwanted parts of it? This complaint was rapidly Shanghai/Shenzhen CSRC addressed, and by 1994 share “transfers” were allowed, but Market capitalization = A & B shares only only with other state-controlled entities. This step completed Negotiated transfers the practical segmentation of the Chinese stock markets. State Asset Management Bureau Each major class of shares had its own regulator, Note: SAMB = State Asset Management Bureau exchange, market participants, and valuation methodology (see Figure 6). For state and legal person shares, share trans- fers were to be first approved by the State Asset Management shares of such IPO companies could trade only on the two Bureau (SAMB), an agency of China’s Ministry of Finance. domestic exchanges, on which virtually anyone or any entity, Shares were valued based on the concept of “net asset value state-owned or otherwise, could open an account. Compa- (NAV)” per share, with a floor of one RMB per shares (the nies with state, legal person, and A and B shares companies value at which the shares were created on incorporation). were audited by domestic firms based on domestic accounting Market participants were limited to state entities, and over- standards passed in 1994, and the results of such audits were the-counter exchanges were established in most cities to published semi-annually in the China Securities Daily. facilitate share transfers. For companies with overseas listed shares, the general As for A (and B) shares, IPOs were approved by a variety picture is well known. These companies are audited by inter- of state agencies during the 1990s, and IPO pricing was fixed national firms according to international standards and based on a formula determined by the securities regulator, underwritten by major international banks using standard the China Securities Regulatory Commission (CSRC). The approaches to valuation. Such companies are also, of course,
12 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Figure 7 What valuation for China Eastern Airlines shares at their respective market prices are added to this domestic figure, China Eastern’s market capitalization is
3,000 $2.4 billion. But what if all shares—A, state, and overseas shares— were valued at the overseas price? The value for the airline 2,500 2,400 2,200 drops dramatically to $619 million. Finally, if all shares are valued based on the NAV approach adopted for state share 2,000 transfers, the company is worth $865 million. To some extent, the fact that the controlling majority of 1,500 China Eastern’s shares remained locked up in the hands of a government agency suggests that this search for a representa- 1,000 865 tive company market value is open-ended and even somewhat
619 meaningless. What’s more, the fact there have been no major
Est. Market Capitalization USD mm 500 M&A transactions conducted through China’s exchanges— such transactions between listed company holding entities have all happened outside the exchanges—suggests that 0 (A shares + State (A Shares + State (A + H + S) (A x A share price) the stock prices quoted on most Chinese exchanges convey shares) x shares) x A share x H share price + (H & N shares little information to practitioners about the actual values A share price price + (H & N shares x H & N share prices) x H&N share prices) + (State shares x NAV) of the enterprises themselves. And this situation also begs the question: just what do the minority shares listed on the Source: Hong Kong and Shanghai exchanges, Wind Information, Bloomberg; author’s various exchanges actually represent? What do they entitle calculation an investor to? required to satisfy local regulators and exchange listing rules. The Attempt to Eliminate the Segmented And, finally, the non-convertible RMB injected a currency Market Problem valuation element into share valuations as well as effectively This confusion over company valuations was addressed, preventing price arbitrage between onshore and offshore although without complete success, by policymakers in 2005. markets. This absence of arbitrage ensured that, for example, As early as 2000, the securities regulator had begun seeking H-shares in Hong Kong trade at different prices (even today) ways to make the huge block of state shares tradable, at least than shares of the same company in Shanghai. in theory. This was by no means an effort to promote outright privatization; China’s use of listings and stock exchanges Valuation Issues and Segmented Markets has always been a fund-raising exercise aimed primarily at In summary, the Chinese government’s effort to prevent the strengthening what remain state-controlled corporations. privatization of its state enterprises while at the same time Instead, it was an effort to unify the state’s oversight of shares, raising “cheap” capital for them has resulted in a complex markets, and all market participants.2 market situation for investors. This is most clearly obvious in This early effort led to a complete market collapse in the difficulty in arriving at as basic a figure as market capital- mid-2001 as investors believed that the government intended ization for listed companies. to dump its block of shares on the market. For the next four Take the case of China Eastern Airlines, which is a years, the market remained at record lows and a large part company with state shares listed in New York, Hong Kong, of China’s securities industry was bankrupted. During these and Shanghai. The New York and Hong Kong shares trade years a debate broke out over how to solve what all sides at similar values, given the market’s ability to arbitrage accepted as a common problem. between the two markets. But, as shown in Figure 7, the By 2005 a conclusion had been reached. All sides agreed market capitalization of China Eastern can be calculated in that there had been an unwritten contract between the state at least four different ways. In the first, all shares including and A share investors. This agreement reflected an explicit state shares are multiplied by the market-based price for A understanding that the state, in return for the right to float shares on the Shanghai exchange, which results in an estimate its non-tradable shares, would compensate A share investors of $2.2 billion. This excludes the overseas listed shares, but with some form of financial consideration to make up for nonetheless represents the domestic market capitalization their potential losses. The government decided that it would methodology. If the value of the Hong Kong and New York pay a certain amount of its state shares to A share investors
2. In recent years the Shenzhen exchange with Beijing’s blessing has allowed the est of these barely makes it into the top 400 listed companies in China by market capi- listing of small private companies on the SME and the ChiNex boards, but even the larg- talization.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 13 Figure 8 Overview of the “G company” reform, Table 1 Post-IPO first day price jump and trading volume, 2005-2008 1998-2010
Original share structure Post-reform share structure Number of listings Average 1st day Average 1st day Share Shareholder Share Shareholder Type Type pop turnover 1998 92 149% 62%
A shares Funds, Funds, QFII, 1999 93 113% 60% 35% 45% QFII, retail retail 2000 135 152% 59%
A shares; 2001 77 138% 64%
state holder 2002 68 134% 62% subject to lock up 2003 67 72% 52%
55% 2004 100 70% 55% Various Parent Group, Parent Group, state shares 65% SOE, state SOE, state 2005 14 48% 58% agency agency 2006 66 84% 70% 2007 126 193% 65% 2008 77 115% 80% 2009 99 74% 79% Source: Wind Information and author’s calculations 2010 127 47% 69%
(with the exact terms of the transaction to be worked out by Source: Wind Information and author’s calculations each company and its investors). This would then allow the government and state agency investors to convert their previ- newly listed shares—jumps that, as can be seen in Table 1, ously non-tradable state shares into tradable shares on the are much larger than the 15-20% average first-day returns stock exchanges. Any sales of these state-held shares, however, for U.S. IPOs. The root cause of this phenomenon is govern- were subject to a two-year lockup period and final approval ment intervention in the pricing process itself; the securities by the securities regulator. regulator has always, in effect, priced China’s domestic IPOs. This new arrangement was expected to eliminate regula- In addition, the lottery arrangements made for investors to tory overlap, clarify the division of value between state and participate in the IPO allocation of shares are highly flawed. minority shares and, in the process, to reduce the percentage The consequence is the market’s single-minded focus on the of state holdings from 65% to about 55% (as shown in Figure listing itself, with almost no attention paid to trading in the 8), thereby increasing the fractional ownership and perhaps secondary markets. value of the minority holdings. To ensure that there are no failures in payment when But what did it accomplish in fact? The principal effect shares are allocated, participating investors must commit of this arrangement has been to bring all domestic company the full value of their bid in advance of the IPO and the shares under the sole purview of the CSRC; this is an impor- commencement of trading in the shares. In addition, tant achievement. By 2008, as the lock-up period came to participants are limited to those presumably active inves- an end, these old state shares were listed on the market and tors who actually hold shares in their accounts. There is included in the market float, even though they did not neces- no guaranteed minimum allocation for small bidders; as a sarily trade. But by the middle of 2013, according to estimates consequence, investors are encouraged to submit as many based on the end owner of the shares in the market, the state bids as possible, with funds being returned to failed bids and its agencies continued to own around 60 percent of the only after the listing. market cap; the main goal of the agreement has not been This obviously causes huge oversubscription rates for achieved. Moreover, the new arrangement has also of course Chinese IPOs that tie up the entire banking system for days done nothing to eliminate the valuation difference between on end. As one example, China Construction Bank’s Shang- domestic and overseas shares of the same company attribut- hai IPO in 2007 was 39 times oversubscribed and tied up over able to the RMB’s limited convertibility. $280 billion in subscription deposits. The most important result of this arrangement, however, Problems in China’s Primary Market is that it turned what had been a market created and One of the best known characteristics of China’s domestic dominated by small retail investors into one dominated by exchanges is the failed valuation methodology that until this domestic institutions, including state enterprises and govern- day continues to create huge first trading day price jumps for ment entities. Only institutions have access to sufficient funds
14 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Figure 9 Trends in open securities accounts
80 SH-Accounts SZ-Accounts
70 SH-Holding SZ-Holding
SH-Traded SZ-Traded 60 Open accounts, Shanghai, Shenzhen 50
40 Accounts holding securities, Shanghai, Shenzhen
Accounts Millions 30
20 Accounts actively trading, Shanghai, Shenzhen
10
0 Jul- 11- 11 Jul- 11- 12 Jul- 11- 08 Jul- 11- 09 Jul- 11- 10 Jan-11-09 Jan- 11- 11 Jan- 11- 12 Jan- 11- 13 Jan-11-08 Jan- 11- 10
Source: Wind Information to submit the large number of lottery bids needed to secure a The Investor Base—Not Dominated by Retail desired allocation. In 1999, in an effort to preserve the rights Because participants know that they are stacked in favor of of smaller investors, the category of “strategic investor” was the state, it is hardly surprising that the markets have been created for institutions only. Such participants, in return for in the doldrums virtually since the turn of the century. There a guarantee of their full allocation of shares in the IPO, were are around 150 million open security accounts in China, but required to “lock up” their shares for a three- to six-month this number must be halved to reflect the fact that separate period following the IPO itself.3 accounts must be opened to trade in Shanghai and Shenzhen This arrangement has made possible the huge IPOs of (see Figure 9). The number must be halved again, to around state enterprises that have come to characterize the Shanghai 30 million, if we look at only accounts that actually hold and Hong Kong markets. Such large transactions give the securities. This level has remained fairly stable over the past impression of huge market demand when, in fact, it is simply several years, and accounts that actively trade shares in the the state reallocating capital among its various enterprises. two markets today number around 25 million. This internal circulation of wealth and favor takes place As summarized in Tables 2 and 3, the available informa- not only through the allocation process, but through the tion about investor accounts holding securities indicates a IPO pricing process, which is arguably yet another tool used market dominated by retail investors—but a closer look at the by Beijing to redistribute capital within the state sector. The accounts suggests otherwise. The data are divided between workings of this process can be seen in the results of some institutional and retail investors, and accounts are categorized of the mega-listings for central SOEs. Perhaps the most by the value of securities held. egregious case was the IPO of PetroChina, which left over Based on fairly conservative assumptions about the actual RMB 45 billion, or about $5 billion, of the Chinese taxpay- value held by each account, institutional investors account ers’ money on the table. In the West, such a huge loss to the for only 17 percent of total securities held. But this data does company would have dire consequences for senior manage- not necessarily include the accounts of the above-mentioned ment and possibly the board of directors. But in China, the “strategic investors,” who participate in specific transactions view of such losses was perhaps best expressed by the chair- such as IPOs (see Table 4). man of Shenhua Coal, who, after his company’s IPO was In the case of retail, 42 percent of accounts hold RMB underpriced by $2.5 billion, was quoted in the South China 100,000 (about $10,000) or less, and 87 percent hold less Morning Post as saying, “The debut priced [of my IPO] was than RMB 5 million (around $500,000), a group that within expectations, but I am still a wee bit disappointed.” accounts for 72 percent of value held. From these numbers,
3. There have been persistent rumors that large SOE “strategic investors” could get thereby guaranteeing their participation in the IPO share price jump. around such “lock-ups” by selling their shares forward with the help of securities firms,
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 15 Table 2 Institutional investor accounts holding securities
Retail Accounts
Assumed Value per As % of Total Value of No. Retail Accounts Account Category Value % of Value Retail Retail + Institutional a <10,000 RMB 19,782,388 10,000 197,823,880,000 6% 5% b 10-100,000 25,917,627 50,000 1,295,881,350,000 36% 30% c 100-500,000 6,805,327 100,000 680,532,700,000 19% 16% d 500-1,000,000 830,537 500,000 415,268,500,000 12% 10% e 1-5,000,000 501,326 1,000,000 501,326,000,000 14% 12% f 5-10,000,000 36,904 5,000,000 184,520,000,000 5% 4% g 10-100,000,000 19,473 10,000,000 194,730,000,000 5% 5% h > 100,000,000 1,128 100,000,000 112,800,000,000 3% 3%
53,894,710 3,582,882,430,000 100% 83%
Table 3 Retail investor accounts holding securities
Institutional Accounts
No. Institutional Ac- Assumed value per % of Total Value As % of Total Value of counts account Category value Institutional Retail + Institutional a <10,000 RMB 6,950 10,000 69,500,000 0% 0% b 10-100,000 16,928 50,000 846,400,000 0% 0% c 100-500,000 17,818 100,000 1,781,800,000 0% 0% d 500-1,000,000 7,952 500,000 3,976,000,000 1% 0% e 1-5,000,000 14,688 1,000,000 14,688,000,000 2% 0% f 5-10,000,000 4,383 5,000,000 21,915,000,000 3% 1% g 10-100,000,000 8,834 10,000,000 88,340,000,000 12% 2% h > 100,000,000 6,063 100,000,000 606,300,000,000 82% 14%
83,616 737,916,700,000 100% 17%
Source: China Clear, February 2013, Table 2.10 it can be seen just how limited retail participation in IPO lock up required by the share reform described previously and lotteries actually is. IPO investors are limited to one share all shares owned by strategic investors as well as legal person application per RMB 10,000 of securities actually held in investors involved in the share reform program. The number their account prior to the IPO; and as already noted, the that results, about $400 billion, represents the value of the application amount must be deposited with the exchange shares that can actually trade on the exchanges. This tradable during the lottery process. market capitalization number is the basis from which were As for the remaining 13 percent of retail accounts, their deducted additional identifiable figures, such as the value of owners have more than RMB 5 million (almost $900,000) mutual fund holdings. In total, such amounts equal nearly in their accounts. There are estimated to be 57,000 of such 25 percent of the tradable market cap. accounts, and one wonders what kind of retail investors own What of the other 75 percent? We assumed that retail them. The same account categories (RMB 5 million and investors place half of their money in funds and invest the above) account for 94 percent of the value held by institu- other half directly. Netting this out leaves an incredible 60 tional investors in some nearly 20,000 accounts. percent of the tradable market cap owned by … who? A clearer understanding of the character of China’s In short, the limited holdings of retail investors means domestic markets can be inferred from an estimation of the that China’s primary IPO markets as well as its secondary ownership of the shares trading on the market (or the “float”) markets are dominated by state-owned institutional inves- as shown in Table 4. This estimate begins with the official tors of some kind, as well as the fabulously rich. This is the total market capitalization figure for December 31, 2006. reason why China’s domestic equity markets are known as From this is subtracted all shares subject to the three year “policy” markets: the government sneezes, the market crashes.
16 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Table 4 Investors in China’s stock markets, Figure 10 RMB appreciation and the Shanghai 300 Index December 31, 2006 0.15 6000 US$ / RMB CSI300 US$ bn % of Total 0.145 5000 Total A share market capitalization 1,318 100.0 Less: capitalization under 3 year lock up 913 69.0 Tradable market capitalization 405 100.0 0.14 4000 Total identifiable institutional investors including: 100 24.7
- Domestic funds (actual number) 60 14.8 0.135 3000 - QFII (100 pct. of existing total approved quota) 20 4.9 US$/RMB Rate
- Securities companies estimate 10 1.2 CSI Index Points 0.13 2000 - NSSF (100 pct. of approved limit) 5 1.2 - Insurance companies (100 pct. of approved limit) 5 1.2 0.125 1000 Estimated Retail investors 60 14.8 Estimated Other Investors including: 245 60.5 - State agencies 115 28.4 0.12 0 Jan-4-05 Jan-16-06 Jan-29-07 Feb-13-08 Feb-20-09 Mar-1-10 - State enterprises 65 16.0 - Large-scale private investors 65 16.0
are property and the stock markets. Of the two, the stock Source: China Economic Quarterly 2007 Q1, p. 11 markets are generally preferred since they are more flexible China’s markets can thank the small mom and pop investor than the property market (not that those with the means for promoting their establishment, but this is hardly the case cannot play both!). The amounts invested in stocks are likely any longer. The markets have long since left retail investors to be smaller, but liquidity is substantially better there than far behind. in the property market. And in contrast to interest rates, the equity market equivalent, the price-to-earnings (or P/E) Are China’s Markets Casinos, Successes or Both? ratio is free to run as high as the market will take it. In the It has been nearly two decades since the Shanghai and glory days of the Golden Bull Market during 2006 and Shenzhen exchanges were established. Why, if many influ- 2007, the overall Shanghai P/E multiple rallied from 15 to ential observers regard them as casinos, have they been so nearly 50 times. With that kind of valuation expansion, the successful? How have they come to be seen as beacons of potential upside is very large indeed! China’s economic reform and attained such central roles in And so for all the reasons just cited, the Chinese market the country’s economic model? simply doesn’t have natural stock investors: everybody is a The answer is simple: you can, if you are well connected speculator. As can be seen in Figure 10, the wild boom during or lucky, make money from them. These markets are driven the Golden Bull Market coincided with the government’s by liquidity and speculative forces—but little else, given policy of a measured and wholly predictable appreciation of the almost arbitrary business decisions made by companies the renminbi against the U.S. dollar. Hot money from every influenced more by politics than profit. How can this not corner of China and beyond poured into a market that came be the case when companies are the property of the party to believe there was no upward limit. But, of course, all good and its families? things must come to an end; and from early 2009 China’s hot Although such a market will seem daunting to investors money deserted the exchanges and flowed into real estate and from developed markets, the Chinese are long accustomed various shadow banking products. to operating in a No Man’s Land of political interference and For those less fleet of foot, Chinese history and bitter contradictory signals. None of this stops them from “playing,” experience teach that life is too volatile and uncertain to take or being played by, the market: if you buy a share at RMB the long-term view. The natural result is a market dominated 10 and sell at RMB 15 you make RMB 5! Putting the same by short-term traders who dream of a quick return. The one money on deposit with banks or playing the bond market natural investor is the state itself, and it already owns the is hardly worth the effort, especially since interest rates are National Champions. In contrast, ownership in developed kept low to favor state borrowers, not lenders, and so do not markets is far more diversified; large companies simply do not provide a real return over the rate of inflation. have dominant shareholders owning more than 50 percent of In China, the only two ways to make this real return their shares. To cite just one case, the largest shareholder of
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 17 UBS, Switzerland’s biggest banking group, is the Government an investor look at Petrochina and compare it with Exxon- Investment Company of Singapore, whose position represents Mobil when it is nearly 85 percent controlled by the state less than seven percent of UBS’s market cap. Contrast that and will remain so as long as the party remains in power? It with Bank of China, where even after its IPO the bank’s is the same with China Mobile or Unicom; can they really largest state shareholder still controlled 67.5 percent of the be compared with Vodafone, T-Mobile or Bharti Airtel? The bank’s stock. fact that foreign telecommunication providers are barred from Since China’s stock markets, which include Hong Kong, China’s domestic market means that Mobile and Unicom are not places that decide corporate control, the pricing of have a comfortable duopoly. Their privileged positions are shares carries little weight when thinking about the whole simply not subject to the same regulatory or market checks company simply because it never is for sale. This is why there and balances faced by their global peers. And for this reason, is no true M&A business in China, and most definitely there is no way for outside investors to assess their future none involving the acquisition of listed SOEs by non-state value. That value depends almost entirely on the continua- or private enterprises. Instead, market consolidation is driven tion of advantages conferred—and subject at any moment to by the government fiat and is accomplished by mixing listed removal—by the state. and unlisted assets at arbitrary valuations. This means that share prices are simply reflections of So was Deng Right, Can Stock Markets Be Used in a market liquidity and demand at any given time. The high Socialist Economy? trading volumes in the market are its most misleading charac- These comments, however, are those of an outsider. If Deng teristic since they give outside observers the impression that Xiaoping were around today and able to look back at the it is a proper market. High volumes lend credibility to the 25 years or so of China’s experiment with capitalist stock idea that prices are sending a signal about the economy or markets, he would almost certainly conclude that the effort a company’s prospects; they do not. The reality of Chinese had been worth it. After all, for the first time China has a markets, however, is that heavy volume is more likely to be first-rate infrastructure supporting a national market for an indication of excess liquidity than any perceived change capital—and it has succeeded in using its control over the in fundamentals. Hong Kong market to promote greater economic (and polit- Much of the effort over the 1990s to develop the markets ical) integration with the mainland. And this effort, as we was aimed at encouraging participation by more long-term insti- have seen, has created national corporations that compare tutional investors of the kind that play a major role in developed favorably in terms of market capitalization with the world’s markets. Indeed, the entire domestic mutual fund business was largest multinationals. China’s National Team would seem created by the CSRC in the late 1990s with this goal in mind. to be poised to leverage the country’s huge foreign reserves The introduction of foreign investors through the creation of to participate actively in the ongoing globalization of the the QFII facility in 2002 was another step in this direction. world’s economy. Moreover, the operations and performance The relatively recent growth in the volume of company and of these giants are more transparent than ever before—and economic research at both local and foreign brokerage houses to everyone—thanks to the legal and accounting standards has all been based on the belief that China’s markets are becom- they must maintain. And, not to be forgotten, the sale of ing, or will become, more driven by fundamentals. minority stakes in these companies has raised as much as This entire effort is misdirected. It isn’t the absence of $1 trillion largely in support of state enterprises. So what’s equity research that makes the market a casino. It is the not to like? absence of genuinely accountable companies subject to And yet … China’s domestic market is rife with moral market and investor discipline. If the Chairmen and CEOs of hazard. Beijing plays every role from issuer, to underwriter, China’s major companies care little about SASAC, they care to regulator, to controlling investor and manager of the even less about the Shanghai stock exchange or the legion of exchanges. Efforts to simplify domestic arrangements—the domestic equity analysts. The CEO knows full well that his old share classes have been eliminated—have served only to company possesses the resources to ensure the performance conceal the fact that the state in its many guises still owns of its own shares. The National Champions will continue to nearly two-thirds of domestically listed company shares. It is dominate China’s stock markets, accounting for the lion’s much harder to pierce the veil of nominee accounts in Hong share of market capitalization, value traded, and funds raised. Kong, which always rank among the top ten investors in Red To be sure, the growing number of private (non-state Chips and H shares. Outsiders cannot help suspecting that owned) companies listed on Shenzhen’s SME and ChiNext state entities largely control the share price movements of boards is encouraging. But most of these companies are tiny Hong Kong-listed Chinese companies. As for the regulatory in the broader market context. Investors may be able to look bodies looking after the HKSE, there may be, as one ex-senior at the SME or ChiNext market and apply the usual invest- regulator mentioned, some semblance of influence as Chinese ment analysis used in the international markets. But how can companies list, but once listed there is very little.
18 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Figure 11 The Shanghai Composite Index 1990 – 2013
7,000
6,000
5,000
4,000
3,000 CSI 300 Index
2,000
1,000
0 19- 91 19- 93 19- 95 19- 96 19- 97 19- 98 19- 99 19- 00 19- 01 19- 02 19- 03 19- 05 19- 06 19- 07 19- 08 19- 09 19- 10 19- 12 19- 13 19- 94 19- 04 Dec- 19- 11 Dec-19-90 Dec- Dec-19-92 Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec-
Source: Wind Information
But what about the companies themselves? The domestic and overseas listing experience has helped promote improved Carl Walter lived and worked in Beijing from 1991 to 2011, first corporate governance and management standards in exceptional as an investment banker involved in the earliest SOE restructurings and cases only. For the most part China’s National Champions overseas listings, then as COO of China International Capital Corpora- remain state-controlled enterprises and act like them. tion, China’s first and most successful joint venture investment bank. As Institutions that are part of the state control the Shang- an investment banker, he played a leading role in China’s groundbreaking hai market, which runs the main board containing China’s first IPO in 1992, as well as the first listing of a state-owned enterprise biggest companies. The IPO lottery process serves to limit the on the New York Stock Exchange in 1994. As a member of the Manage- participation of retail investors in favor of these big institu- ment Committee of CICC, he supported many debt and stock offerings tions. The valuation of new shares takes place in a process by domestic companies, and participated in numerous financial reforms that is closely supervised by the securities regulator and seems over the years. Until his recent retirement, he was JP Morgan’s China unable to prevent those first-day trading “pops” that enrich chief operating officer as well as CEO of its China banking subsidiary, state institutions and the politically connected. where he helped build a successful and profitable domestic security and It would seem little wonder, then, that the market seems currency trading operation. to have flat lined (see Figure 11) after the huge policy play on Mr. Walter is the co-author, with Fraser J.T. Howie, of two books: RMB appreciation in 2007 and 2008. The new government Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary bent on eliminating corruption seems unable to figure out Rise (Wiley, 2012); and Privatizing China: Inside China’s Stock Markets exactly what it wants to do with this piece of China’s reform (Wiley, 2005). Mr. Walter’s ongoing research focuses on China’s bank- effort. When Zhu Rongji supported the listing effort back in ing and fiscal systems, including the debt and capital markets, which he the early 1990s, the hope was that the markets would create plans to turn into another book. state enterprises able to compete on the same footing as their Fluent in Mandarin, Mr. Walter holds a Ph.D. in Political Science international competitors, while at the same time raising from Stanford University and a BA in Russian Studies from Princeton. In capital but not resulting in privatization. Judging the 25-year 1979 he was a member of the first group of graduate students to return experiment on this basis suggests that China’s adaptation of to China after the revolution and received a certificate of advanced study capitalist markets to its own circumstances has yet to yield from Peking University. In 2013 he was a visiting scholar at the Shoren- the results its early promoters had hoped. stein Asia Pacific Research Center at Stanford University. After biking with But a quarter of a century is a short time in the country’s his daughter across the United States, he has settled for the time being efforts to modernize. It may be too early, perhaps, to even in New York, where he acts as an independent consultant. suggest that Deng was wrong.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 19 Corporate Governance in China
by Randall Morck, University of Alberta, and Bernard Yeung, National University of Singapore*
hina’s recent economic history is phenomenal. with high grade point averages, successful professionals, and The Communist Party of China (CPC), by aban- other persons of accomplishment are invited to join, and C doning Marxist-Leninist dogma and adopting promotion within the Party is, to an extent at least, merit- pragmatic economic policies, has lifted hundreds based. “Market Socialism with Chinese Characteristics” seems of millions of people out of abject poverty in a few short a much better description of all this than “capitalism.” decades. No other government in human history has accom- In fact, China is going where no country has gone before. plished anything remotely comparable. Most Nobel Peace Its economic system is something largely new and outside the Prizes celebrate far slighter achievements. experience of Western academic economists. Foreign experts Communist China’s accomplishments should caution have nonetheless offered prescriptions that China’s leaders, in outside experts. Economics surely has more to learn from some cases, have followed, or perhaps swallowed. Thus, China China than China has ever learned from economics. Much has financial regulators and regulations. It has stock markets rhetoric from the right (“See what happens when capitalism and banks and business corporations. Its corporations have is unleashed!”) and the left (“Capitalism destroyed Chinese boards of directors, with careful attention to the fraction that equality, Mao’s greatest legacy!”) is, in our opinion, far off are designated as “independent.” Its government negotiates target. China has not adopted capitalism, and Mao left no free trade agreements and adjusts the money supply and fiscal legacy of real equality.1 policy to stimulate the macroeconomy. In all of these ways, The CPC refers to its economic system as “Market Social- China looks and acts like a capitalist economy. ism with Chinese Characteristics.” Journalists reporting on But all is not as it seems. The Party continues to enunciate China largely ignore this official phraseology, perhaps smiling Five-Year Plans, which delineate all-embracing Party objec- at the Party leadership’s unwillingness to formally acknowledge tives. Financial regulators and judges are virtually all Party having abandoned communism and embraced capitalism. members as well as government employees, and their careers Observing the formation of stock markets, giant banks and are overseen by various Party organs, notably the Organization corporations, business schools, and financial regulators, they Department of the CPC, which ensure that cadres throughout can be forgiven for jumping to conclusions. In fact, the Party China act in harmony with Party policies. Cadres’ job security, leadership is being quite deliberate in its choice of words. prospects for promotion, and ability to advance the careers China is a market economy. The prices of most goods and of their underlings all depend on their own overt demonstra- services are set by supply and demand. China is also socialist tions of harmonious cooperation with Party objectives.2 In in a sense Lenin would recognize. Its government is a people’s general, listings on the domestic stock markets are limited democratic dictatorship of the proletariat—a people’s democ- and rationed out by bureaucrats intent upon implementing racy in that the government rules in the name of the whole Party objectives.3 Chinese banks and other financial institu- people, and a dictatorship of the proletariat in that the CPC, tions are essentially all state-owned enterprises of one form or ruling in the name of the proletariat, suppresses political another, and their lending policies must be consistent with dissent beyond certain boundaries using the police power of Party objectives4—though recent CPC Third Plenum reforms the state. Finally, China remains fundamentally Chinese. The call for established nonfinancial firms being granted banking CPC has come to resemble the meritocratic Imperial Civil licences. In addition to having CEOs and boards of directors, Service that governed China in its previous eras of greatness. all but the least significant Chinese corporations also have Membership in the Party is a badge of high status. Students Party Secretaries and Party Committees.5
* Randall Morck gratefully acknowledges partial financial support from the Bank of Plans: Institutional Reforms Necessary for the Realization of the 12th Five-year Plan’s Canada. These views are the authors’, and may not reflect those of the Bank of Canada Objectives” by Randall Morck and Bernard Yeung. Sections of the article also draw on or any of its staff. We are grateful for extremely helpful suggestions from the editor, Don Fan, Morck and Yeung (2012). Full citations of all references in the text or footnotes are Chew, and from Dr. Duvvvuri Subbarao. provided at the end of the article. 1. See Dikötter (2010) on the social and economic inequality created by Maoist re- 2. See Deng et al. (2014). forms and Freeman (2014) on the current Chinese leaderships efforts to correct these 3. See Aharony et al. (2000) and Tian (2011). problems. In addressing the stark differences between China’s current economic system 4. See Pistor (2012). and capitalism, this article draws on the 2012 policy position paper “The Best Laid 5. See McGregor (2010).
20 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 This is not to say that China’s institutional reforms are Middle Income Trap, major reconfigurations of both corpo- Potemkin Villages—artificial constructions designed to rate governance and country governance seem necessary. impress credulous foreigners. China’s reforms are real. CEOs Latin America stands out especially as having difficul- and boards have real authority and make real decisions. ties with this transition. Argentina, Mexico, and Venezuela Corporations’ Party Secretaries and Party Committees have each sustained periods of rapid industrialization and were veto power over critical decisions, but exercise it only very hailed as emerging First World countries, only to stagnate selectively to help the CEO and board avoid deviating from for decades as elites entrenched their economic and political Party objectives. Moreover, the Organization Department control.10 Many countries in the Middle East and other parts of the Communist Party genuinely values competence, and of Asia also fit this bill. A common theme across countries is cadres’ promotions may be genuinely merit-based—though that the most formidable barrier to a successful transforma- loyalty, obedience, and circumspection doubtless also tion is the self-interest of powerful people whose wealth and matter. 6 The CEO of a growing and profitable firm might power depend upon the continued importance of institu- be promoted to Mayor or Party Secretary of a large city, and tions appropriate to catch-up growth, but inappropriate for the Mayor of a dynamic small city might be promoted to continuing the ascent to sustained high-income status. China Party Secretary of an important corporation. is now approaching the point where this sort of institutional How did such a system become so successful? Institutions transformation seems necessary, and where these opposing widely accepted as key to rapid economic development— forces muster strength. sophisticated contracts, property rights, corporation, and securities law, a financial system that encourages innovation, Institutional Development investor rights, a powerful middle class, and even the rule of China’s economic success is much publicized, but the abysmal law—are absent or, at best, ephemeral in China.7 We propose depths from which it rose are less fully appreciated. Plumb- here that the Party’s creation of something approaching a ing those depths provides important insights into China’s genuine meritocracy explains much of the success, and that current institutions. the Party’s stated objectives and effective control of members’ careers may, in retrospect, have helped solve the coordina- The Fall of China tion problems that the mid-20th century economist Paul European traders found 16th century China a united empire, Rosenstein-Rodan rightly saw as barriers to rapid economic and Chinese officials found the Europeans rather unimpres- development.8 sive, and soon confined them to a small stretch of riverbank However, as we argue at the end of this paper, institu- in Guangzhou, where their trading missions (called “hongs”) tions conducive to a Big Push, especially those associated conducted limited and carefully supervised transactions with with corporate governance, are likely to prove inappropriate select local merchants. As the Emperor Qian Long patiently or even dysfunctional after “catch up” growth ends. The only explained in a letter to Britain’s King George III, proven paths from middle- to high-income status require the institutions developed by existing high-income countries. Our Celestial Empire possesses all things in prolific abundance Historically, many countries that managed short spurts of and lacks no product within its own borders. There was therefore no rapid development but then failed to adopt such institu- need to import the manufactures of outside barbarians in exchange tions have ended up as “always developing, never developed” for our own produce. But as the tea, silk and porcelain which oligarchic or “crony capitalist” economies. A hopefully untrue the Celestial Empire produces, are absolute necessities to European national joke proclaims that “Brazil is the economy of the nations and to yourselves, we have permitted, as a signal mark of future, and always will be.”9 Today’s large high-income econo- favour, that foreign hongs should be established at Guanzhou, so mies’ institutions take different forms, but all came to relegate that your wants might be supplied and your country thus participate resource allocation to decentralized planning by competing in our beneficence. firms that are financed by middle-class investors’ savings, responsive to market forces, and subject to the rule of law. The Emperor had clearly not heard of the Law of Compar- When such a transition is necessary for China to avoid this ative Advantage, which affirms that any country gains from
6. See Landry (2008) for empirical evidence based on CPC cadres’ promotion records. 8. On how cadres are selected and promoted see Deng et al. (2014), Landry (2008), 7. Precisely which institutions matter most in which sequence, is debated. Hayek McGreggor (2010). For more details on these coordination problems and how central Big (1944) argues for the essential importance of the rule of law—that is, for no person or Push coordination might solve them, see Rosenstein-Rodan (1943). For a formal model organization to be above the law. Fukuyama (2010) elaborates on this, arguing that the of this role for the state in a Big Push, see Murphy, Shleifer and Vishny (1989). rule of law is fundamentally foreign to China. Schumpeter (1911) stresses the importance 9. See “Will Brazil remain the country of the future?” Economist, Oct 8th 2012. of innovation and of a risk-tolerant financial system to sustained prosperity, and La Porta et 10. On entrenched oligarchies in Latin America and elsewhere, see e.g. Bortz and al. (1998) argue for the importance of shareholder-centered corporate governance. Acemo- Haber (2002), Calomiris and Haber (2014), Edwards (2010, Galeano and Allende glu and Robinson (2012) posit a large and powerful middle class—they stress yeoman (1997), Haber, North and Weingast (2007), Haber (1989, 2002), Morck, Stangeland farmers—as a precondition for broad-based development. This uncertainty leaves rapidly and Yeung (2000), Morck, Wolfenzohn and Yeung (2005), and Rajan and Zingales developing economies little scope for picking and choosing partial reforms. (2003, 2004).
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 21 trade. British merchants sought more trade and soon made When Mao finally died in 1976, China was poorer than the Chinese “offers they could not refuse”: they peddled sub-Saharan Africa. Agriculture had collapsed, and tens of opium. As opium addiction spread, the Emperor Dao Guang millions had died in famines. Creative thinking was politi- launched a War on Drugs. His Drugs Czar, Commissioner cally hazardous, and vociferous loyalty trumped competence Lin Ze-xu, confiscated and burned the Hong’s opium stores throughout the Party and government. Mao’s death marked in 1839. Remarkably, the British opium dealers convinced the end of the Cultural Revolution (1966-1976), but left the Parliament to respond with gunboats, which quickly economy in ruins and the people mired in poverty, illness, overcame China’s technologically antiquated defences.11 and illiteracy. In 1978, China’s per capita GDP ranked among Further Chinese attempts to ban opium provoked the Second the lowest in the world. Hepatitis was endemic and virtually Opium War in 1857, and a more devastating military defeat. all tap water was unsafe.12 In 1982, 34.5% of all adults and Both Opium Wars left China owing huge indemnities that 49% of female adults were illiterate.13 drained government coffers of silver, and the second opened From this unpromising starting point, China’s Commu- the country to Christianity as well as opium. The Tai Ping nist reformers have lifted living standards to Latin American rebellion, led by Hong Xiuquan, the self-proclaimed Little levels. In 2013, the World Bank listed China’s per capita GDP Brother of Jesus, was roughly contemporaneous with the as roughly matching that of Peru. Peruvians are not the richest Second Opium War, and its costly suppression further people in the world, but are incomparably better off than drained the treasury and devastated the land. most Chinese in 1978, and most sub-Saharan Africans now. By the turn of the 20th century, China was a failed state, China, like Peru, is now a middle-income country and, like its imperial government still largely contemptuous of foreign much of Latin America, confronts middle income country technology and its people afloat on opium. Counterfactuals in problems—inequality, oligarchs, and a historically justifiable history are scarcely objective, but we wonder what would have mistrust of the West. happened had the Celestial Empire instead traded tea, silk, and porcelain for European technology, as Meiji Japan did Socialist Legal Origin after 1868? Might foreign knowledge have followed foreign The system Mao imposed, which was based on Stalin’s Soviet trade, as in Japan? Might the Fall of China have been less Union, continues to influence Chinese governance. To make crippling, or even entirely avoided? these connections clearer, we offer a brief overview of social- In fairness, factions within the Qing court pressed for ist governance.14 the importation of foreign technology and ideas, but without According to the famous Austrian economist, Fried- real success. The imperial court was rife with corruption, rich von Hayek, the central problem in economics is not, as factional politics, and incompetent officials in inherited senior commonly expressed in textbooks, the allocation of scarce positions. The moribund dynasty collapsed in 1912 with the resources to competing ends, but “rather a problem of how to foundation of the Republic of China. Power evaded Sun secure the best use of resources known to any of the members Yat-sen’s Nationalist Party as the warlord Yuan Shikai sought of society, for ends whose relative importance only those to found a new imperial dynasty. The ensuing conflicts left individuals know. Or, to put it briefly, it is a problem of the China a patchwork of warring fiefdoms. By the 1920s, China utilization of knowledge not given to anyone in its totality.”15 was “merely a geographical expression,” and appears on maps Hayek argued that markets efficiently gather this informa- of the era as a multi-colour mosaic of states. The Nationalist tion and shape incentives so that all concerned unknowingly Party, now led by Chiang Kai-Shek, and the Communist coordinate their actions to minimize waste.16 Modern finance Party, led by Mao Zedong, soon emerged as the two major theory is more qualified, with its recognition that agency contenders in a full-fledged civil war. problems and other information asymmetry problems cannot By the 1930s, China was so economically and politically be eradicated. Much work in corporate governance turns on enfeebled that Japan’s military zealots perceived it ripe for how to manage these problems and limit their social and conquest. Having seized Manchuria in 1932, Japan invaded financial costs.17 China-proper in 1937. After Japan’s World War II defeat, the Lenin devised an alternative system of governance. The civil war resumed. The Communist victory in 1949 left Mao fundamental problems in the socialist governance are also free to implement, in succession, forced agricultural collectiv- problems of information and incentives.18 Central planners ization, the Great Leap Forward, and the Cultural Revolution. need reliable information about the productive capacities
11. In fairness, the Europeans were subjected to torture and summary execution by sharply distinguish socialism from social democracy. often corrupt officials, letting the British justify military actions as necessary to establish 15. Hayek (1945, p. 78). treaty ports subject to European rule of law—with opium legalized in these, if not in 16. For more detail, see Hayek (1937, 1944) Europe. See esp. ch. 3 in Fay (1975). 17. These problems, formalized by Jensen and Meckling (1976), are relevant in any 12. For details on the prevalence of hepatitis, see Liu and Fan 2007. large organization (La Porta et al. 1997). 13. World Development Indicators database, World Bank. 18. On agency problems in socialist economies, see Shleifer and Vishny (1992, 14. We follow Chinese practice in using the term communism to describe a money- 1998). less utopia and socialism to describe a country striving to achieve communism. We
22 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 and needs of people and enterprises throughout a large and were paid minimal salaries; for example, in 1988 university diverse country. Given that information, planners can formu- professors in China averaged RMB211 per month (US$43 late input and production plans, whose implementation must at the official exchange rate).22 However, workers’ production then be entrusted to potentially self-interested agents. Much units provided (very) basic housing, food, health care, and of the surveillance apparatus in the Soviet Union was initially children’s schooling. Wages were only for buying luxuries, justified as providing central planners with the information such as bicycles or extra shoes. Salaries, living conditions, they needed both to allocate resources and to ensure that and food rations were generally unrelated to effort. Rather, factory managers, workers, railroad employees, and others continual exhortations about loyalty and duty to the Party acted as faithful agents. Many did not, of course, and self- and proletariat were used to motivate effort. interested behavior such as selling inputs and outputs on the This system has obvious design flaws. First, disconnecting black market became widespread. To control such agency individual effort from individual rewards creates free-rider problems, the Soviet leadership devoted ever increasing problems. Workers, paid the same for working or not working, resources to surveillance and came to regard market transac- understandably find the latter more pleasant; and agricultural tions as treasonous sabotage worthy of the death penalty. and industrial productivity accordingly collapsed by the late China adopted this system in stages in the 1950s, and all but 1950s. Second, managers, controlling only funds designated eliminated private enterprise in these years. to pay for inputs, understandably exaggerated their input The essence of socialist governance can thus be summa- needs. The resulting soft budget constraint problem—that rized succinctly as follows.19 Every part of the economy is, the ever-increasing costs of production that managers must be saturated with Party cadres who feed information reported so as to expand the resources under their control— upwards through successively higher-level tiers of cadres and, quickly became a major governance problem in China, as in ultimately, to the central planners. The central planners issue other socialist economies.23 production quotas to the managers of factories, railroads, Managers’ objectives were specified as quantitative army bases, and other operational units. In the Cold War era production targets, so rational managers sacrificed quality Soviet system, each unit had a cash account at a state bank, for quantity. Consumers coped by avoiding goods made near into which the central planners deposited funds the unit the end of a quota period, when quality control was worst, could draw upon to pay its workers and to acquire inputs. as factories raced to meet their quotas. Factory managers, Productive operations, such as collective farms or factories, granted control rights without corresponding cash flow rights, each had a second non-cash account with the state bank, in understandably maximized their private benefits. Managers which their sales revenues accumulated. The unit could not could extract favors, if not outright bribes, for providing transfer funds from one account to the other. Only the central goods—especially goods of verifiably high quality—that planners could do this, and only in accordance with the were in short supply. Quite predictably, virtually everything central plan. The government and Party funded themselves was always in short supply, even though simple planning with the difference between what accumulated in non-cash errors would presumably have led to shortages and surpluses accounts and what was transferred to cash accounts. There in roughly equal proportion. A shadow free-market economy were no taxes. thus arose to allocate the goods and services people actually This deep integration of public finances with central wanted, needed, and could afford in one way or another.24 planning was, and perhaps still is, a key obstacle to more This legacy of gray-market transactions, in which favor- complete reform. Complete privatization threatens govern- trading (guanxi) was widely socially accepted as necessary ment revenues, for accounting standards are problematic,20 for simply getting by, persists in modern Chinese business the Chinese citizenry are unaccustomed to paying taxes ethics.25 and Chinese governments at all levels are unaccustomed The predictability of input costs and output levels attained to collecting them efficiently. However, the government is primary importance under this system of governance. Central working towards developing a comprehensive income taxation planners wanted their plans to be attainable, and managers system,21 and recent reforms are laying the groundwork for wanted their cost and output mandates to include a predict- a property tax. Nevertheless tax collection from businesses able (and, if possible, ever larger) wedge between revenues remains challenging. and real costs to fund their private benefits. In the Soviet Under socialist governance, workers and managers system, innovation was avoided because it made costs and
19. On Soviet governance, see Smith (1984); on the Soviet money and banking sys- 23. On the soft budget constraint in socialist economies, see Kornai (1986). tem, see Nakamura (2012). On the era of central panning in China, see Chow (2011). 24. On the ubiquity of shortages and paucity of surpluses under socialism, see Shle- 20. See Piotrosky and Wong (2012) for details regarding seeming deficiencies in ifer and Vishny (1992). Chinese accounting practices. 25. See Lü (2000). 21. See Gordon and Wei (2012) on barriers to the development of tax-financed gov- ernment in post-1978 China. 22. See Shoresman (1998) on the history of academic salaries in China.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 23 output levels unpredictable and risked increasing supply— 20th century ideology: the social value of great men who, both major potential problems for planners and factory or by transcending conventional ethical standards, lift society collective farm managers alike.26 The situation in China was, through great leaps of faith. Mao’s faith was a deep belief if anything, worse: prior to 1978, innovators risked being in the ultimate goal of Communism, a moneyless economic branded as counterrevolutionary, made social outcasts, utopia in which altruistic citizens would voluntarily work and sometimes even banished to remote collective farms or hard for the common good and the state would fade away re-education camps.27 The authors’ visits to Chinese factories completely. in the 1980s were thus something of a journey into indus- This paradise was, of course, attainable only via the trial history. Coal-fired railroad locomotives, as in American Socialist path charted by Stalin. Precisely what that path Western films, were still in production, and textile mills still entailed came to be disputed. The Rightist faction sought used machinery that was in place on Liberation Day in 1949. to reengineer economic institutions; Mao’s Leftist faction This premium on stability surely made socialist governance sought to reengineer human nature. The rightists were social simpler for both planners and managers, but left China with engineers with technocratic mind sets, the leftists were antiquated and inefficient technologies that locked in low romantics with literary ideals. productivity. Realizing that reality was not conforming to his While China’s managers and political leaders clearly plans, Mao’s solution was to intensify social pressure. In understand the costs of laggard technologies, the political the 1950s, his Great Leap Forward sought to industrialize leadership, especially, retain an overarching acceptance of China overnight by mobilizing all peasants to deforest vast stability as a social goal—seemingly without realizing the landscapes to make charcoal to slag mounds of household inherent contradictions in this. Technological progress neces- metal goods in village iron foundries. China boosted its iron sitates accepting a substantial instability about which firms production, albeit of such abysmal quality as to be economi- survive and prosper, which professions pay well or poorly, cally worthless, even as tens of millions perished in famines and which sectors of the economy expand or shrink, but this amid unattended fields and man-made dust storms in a China microeconomic instability stabilizes overall prosperity. Unfor- no less industrially backward. In the wake of this disaster, tunately, technological stagnation, like pervasive shortages, Rightists gained influence, and the CPC grew increasingly abysmal quality control, low productivity and high costs, technocratic. became the new normal. Altering mind sets accustomed to Appalled by this, Mao organized the Cultural Revolution this world became a major challenge to reformers. in the late 1960s by bestowing ethical and social status on Given these governance problems, the Chinese economy any who arose to purge the Party of its technocratic elitists. stagnated. In the Great Leap Forward of the late 1950s, Mobs destroyed ancient temples, the university system, and a and again in the Cultural Revolution of the late 1960s and generation of Chinese intellectuals. This chaos and hard-line early 1970s, Mao sought to reinvigorate China by equating Leftists’ relentless attempts to grab power as Mao’s health self-interest with criminality and even treason, and by encour- declined sank China into deeper poverty.30 Deng Xiaoping’s aging people to seek social status by denouncing economic Rightist “reformers” took charge of the CPC in 1978 after traitors.28 Both episodes merely brought deeper economic a thorough purge of prominent Leftists. Critically, Deng’s collapse and a general acceptance that being an economic Rightists were neither democrats nor free market liberals. criminal was not really a bad thing. Indeed, defying, circum- Rather, they sought a pragmatic and scientifically engineered venting, or otherwise cheating a system that many privately Socialism, free of romanticized idealism. After the errors regarded as evil and oppressive came to be seen as morally and excesses of romantic communism, China was ripe for a laudable.29 We suspect that this entirely understandable pragmatic economic approach. ethical inversion—good people defy bad rules—remains an Deng’s first major reform reintroduced market incentives important element of modern China. in agriculture: peasants could sell excess produce in farmer’s markets. The result, an abrupt reappearance of plentiful fruit Maoist Catharsis and the Resurrection of China and vegetables, encouraged further reforms. By the 1990s, Following Mao’s death in 1976, reformers led by Deng Xiaop- only a few key prices remained under state control. China ing took charge. Deng’s faction of the Communist Party of had become a market economy in the sense that, for the most China was a technocratic (Rightist) element that had long part, prices were set by supply and demand. vied with Mao’s idealistic (Leftist) faction. Mao, a one-time With socialism collapsing across Eastern Europe in 1989, poet enamoured of philosophy, embraced a popular early and then in the Soviet Union in 1992, pragmatism neces-
26. On the dearth of innovation under Soviet socialism, see Berliner (1978). 29. On the ethical legacy of communism, see e.g. Holmes (1993), Rose et al. 27. ON the Cultural Revolution, see e.g. Feng (2007). (1998). 28. See Centola et al. (2005) on the manipulation of ethical norms by dictatorships 30. Key episodes included attempts to seize power by Lin Biao and the Gang of Four and Willer et al. (2009) for discussion of the Cultural Revolution in China in this context. and a history of Rightists versus Leftists tensions within the CPC, see Baum (1996).
24 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 sitated further reforms. But the suppression of the Tien An These reforms combine to give China the appearance of Men Square protests vividly demonstrated that multi-party a free market economy, with institutions recognizably similar democracy was not on this list. However, many of the post- to those found in the Western world in general, and in the socialist governance reforms implemented across Eastern area of governance, especially, in the United States.32 Appear- Europe and the former Soviet Union were on the list. Inher- ances can be deceiving. Corporate governance, like all laws iting essentially the same system of socialist central planning, and regulations in China, must be interpreted through a key the former Warsaw Pact countries, and then the Baltic states provision in the Constitution of the People’s Republic of all ultimately adopted broadly similar sequential reforms. China that enshrines a “Leading Role” for the Communist China, with reservations, followed along. Party.33 A major task reformers faced was the mass privatization of As an example of how this works, consider CEO pay.34 the means of production. The first step towards this goal was CEO pay in China superficially resembles that in the United corporatization. Land, plant, and equipment, previously all States. The CEOs of SOEs earn bonuses tied to account- the property of the state, had to be allocated to newly desig- ing earnings and, for some listed state-owned enterprises, nated state-owned enterprises. This was an epic accounting stock returns. But only parts of these bonuses are disbursed challenge, for where one state-owned enterprise ended and immediately. Substantial fractions of CEOs’ bonuses another began had to be established. This done, the various accumulate in funds and are disbursed every few years after post-socialist economies adopted different actual privatization the CEO’s performance is reviewed by the Organization strategies. The Czech Republic and Russia allocated vouchers Department of the Communist Party. Thus, SOE CEO pay to their citizens, and then conducted voucher-denominated is linked to both financial performance and Party loyalty. The initial public offerings. Poland established a coterie of insti- latter is arguably the more important, for the Organization tutional investors, assigned these shares in all privatized large Department also determines which CEOs keep their jobs, firms, and tasked them with paying pensions and insurance gain promotions to more prestigious positions in the corpo- claims. Hungary sought foreign buyers for its privatized firms. rate world, government, and Party, or end up demoted or even In hindsight, the Polish approach attracted the least criti- more severely punished. This system of corporate governance cism.31 Voucher privatizations invited corruption: handfuls of is deemed essential, for without it the Party could not exercise Party insiders built business empires by buying vouchers from its Leading Role. suspicious populations that preferred cash in hand to shares As a second example, consider statistics that show of uncertain worth. Foreign buyers provoked troublesome the expanding role of private sector firms in China, often nationalist reactions. highlighted in journalistic accounts of China’s economic China’s approach was to go slow. State-owned enter- rise. A degree of sleight of hand is at work here, for Chinese prises were corporatized, but not thereafter immediately official statistics count as “private sector” any firm in which privatized. Rather, China’s leaders sought to do as much the state does not hold a direct control block of shares. Thus, reform as possible while pausing at this intermediate step. any controlled subsidiary of an SOE is deemed to be a private State-owned enterprises have learned to contend with balance sector firm, as are any firms owned directly by government or sheets and earnings statements for many years, as succes- Party officials, or by state-controlled agencies. Lenovo is thus sive reforms gradually increased their economic autonomy. a private sector firm, even though it has a dominant owner, State-owned enterprises came to have chief executive officers, Legend Holding Company (with a 32.44% equity block in boards of directors, and levels of middle managers. They 2013), whose major shareholders are the Chinese Academy of now pay for inputs (including labor), sell outputs at market Science, the Lenovo Employees Fund, and China Oceanwide prices, and keep the profits or disburse them as dividends. Holdings Group (each with at least a 20% stake in 2013, Many state-owned enterprises have listed their shares, or the the last controlled by Lu Zhiqiang (a prominent member shares of a controlled subsidiary, on one of China’s two stock of CPPCC Standing Committee).35 A skeptical interpreta- markets, in Hong Kong, or even overseas in the United States tion of these statistics is that they represent a façade of free and elsewhere. A securities regulator oversees the domestic markets; a more generous interpretation is that they reflect markets and vets initial public offerings. These reforms have “baby steps” along a Polish path to full privatization, perhaps created a new cast of more or less private sector firms, which with the Chinese Academy of Science serving as a nascent have brought a new dynamism. institutional investor. Yet here, too, Chinese reluctance to
31. See Blanchard et al. (1993) for a comparative analysis of the deconstruction of 34. For more detail on CPC and state organs’ oversight of CEO pay in China, see socialism in Eastern Europe and Åslund (2001) regarding the former member republics Landry (2008) and McGreggor (2010). For pay-performance sensitivity in China, see of the Soviet Union. See also Åslund (2007). Firth et al. (2006). 32. See Allen et al (2012) and Allen and Shin (2012). 35. This information is from the websites, of Lenovo, Legend Holding Company, and 33. See Guo (2012) on the Leading Role of the CPC in the Chinese constitution. An Oceanwide Group. English translation of the constitution is at english.people.com.cn/constitution.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 25 pursue full privatization preserves the Party’s constitutionally securities, bankruptcy, property and tort laws and regula- mandated Leading Role. tions. On its face, the Chinese legal system appears to be As yet a third example, consider the freedom of action rapidly conforming to international best practice. However, of CEOs and boards of directors at both SOEs and private- the Constitution, in granting the Party its Leading Role, and sector firms. In principle, the CEO is duty-bound to run the these judiciary processes, in placing the Legal Committee of corporation efficiently and boards are empowered to ensure the Communist Party above the Law, thus leave all laws and that CEOs do their duty. In practice, every SOE and all but regulations subservient to Party objectives. If Party policy the smallest private-sector firms also each have a Commu- conflicts with a law or regulation, wise judges give primacy nist Party Secretary and a Communist Party Committee. to Party policy. To do otherwise would be unconstitutional.38 At present, any enterprise employing four Party members or more can have imposed upon it a Party Secretary and Corporate Governance and The Big Push Party Committee if the Party deems this useful.36 The Party That this system lifted hundreds of millions out of poverty Secretary and Party Committee do not intervene in normal and into the ranks of the global middle class is not necessarily business practices, much as the Business Judgement Rule in an insult to free market economics. First, very rapid growth the United States denies the country’s judges the power to from the abysmal nadir of 1978 is, in part, surely the mere meddle in day-to-day corporate decision-making. However, reversal of the worst of Mao’s disastrous economic policies. the Party Secretary and Party Committee do serve the Party Restoring basic market incentives, importing foreign tech- by keeping higher-level cadres up to date about the corpora- nology, reallocating labor to more productive activities, and tion’s activities, and by intervening as necessary to help the holding down the yuan to spur exports to a stable and pros- CEO and board avoid erroneously making decisions that are perous West were all simple measures along these lines. But inconsistent with Party objectives. This is, of course, necessary China’s success increasingly appears to be far more than this, to render Chinese corporate governance institutions consis- and so requires a deeper explanation. tent with the Party’s constitutionally enshrined Leading Role. The Chinese system’s hidden virtues emerge when New firms must live within this system. Thus, the 2014 interpreted through the work of the mid-20th century devel- IPO of the Chinese internet firm Alibaba was heralded as the opment economist Paul Rosenstein-Rodan.39 The influence largest ever floated in the U.S. Fewer accounts stressed that the of Rosenstein-Rodan, who designed the World Bank and public float was only 15% of the firm, and that a constituency- trained countless students and disciples to serve as prominent based shareholder voting system guaranteed Lakeside Partners government officials in developing economies throughout the control of the board. Lakeside’s partners includes Alibaba’s world, is hard to overstate. founder Jack Ma as well as its chief risk officer and Communist Party Secretary, Shao Xiaofeng, a former senior police officer. 37 Coordination Failure as a Fundamental Obstacle to The country’s judicial system raises yet other issues. Development China’s judges are government employees, paid by local or Rosenstein-Rodan saw coordination failure as the primary central governments but nominated by the matching level obstacle to the industrialization of a low-income, predom- of “People’s Congress,” further screened by the matching inantly agricultural economy. Thus, a lone steel mill on the Organization Departments of the Communist Party and African savannah is apt to be a commercial failure because finally approved by the Standing Committee at the match- its production cannot be coordinated with the activities of ing level of the Communist Party. Critically, judges are networks of suppliers and customers. Just as an organism responsible to the Party first and foremost. China adopted cannot survive without an ecosystem, a firm cannot survive a civil code legal system; so judges’ decisions are based on without an economy.40 selected application of legal codes. Often, there is guidance in This perspective recognizes a high-income free market these application decisions by committees inside the People’s economy as a complex dynamic system in which each actor Congress and the Party’s Political and Legal Committee has implicitly depends on the predictable actions of countless the power to intervene in deliberations, and even to overturn others. For example, a steel mill depends on the existence of coal verdicts issued by judges. Most judges are Party members and mines, iron ore mines, and transportation companies as well as making decisions that contradict Party policies and guidance a wide range of buyers of steel—machine tools manufacturers, leads to Party disciplinary actions. China has accumulated construction companies, shipbuilders, and the like. Moreover, large bodies of generally American-inspired corporations, the steel mill depends on there being enough of each of these
36. For more details about the importance of Communist Party Committees and Sec- these conditions are violated in China. For more detail, see Fukuyama (2011) and Guo retaries in corporate governance and in general, see McGregor (2010). (2012) 37. See “Alibaba Partners Include Onetime Top Cop,” Wall Street Journal, June 17, 39. See Paul Rosenstein-Rodan (1943) and elaborations (Myrdal 1957; Murphy et 2014. al. 1989; Rodrik 1996; Rodriguez-Clare 1996). 38. Judicial independence is generally assessed using criteria for the tenure and 40. Murphy, Shleifer and Vishny (1989a), Rodrik (1996) and others update Rosen- promotion of judges, and for their independence in interpreting and applying the law. All stein-Rodan’s reasoning with formal models that affirm his basic intuition.
26 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 to prevent its being “held up”—that is, squeezed by monopo- tively raise economy wide demand and thus sales. Also, every lists or monopsonists occupying any point along the chain. firm depends on sufficient competition to generate competi- Each firm in the chain, in turn, depends on countless other tive prices in countless markets throughout the economy, firms along its supply chains, and all the other firms along all of which in turn reduces production costs collectively. Finally, their supply chains, and so on.41 And all of these firms depend every firm also depends on a range of public goods that only on enough other firms paying middle income salaries to vast the state can provide. Yet private investors and bankers are numbers of employees, who double as consumers in final goods understandably reluctant to commit capital to ventures in markets.42 While openness lets foreign market participants fill proportion to the benefits they provide distant third parties. some network gaps in the development of a small economy,43 Because of these problems, Rosenstein-Rodan concludes China is no longer a small economy. that Anticipating the first mover problem in game theory, Rosenstein-Rodan recognized that no firm would step forth Existing institutions of international investment (floating of alone to launch the industrialization of an otherwise predomi- shares and loans) are inappropriate to the task of industrialisa- nantly pre-industrial economy, but that a multitude of firms tion of a whole area. They deal with too small units, and do not doing so simultaneously could all render each other viable. take advantage of external economies. Capital mostly goes to To transcend the first mover problem, he therefore called for individual enterprises. There has never been a scheme of planned a “Big Push” wherein the state would coordinate the simul- industrialisation comprising a simultaneous planning of several taneous industrialization of multiple firms in all sectors of complementary industries.45 the economy. This, he argued, could transition the entire economy en masse from its low-level equilibrium, in which He therefore calls for Big Push development: the individual self-interest prevents economic development, to a government funded and coordinated development of entire high-level equilibrium, in which every firm is sustained by economies as the only viable way of internalizing all such the existence of all the others. externality problems. Of course, public investments such as roads, bridges, As we explain below, one interpretation of China’s schools, and hospitals are also unlikely to find adequate economic rise is that the CPC is successfully funding and private-sector backing, and the government of a low-income coordinating a Big Push of precisely the sort Rosenstein- agricultural economy may lack the tax base to fund socially Rodan prescribed. To be sure, this interpretation is marred optimal provision of these and other public goods on which by widespread criticism of Big Push development plans as rife every firm also depends. However, if the economy can transi- with government failure, breeding grounds for corruption tion to the high-level equilibrium, a huge network of firms, and, historically, tragic economic stagnation.46 along with their employees, become available to tax, enabling the government to fund the schools, roads, and all the other Keeping up with the Neighbors public goods on which all firms also rely. The government’s Although Rosenstein-Rodan is quite plausibly right about coor- problem of economic development is thus one of coordinating dination failure as a barrier to development, he is almost surely the transition from a very stable low-level equilibrium to this wrong about the limitations of financial systems, and therefore self-sustaining high-level equilibrium.44 about the need for government to play a leading role. Many Rosenstein-Rodan highlights three particularly impor- rapidly developing economies feature huge business groups tant characteristics of the low-level equilibrium that keep with many member firms in many different industries, their it highly stable. First, the financial system, accustomed to governance all coordinated by a single ultimate controlling providing capital to specific firms for specific purposes, is not shareholder—usually a prominent business family. Such busi- up to capitalizing simultaneously an economy-wide network ness groups (called zaibatsu) in late Meiji Japan can be seen of firms. Second, the financial system is not up to the task of as having orchestrated a “private-sector Big Push”—or, more coordinating the establishment and growth of firms in such precisely, a race between competing Big Push efforts, each a network so that, for example, steel mills, cement plants, undertaken by a zaibatsu led by a different tycoon or busi- and construction firms able to use steel and concrete all ness family.47 And in recent work, we argue that similarly large come online in synch. Third, the financial system cannot industrially diversified business groups arose in other developing fund externalities. Every firm is, by its simple existence, a economies, and in the histories of many developed economies, positive externality for every other firm because they collec- to effect similar episodes of rapid industrialization.48
41. On these issues, see Matsuyama (1992, 1995), Gans (1997), DeFontenay 45. Rosenstein-Rodan (1943, p. 204). (2004), DeFontenay and Gans (2004ab) and Hermalin et al. (2010). 46. Easterly (2006) 42. See Myrdal (1957), Murphy et al (1989b) and others. 47. Morck and Nakamura (2007) 43. See Venables (1996), Skott and Ros (1997) and Trindade (2005). 48. Morck and Yeung (2013). Leff (1978) also draws attention to business groups 44. Murphy, Shleifer and Vishny (1989) formalize this using the mathematics of potential role in rapid industrializations. game theory.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 27 The Case of Japan: A Failed Public-sector Big Push then sold them (at a loss) to private buyers. However, after Followed by a Private-sector Success. A brief history of contributing government money, the government planners Japan’s Big Push can help illuminate the current state of exited rapidly in the 1880s. China’s economy.49 In the mid-19th century, a series of Japan’s post-World War II reconstruction and ascent to very uninvited visits by American steam powered gunboats high-income status did occur amid substantial government with state-of-the-art weapons revealed how humiliatingly intervention and bank influence over corporate governance. backward Japan was. The Tokugawa shogun, who under- However, a substantial revisionist literature now argues that standably yielded to U.S. demands to open trade, was the scope of state intervention in post-war Japan was vastly promptly overthrown by samurai warriors outraged at his exaggerated by foreign experts looking for a case of a successful cowardice. Their new regime, dubbed the Meiji Restoration state-run industrial policy. Data subsequently made available to honour the figurehead Meiji Emperor, soon understood show that the sectors that received the largest government subsi- why the shogun capitulated to the barbarians. Chagrined, the dies developed the most slowly, and that government planners Meiji leadership resolved to acquire foreign technologies so as succeeded mainly in targeting loser firms.50 to rid Japan of foreigners. Japanese students, sent abroad in In sum, Japan’s initial 1870s state-led Big Push was a large numbers, returned with knowledge of how far behind failure. The country caught up with parts of Europe by the Japan truly was. 1920s with its economy largely guided by its zaibatsu. Japan The Meiji leaders’ first development strategy, implemented rebuilt itself after World War II, after the American military in the 1870s, was to establish several dozen state-owned enter- government dismantled the zaibatsu and left an economy of prises, one in each modern industry, run by foreign-educated largely independently governed firms, which lifted it over the Japanese or hired foreign experts. The state-owned enterprises final step to sustained high-income status in the mid-20th proved increasingly ravenous for subsidies, and Japan experi- century. enced near simultaneous financial, currency, and sovereign The Case of Korea: Another Private-sector Big Push debt crises. Classical Liberal reformers took charge, organized Success. In the 1950s, South Korea was poorer than any the world’s first mass privatization, and implemented laissez- country in sub-Saharan Africa, and far poorer than North faire economics. Japan’s government remained overtly Korea; by the late 1990s, its standard of living rivalled many non-interventionist until the military takeover in the 1930s. countries in southern Europe. South Korea’s era of very rapid The former state-owned enterprises ended up owned development was from the 1970s through the 1990s. During by prominent merchant families, such as the Mitsui and this era, the economy was dominated by large full-set diversi- Sumitomo, and a handful of upstart entrepreneurs. From the fied business groups called chaebol. 1880s through the 1920s, the leading business families and Thechaebol appear to have played a similar coordination upstarts used first earnings from their existing firms and then role to that of the zaibatsu in late 19th- and early 20th-century public share issues to capitalize new firms in new industries. Japan.51 The Korean government intervened extensively in the By the turn of the 20th century, the largest business groups— economy in the 1950s and the country exhibited little real Mitsubishi, Mitsui, Nissan, and Sumitomo—achieved “full economic growth. In the 1960s and 1970s, state interven- set diversification”—that is, each zaibatsu had one, and rarely tion became intensely focused on relatively narrow priorities: more than one, member firm in every significant industry in first export promotion to generate foreign currency for arms the economy. Japan developed rapidly in these decades, with purchases in the 1960s; then subsidies to an even narrower little input from the government and little bank financing; set of heavy and chemicals industries viewed as militarily and by the 1920s, it was pulling alongside parts of Europe in important in the 1970s. After a major financial crisis in terms of industrial output and living standards. 1979, the government adopted overtly free-market policies Full set diversification quite plausibly reflects each group’s and state intervention largely ceased, except for the sorts of controlling tycoon or business family coping with the interde- R&D tax credits and other implicit subsidies found in most pendencies and externalities that Rosenstein-Rodan outlines high-income country tax codes. by coordinating the organization and growth of numerous Thus, decade by decade, Korean business groups were firms, each in a different sector. Moreover, Japan’s ascent increasingly left to their own devices, though their too-big- to high-income status occurred after the state withdrew its to-fail status and political influence arguably cut their costs guiding hand. Japan’s ultimately successful industrialization of capital and helped them ride out a series of financial crises was initially partly state-subsidized, in that the government in the 1970s, 1980s, and 1990s better than could smaller established a stable of modern state-owned enterprises and independent firms.
49. For more details, see Morck and Nakamura (2007) takeover defenses (Morck and Nakamura 2005). Some revisionists, most notably Miwa 50. See Beason and Weinstein (1996), Beason and Patterson (2004), and many and Ramseyer (2006), take the extreme position that government planners had no influ- others on the relatively limited role of government planners and keiretsu business groups ence whatsoever during the postwar era and that keiretsu business groups never existed. in post-war Japan and the misleading group-think that came to dominate academic and 51. See Lim and Morck (2014). popular articles on Japan in the 1980s. Keiretsu business groups are now regarded as
28 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Rosenstein-Rodan envisioned government planners Although the Korean chaebol were legally proscribed from scientifically plotting out and implementing the coordinated controlling banks, most controlled non-bank financial insti- development plan he deemed necessary for a Big Push. But the tutions. Both the zaibatsu and chaebol made extensive use of cross-country coordination achieved by Korean business groups related-party transactions to channel subsidies from profitable is recent enough that we can ask them why they did what they member firms to member firms needing capital. Such transac- did. Koo Cha-Kyung, chair of the apex firm in Korea’s LG tions are generally regarded as a mechanism for accumulating chaebol, recounts the economic network gaps and market forces wealth in the pockets of the controlling shareholder, but the that forced the group’s coordinated cross-industry expansion: rapid and broad economic development of both countries raises a more benign possibility. Perhaps tunneling between My father and I started a cosmetic cream factory in the late group firms approximated the cross-industry subsidies that 1940s. At the time, no company could supply us with plastic caps Rosenstein-Rodan’s Big Push planners would have used to of adequate quality for cream jars, so we had to start a plastics start new firms in new industries and sustain them as other business. Plastic caps alone were not sufficient to run the plastic parts of the economic network came online. molding plant, so we added combs, toothbrushes, and soap boxes. Japanese and Korean financial history thus motivates our This plastic business also led us to manufacture electric fan blades contention that Rosenstein-Rodan and his modern follow- and telephone cases, which in turn led us to manufacture electri- ers might be right about the problem, but wrong about its cal and electronic products and telecommunications equipment. solution. 55 Lone steel mills on the African savannah are The plastics business also took us into oil refining, which needed indeed financially unviable without the vast ecosystem of a tanker shipping company. The oil refining company alone was firms and markets that constitutes a modern economy. But paying an insurance premium amounting to more than half the state planners, operating without profit incentives, were not a total revenue of the largest insurance company in Korea. Thus, an viable solution either. Rather, private sector business groups, insurance company was started. This natural step-by-step evolu- run by controlling shareholders both willing and able to tion through related businesses resulted in the Lucky-Goldstar approximate maximizing the profits of their entire collec- (LG) group as we see it today.52 tion of firms, appear to work. Indeed, a large business group containing many firms in diverse industries, all under the Note that there is no discussion of an overarching central common control of a single tycoon, is precisely the private plan formulated by central economic planners. Rather, each sector “scheme of planned industrialisation comprising a capitalization of a new affiliated firm in a new industry was simultaneous planning of several complementary industries” necessitated by the needs of existing firms, and each such whose possibility Rosenstein-Rodan explicitly denies. cross-industry expansion created new pressures that led to Of course, how the business group is governed matters. the capitalization of yet more new firms. The controlling Studies show business groups can be effective mechanisms shareholder, of course, needed the foresight to recognize these for working around absent or dysfunctional institutions in needs and the capital to act on each. low-income economies.56 These abilities also make them good Like the major Japanese zaibatsu, the largest Korean mechanisms for private-sector cross-industry coordination of chaebol—Samsung, LG, Hyundai, and Daiwoo—achieved the sort needed in a Big Push.57 However, all such advantages full set diversification: each group had one member firm in for large business groups evaporate once a modern economy every major industry. Also like the Japanese zaibatsu, all is fully in place, and being able to coordinate multiple firms the firms in eachchaebol group were controlled by a single in diverse industries ceases being socially useful. business family by means of a pyramidal structure of listed We postulate that the middle-income trap mentioned firms controlling other listed firms.53 In both cases, financ- earlier occurs when business groups lobby to limit institu- ing for new firms was predominantly from share issues; bank tional development so as to retain their competitive advantage loans played little role in financing new group firms. The over other forms of business organization. Once Big Push Japanese zaibatsu did contain banks as member firms, but development nears completion, large business groups, run by the successful groups used risk-tolerant minority equity issues highly connected senior tycoons or their heirs, can remain to public shareholders plus retained earnings from existing profitable by maximizing political rents extracted from the firms to fund start-ups.54 state, monopoly rents extracted from consumers, and even
52. On the role of the chaebol in South Korea’s Big Push, see Morck and Lim (2014). 56. Obviously, this raises a whole new field of research—business group governance. 53. After 2000, some chaebol restructured themselves using “circular ownership” At present, we know little about what constitutes good governances. The importance of wherein Firm A controls firm B, which controls firm C, and so on, … which controls Firm business groups throughout the developing world, and their seeming central role in the A. This restructuring is thought to be a response to regulations limiting pyramiding and successful development of Japan and Korea, make filling this gap in the literature all the banning crossholdings. See Almeida et al. (2011). more important. For speculation about what questions such research might most use- 54. The sole zaibatsu that did use its member bank to fund its expansion, the Suzuki fully investigate, see Morck (2012). zaibatsu, collapsed in a debt crisis in the 1920s. See Lynn and Rao (1995). 57. See Khanna and Yafeh (2007) for a survey of the literature on business groups. 55. Notable among then, Murphy, Shleifer, and Visny 1989; Sachs 2005.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 29 monopsony rents from workers and savers.58 Arguably, the Organization Department of the CPC, as If China has developed via a state-coordinated govern- directed by top CPC cadres, has at least as much influence ment-financed Big Push, it is perhaps the first country ever over CEOs and other top managers of centrally controlled to do so. Other state-led Big Push attempts, such as India’s SOEs as their boards have, and may well matter far more. A post-independent Nehruvian-socialist plan for rapid devel- similar arrangement exists between local level Organization opment and Nassar’s Arab-socialist plans for Egyptian Departments and locally controlled SOEs. The Organization industrialization, have in general fared even worse than Japan’s Departments of the CPC tracks the careers of all Party cadres, aborted state-run development strategy of the 1870s. Given and maintaining one’s Party membership in good standing is the abundant examples of failed state-led Big Push efforts essential to the career of a prospective CEO.61 throughout the Third World, William Easterly, a leading Cadres’ scope for promotions is broad, and not limited to development economist, laments “the stubborn survival of the corporation or even the business sector.62 The Organization the legend of the big Push”—a legend that, “despite evidence Department of the CPC might elevate a successful SOE CEO of its failure, has continued to foster the planning approach to an important Party or government position, or even to an to development.”59 important position in a private firm. Less obviously successful cadres might be moved sideways or demoted. For example, Why Chinese Corporate Governance Is Interesting in a series of 2011 Organization Department decisions, the How, then, has China seemingly accomplished a state-led Big Organization Department of the CPC promoted China Petro- Push more or less precisely as Rosenstein-Rodan prescribed? leum and Chemical Corp (SINOPEC) chair Su Shulin to Why did this work in China after it failed elsewhere? Is China Party Secretary for Fujian province; replaced Su at SINOPEC exceptional? If so, how? with China National Offshore Oil Corp (CNOOC) chair Fu We believe these are important research questions in Chengyu; and replaced Fu at CNOOC with China National Chinese corporate governance, and urge that more research Petroleum Corp (CNPC) CEO Wang Yilin. Somewhat to the be directed towards answering them.60 Corporate governance bewilderment of foreign business partners, the Organization is ultimately about who manages the economy’s productive Department had rotated the tires of China’s oil industry. As a resources, what their incentives are, and how well all this testament to the Organization Department’s importance, the works out for the economy at large. Although we don’t claim firms’ independent directors learned of these changes from to be in a position to answer these questions, we can highlight the media. 63 a few aspects of Chinese corporate governance that may well The practical considerations affecting a Chinese corpo- be both unique to China and important contributors to its rate manager’s career advancement thus differ starkly from economic success. those in the U.S. Exactly how these differences play out is largely unexplored. Such wide-ranging careers plausibly State-coordinated Governance broaden cadres’ networks of connections, help them coordi- Perhaps China’s state-led Big Push succeeded because its nate decisions with other government-controlled businesses, government officials are uniquely well selected and motivated. and cement their loyalty to the Party, as opposed to other We consider two aspects of this potential uniqueness. constituencies such as shareholders or regions. Corporate leaders’ incentives. First, does the Chinese To be sure, this is not completely different from what system give its corporate leaders passably efficient incentives? happens in other countries. American investment bank CEOs One of the first things that strikes foreign observers when become treasury secretaries and bank regulators, Canadian tax interacting with Chinese business executives is that corpo- auditors become corporate vice presidents; and the président rate governance is not primarily a corporate matter. Chinese et directeur général (PDG) of a French corporation is often a business corporations are not, for the most part, free-standing former civil servant from the ministry responsible for regulat- autonomous units insofar as governance is concerned. While ing that industry.64 they now have CEOs and boards with independent directors, Indeed, there are remarkable parallels between Chinese these are not the totality of the governance mechanisms under and French corporate governance.65 In France, the 30 years which corporations function. of gloriously rapid post-war reconstruction from 1945 to
58. For a survey of this literature, see Morck, Yeung and Wolfenzon (2005), who ar- 62. See Allen and Shen (2013); Li and Zhou (2005); Lu (2000); Landry (2008); gue that the advantages Khanna and Yafeh (2007) attribute to business groups can deter Pistor (2013) an economy’s ascent from middle- to high-income status. This is because the continued 63. For more details about these decisions, and about how the independent directors dominance of large business groups biases resource allocation so as to protect the vested were out of the loop entirely, see McGreggor (2010). interest of the groups controlling owners. 64. Career moves from government to business are sufficiently commonplace to jus- 59. Easterly (2006) tify the presence in French dictionaries of the Académie Française sanctioned term pan- 60. As opposed to the Chinese “versions” of U.S. research questions that, if relevant touflage (shuffling wearing indoor slippers) and the Japanese term amakudari (descent at all, are mostly of much less economic importance. from heaven) to describe such events. See Bertrand et al. (2010); Heilbrunn (2005); 61. See Landry (2008) and McGreggor (2010) for different perspectives on these is- Kramarz & Thesmar (2006); and Smith (2004). sues. 65. See Pistor (2012).
30 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 1975, dubbed les trente glorieuses, are associated with exten- ing business activity of every kind.69 Business owners quickly sive state intervention in corporate governance. While the found that investing in official connections generated a far role of the state has been now scaled back, many institutions higher return by easing these burdens than any investments of this era remain in place. Both government and business in capital assets or technology. Development slowed and the draw on the graduates of an elite set of schools, les grandes Indian economy became a morass of regulation overgrowing écoles. These admit students from throughout France solely increasingly antiquated and dilapidated physical assets. Such on academic merit. Their graduates, calledénarques after the a situation can become a stable “equilibrium” that severely École National d’Administration (ENA), arguably the grandest limits further growth.70 of the schools, follow a standard career path. CEOs typically Official corruption is, of course, widely recognized as begin in the civil service and later move to senior manage- an important problem in China too. But China’s growth ment positions, often in the firms they previously regulated. has persisted despite these problems. Two characteristics of Most French CEOs, senior corporate managers, and direc- Chinese governments have been proposed to explain this. tors are énarques, as are most government top regulators and One explanation turns on the quasi-meritocratic nature senior politicians.66 Whether because of this system or despite of the CPC. This argument holds that many CPC cadres, it, France achieved very high growth in these decades. We especially at higher levels, are highly intelligent and competent posit that France’s meaningfully meritocratic énarchie helped technocrats, whose careers depend on demonstrable evidence counter its trente glorieuses system’s obvious vulnerabilities to of their facilitation of rapid growth in whatever firms, juris- cronyism and entrenchment.67 dictions, or industries they oversee. This combination of The virtue of such a system in China’s recent financial incentives and competence could limit government failure, history may be its amenability to the centralized coordination and explain why China’s Big Push has worked to date. necessary to effect a Big Push. At this point, research provides For example, a recent study of the governance of China’s few answers and leaves many questions open. Does the rotation banking system finds that top bank executives, government of CEOs and Party Secretaries through different firms and regulators, and party cadres in banks and regulatory agencies government and Party positions help coordinate Big Push form a tight network,71 and argues that influence within this growth? How does a CEO who exploited his firm’s monopoly network correlates with ability. Because of this correlation, or monopsony power to “hold up” another firm, behavior that the system may be more socially productive than networks of Rosenstein-Rodan thought inevitable in an every-firm-for- entrenched cronies in many other developing countries.72 itself economy fare, in China? Is his career advanced because Indeed, some do suggest have suggested that the entire his hold-up play created value for his own firm’s shareholders; Party hierarchy may well be substantially meritocratic, at or does his failure to harmoniously facilitate overall economic least in important ways. Cadres reporting economic gains growth instead land him in an isolated and unpleasant backwa- in the towns, cities, provinces, corporations, or industries ter for the next stage of his career? We do not know. they oversee tend to be promoted, as long as they also obey Government leaders’ incentives. Alternatively, China’s CPC policies and instructions.73 Both factors recall ancient uniqueness may follow from the incentives it sets before its Chinese traditions—examination-based rankings in the government leaders. The failure of previous state-led Big Push Imperial Civil Service and the Confucian virtue of obedi- efforts is attributed to pervasive government failure.68 This ence to superiors. They also suggest a surprising effectiveness line of reasoning holds that the sweeping scale and intensity of the CPC’s human resources management. of state intervention associated with a state-led Big Push so It would be useful to know how meritocratic differ- greatly raise the returns to influencing government officials ent parts of the Chinese country and corporate governance that political influence, rather than investment in produc- systems actually are, and what other considerations affect tivity enhancement, becomes the most reliably profitable cadres’ careers. Is merit more important in cadres’ promotions investment opportunity on offer. Thus, India’s attempt to where the sorts of decisions they make have more economic implement a Big Push in its first decades after independence importance, especially as regards coordinating growth? Is there generated rapid growth for about a decade, and then collapsed regional variation? If so, does the system work better in places into rampant political rent-seeking. The ensuing Licence where cadres’ career moves are more clearly merit-based? Raj featured legions of ill-paid profit-maximizing bureau- These questions remaining unsettled, a degree of caution crats, each conveying approvals, permits, and licences to the is warranted. An appearance of meritocracy may disguise highest bidders, thereby delaying, obstructing, or sabotag- tight networks of patronage and corruption. Or a genuine
66. See Pistor (2012). 70. See, for example, Murphy et al. (1991, 1993). 67. On this era of French corporate governance, see Bauer and Mourot (1994), Gil- 71. Pistor (2012). dea (2002), and ESP. Roe (2003, c. 7). On current problems stemming from those in- 72. See Faccio (2006) and Faccio et al. (2006) for cross country evidence on these stitutions, see Smith (2004). issues. 68. See Easterly (2010). 73. See Landry (2008), Macgregor (2010), Allen and Shin (2012), Pistor (2012) 69. See Dalrymple (1998) on the License Raj. and Spence (1999).
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 31 meritocracy at present might collapse into such a network No hypothesis has solid empirical validation, but all over time. Or merit might be defined in socially suboptimal merit attention. We do not really know how meritocratic the ways; for example, does accelerating a city’s contribution to Communist Party truly is. Nor do we know how the merito- overall GDP growth at the expense of environmental degra- cratic element of Party governance varies across regions and dation constitute genuine merit?74 over time, nor how this variation might affect the governance of banks, state-owned enterprises, and the many “private” Public Choice TheoryA second category of explanations corporations that are nonetheless deeply connected to various about why government failure is as yet in check in China levels of government or to prominent Party or government turns on competition between different parts of the govern- officials. We do not know how aggressively Chinese city and ment. Public choice theory posits that, under certain regional governments compete, what they compete for, and conditions, competition between governments for taxpay- how such competition might affect corporate governance. ers can induce the efficient provision of public goods.75 A jurisdiction that provides poor public goods and services for Hidden Virtues of Spontaneous Privatization? high taxes, or perhaps high side payments to officials, loses Yet another possibility is that China’s success is not due to taxpayers to competing jurisdictions that provide value for its government, and that Big Push coordination is actually tax money. These arguments are invoked to explain why, for led by an emerging private sector that features large business example, taxpayers do not migrate from high-tax states such groups, rather like Japan’s zaibatsu and South Korea’s chaebol. as Minnesota to low-tax states such as Alabama. Government An important phenomenon in 1990s in Eastern Europe services in Minnesota are posited as sufficiently superior to and the former Soviet Union was spontaneous privatiza- discourage emigration. tion—the appropriation of nominally state-owned assets by China is a highly decentralized federation. Its city and politically connected insiders.77 This ranged from prominent provincial governments have substantially different track Party cadres simply backing empty trucks up at state-owned records. Some implemented market reforms rapidly and enterprises’ loading docks to self-dealing in voucher privati- thoroughly; others delayed, hedged, and compromised. It zation programs. The result was the very rapid privatization quickly became apparent that those cities and provinces of the most valuable state assets. This rapid privatization was that freed markets more quickly and fully achieved greater justified by reformers as a necessary evil—better corrupt prosperity. People and business activity fled laggard areas for ex-communist business tycoons than bitter communist the more dynamic market-oriented jurisdictions. This raises ex-apparatchiks plotting the restoration of Communism.78 the possibility that Chinese governments are competing with Something akin to spontaneous privatization may each other to attract business activity and individuals with have occurred on a major scale in China too. Structures of high human capital. controlled listed firms reminiscent of Japanesezaibatsu and This is plausible. Cadres’ running regional governments Korean chaebol appear to have formed, though controlled by control budgets that depend on the earnings of the state- state-owned enterprises rather than family firms.79 To the owned enterprises that their governments control, on the extent that meritorious princelings or other highly placed revenues their governments earn from land leases, and on cadres now control these, a form of private ownership over the tax revenues they manage to accrue. Such cadres therefore business groups may be solidifying, or at least gelling.80 Thus, might desire to maximize the economic activity over which China’s cross-industry coordination, like that in Meiji Japan they preside so as to maximize the budgets they control. A and South Korea, may actually be the work of corporate city or province that provides poor public goods and services tycoons rather than communist central planners. and makes doing business costly loses economic activity to The difference is that in China, in contrast to Japan or other cities or provinces. This reduces the earnings of its state- Korea, the business tycoons to whom development coordina- owned enterprises, the value of its land leases, and its tax tion decisions are delegated also happen to be connected to revenues, leaving its senior cadres subject to tighter budget the Party. As in Meiji Japan, the Chinese government created constraints.76 state-owned enterprises and endowed many with imported technology. However, China’s mechanism for transferring control differs from Japan’s mass privatization, in which
74. See Wu et al (2014). mote economic growth to advance their careers. They have the power to discipline sub- 75. See Buchanan and Tullock (1962) and Tiebout (1956) ordinates who delay, or otherwise obstruct economic activity. This pressure, in turn, has 76. Gordon and Wei (2012) examine the finances of China’s multiple levels of govern- at least the potential to promote efficient government and good corporate governance in ment, and describe how traditional models of intergovernmental competition for taxpay- banks and state-owned enterprises. ers can be modified to accord with Chinese stylized facts and data. Various different 77. See Johnson and Kroll (1991), Aslund (2002) and Shleifer (2005). levels of government control their own banks and constellations of SOE. Communist 78. See Shleifer (2005). Party structures parallel each level of government, and oversee the careers and promo- 79. See Fan, Wong and Zhang (2013). tions of cadres working in those governments, banks, and state-owned enterprises. The 80. See, e.g., Bloomberg News Dec. 26th 2012 at www.bloomberg.com/news/2012- top Party and government officials running each local or provincial administration pro- 12-26/immortals-beget-china-capitalism-from-citic-to-godfather-of-golf.html
32 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 state-owned enterprises embodying imported technologies without connections where GDP growth is underway and were auctioned off to private buyers. Still, the end result may government cadres care more about growing their budgets be similar: the creation of seeds around which large diversi- and less about trading favors with cadres who run businesses. fied business groups can form. Once private ownership is in Here again, speculation has to be replaced by rigorous place, logic of the sort that motivated LG’s expansion in South research. Korea can guide the business group’s expansion along lines More generally, researchers might usefully contrast consistent with Big Push coordination—provided sufficient Chinese corporate governance with Japanese governance capital is available. in the late 19th century, Korean governance in the 1970s Capital in China is cheap and abundant for estab- to 1990s, or even French governance during that country’s lished large firms, if not for entrants. China’s savings rate is postwar reconstruction, rather than present-day American extraordinarily high, and Chinese savers have few investment norms. opportunities.81 They can either put their savings in state- run banks or buy shares in listed firms, most of which are Is China Ready for Anglo-American Corporate state-controlled, either directly or indirectly. The yuan is not Governance? a hard currency (it does not trade freely in foreign exchange For centuries, foreign experts have patronizingly declared markets), and Chinese savers cannot legally invest abroad, China “not ready” for democracy, freedom, capitalism, and save through a handful of strictly limited investment funds. other Western institutions. We are decidedly not taking this The large domestic demand for savings instruments, view. Rather, we raise the possibility that Anglo-American juxtaposed with their limited supply, keeps state-run banks’ corporate governance is disadvantageous to any country interest payments low and makes equity sales by state-owned undergoing very rapid development. This is because Anglo- enterprises remunerative. This amounts to a kind of state- American corporate governance is explicitly about the sanctioned “oppression” of savers to keep the cost of capital governance of individual corporations: each firm’s manage- low for SOEs and their insiders. Financial repression may well ment is charged with maximizing the market value of its be defensible as a way of mitigating coordination problems shares. During a Big Push, this could be a recipe for disaster. that would otherwise curtail the flow of capital into diverse The recurring theme of Anglo-American corporate gover- sectors of the economy. nance rules, regulation, and law is the maximization of firm Research is needed to clarify how Chinese corporate value.83 Independent directors, non-executive chairs, exter- governance contends with potential “hold up” problems, nal auditors, and institutional investors are all contemplated missing pieces of the network of necessary firms, and other as checks and balances that prevent self-interested CEOs or coordination problems associated with operating in an controlling shareholders from running their firms to maximize economy under construction. One recent study reports that their personal utility rather than the wealth of their sharehold- business groups are more vertically integrated in parts of ers. Hostile takeovers and shareholder lawsuits are alternative China with weaker legal institutions, less advanced reforms, mechanisms that can come into play if CEOs defeat these and more interventionist governments—and in cases where checks and balances. All of these alternative mechanisms of controlling owners are more politically connected. The study corporate governance make sense only on the implicit precon- further reports that vertical integration in business groups dition that social welfare is maximized when the value of every without political connections correlates with per capita GDP individual firm is independently maximized. growth, but vertical integration in business groups with Rosenstein-Rodan argues that this precondition is political connections does not.82 One interpretation of these violated during a Big Push. When a Big Push is needed, findings is that vertical integration can also be a coordination product markets are typically “thin.” Yet, firms with market mechanism, and aimed at extracting monopoly rents is more power must forswear exercising it to maximize their share common in less liberalized regions where insiders are more valuations by holding up vulnerable firms. In short, social rapacious. But another is that vertical integration is more welfare optimization requires that corporations be governed necessary where GDP growth remains low and free-market together, or at least in very large groups. institutions are weaker, leaving centralized coordination of China has formally enacted corporate governance regula- economic activity more important. Perhaps the difference tions that are seemingly modelled on those of the United in GDP growth associated with politically connected versus States, but drags its feet about their real implementation.84 unconnected groups is evidence that political connections Thus, real questions arise about the actual power dynamics on slow growth, or perhaps it means business groups can do Chinese boards, the information content of Chinese financial
81. See Young et al. (2012) 84. See Allen et al (2012) for a discussion of Chinese securities. And for a discussion 82. Fan et al. (2014) of the deficiencies of Chinese corporate disclosures, see Piotroski and Wong (2013) as 83. See Shleifer and Vishny (1997). well as Joe Piotroski’s review article in this issue of the JACF.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 33 statements, the economic purpose of mergers, and the sorts of reinforce the carrot and stick system of the CPC, especially pressures institutional investors should be exerting. To many as it contributes to the economic growth that legitimizes its observers, China appears to be adopting the form, but not the political monopoly. substance, of American corporate governance. Champions of If Confucian values, by commending obedience to the Anglo-American model find this deplorable; but if that authority, are an advantage in mobilizing resources for a Big model fails to fit China’s current economic realities, this lack Push, they may be counterproductive in achieving full-fledged of substance is understandable. economic development. Big Push development is a “catch up” strategy, but a large and increasingly persuasive body of empir- Is Chinese Culture Economically Exceptional ical evidence suggests that innovation, especially by “creative Obviously China is culturally exceptional, but does Chinese destruction,” is the essential driver of economic growth for culture, or its deep institutional or historical features more high-income economies. Innovation requires creativity and generally, contribute to its rapid growth? Whenever China originality, not obedience. does poorly, allegations about the intrinsic hostility of Chinese Another consideration is the fluidity of culture. Consider, culture to development draw attention. Now that China is for example, the recent rapid evolution of the concept of doing comparatively well, Chinese culture is lauded as an “marriage” in Christian cultures. Such change makes cultural obvious advantage. variables questionable candidates for deep underlying expla- Thus, a recent study finds that people’s willingness to trust nations. Confucianism in 1912 may well be as far from other people in general correlates with national economies’ Confucianism in 2012 as Plymouth Rock Puritans are from ability to sustain large organizations, such as big businesses.85 their politically correct Congregationalist descendants. China ranks near the top, alongside Finland and Denmark, China’s rulers and people only a century ago were in this kind of trust and near the bottom, again alongside the profoundly conservative and tradition-bound. The Dowager Scandinavian countries, in adherence to hierarchical religions. Empress Cixi allegedly forbade a railroad to Beijing for fear The study designates Roman Catholic Christianity and Islam it would disturb the souls of her ancestors. She supported the “hierarchical” and Confucianism as non-hierarchical. Boxers, the Society of Righteous Fists, who tried to extermi- This judgment call jars somewhat with earlier explanations nate all foreigners in China and believed themselves magically of how Confucius’ teachings limit economic development. protected from bullets. Consider, for example, the following assessment by L.Y. Ho, Mao swept away all this pre-enlightenment magical think- a frustrated Chinese reformer in 1912, of how Confucianism’s ing, if only to replace it with other forms of magical thinking, obsession with hierarchy keeps China backward: such as the belief that human nature might be changed by slogans and terror. Mao’s repeated failures left magical think- Confucianism advocates the superiority of antiquity. From ing discredited in the China of 1978, and pragmatism a sign of that follows the corollary: “Love thy parents and reverence the sophistication. Deng Xiaoping’s famous remark that “it doesn’t Emperor.” As the Emperor is the head of heads, loyalty to the matter what color a cat is as long as it catches mice” was far Emperor precedes filial devotion to parents. The Emperor being more than a witticism. It was a reflection of the empiricism absolute over his subjects as the father over his children, it became and rationalism that were now intellectually respectable. The his interest to inculcate unquestioning obedience in his subjects. Hu-Wen regime (2003-2013) explicitly advocated a “scientific According to the old conception of government, the best way of development” approach. bringing this about was ignorance.86 A 2002 study by Acemoglu, Johnson and Robinson shows that ex-colonies with more advanced indigenous institutions Perhaps traditional Chinese values are more amenable to tend to fare worse after independence. The authors’ explana- rapid development than Ho allows. A Big Push requires coordi- tion focuses on the durability of such pre-colonial institutions nation from above—if not from the state or Party, then from a that, because designed to stabilize extractive economies run for controlling tycoon. Confucius’ teachings sanctifying obedience the benefit of small elites, first pre-colonial and then colonial, to authority might be a positive advantage in limiting agency end up providing greater barriers to broad-based develop- problems associated with a Big Push. More deferential execu- ment. This explanation might be used to suggest that Mao, tives at lower levels throughout a business group might, for by crushing traditional Chinese institutions, also succeeded example, be more likely to obey commands from above and in obliterating any cultural barrier to development in China. thus better act in concert for the good of the business group If so, research focusing on differences in the persistence of or the whole economy. If so, the restoration of Confucian traditional values in different parts of China, or different values underway at present in the People’s Republic may be segments of society, might be useful. Is development slower an important energizer of growth. Confucian values may well where traditional values are more durable?
85. La Porta et al. (1997). 86. Ho (1912, p. 4).
34 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 However, the successes of Korea, Japan, and Taiwan necessitates broader availability of a drug. The American as well as those of Hong Kong and Singapore constitute a government overrode the Wright brothers’ patent on the problem for this explanation. China and its very economically airplane so the American military could arm faster in World successful neighbours have traditional cultural values derived War I. largely from the same historical roots. If Mao’s destruction China’s political discretionary options are different, of traditional values cleared the way for development, how however. The corporate governance of every business of any did China’s neighbors manage their earlier rapid industrial- importance operates subject to options to veto held by an izations? Meiji Japan plausibly remade Japanese institutions invisible boss. Any decision, contract, or property right can profoundly, but the other newly developed countries of the be overridden should the invisible boss exercise an option. Sino-sphere continued to revere their traditions. Corporate decision-making must thus proceed with the Although the idea seems counterintuitive, there is now mixed objectives of maximizing firm value subject to the abundant evidence suggesting that the instability associated constraints these options imply. The CPC’s overriding author- with creative upstart firms continually arising to destroy ity, which most likely reflects decisions made by the Upper established firms actually has a stabilizing effect on the Standing Committee or Politburo, may indeed be instru- economy as a whole by sustaining a broad-based prosperity mental to the successful central coordination of a Big Push. that leaves social problems more tractable than in a stagnant But these ubiquitous discretionary options also guarantee economy.87 How to spark creativity in a society that venerates senior cadres’ paramount power, influence, and policy flexi- hierarchy has become a major policy question in both Japan bility, and are perks that are doubtless hard to surrender. We and Korea. Even if deepening Confucian values help China worry that these options are sowing seeds of corruption, and affect its Big Push, it seems likely that further development hindering the development of the sound firm-level corporate would favor cultural evolution towards a more American governance that will be needed in an innovation-driven ascent acceptance of brash upstarts who overthrow established ways to high-income status. of doing things. Every present-day high-income country once traversed a similar path. Western European absolute monarchs and Habit Formation and Governance Options North American colonial governors once stood above the Even if China’s current emulation of American corporate law, but were humbled by rebellions and revolutions in some governance amounts to little more than “going through the countries and by largely peaceable reforms in others, though motions,” cognitive dissonance can turn habits into values. fear of revolution may have played a role everywhere.88 Absolute CEOs who ritually turn to boards for approval may come rulers first accepted the interference of councils of barons, then to need that approval if it is someday withheld. Directors, unelected legislative councils, and finally freely elected parlia- basking in the social status that position provides, may some- ments. They accepted reforms that denied them the powers day find media or shareholder criticism of their decisions so to appoint and dismiss judges and civil servants, and that disturbing that they reassess CEOs’ decisions to avoid it. ultimately subjected them to the same laws that commoners The critical reason why Chinese corporate governance had to obey. No country, save a handful of small petro-states, remains, to a large part at least, show rather than substance has ever attained and sustained high-income status without is the fundamental constitutionally entrenched position of this transition. Perhaps China is different, but we are inclined the CPC above the law. Every rule, regulation, law, and court to doubt it. decision is subject to the approval of the CPC. This effectively Our greatest concern is that China could be caught in gives the Communist Party options to amend any business a middle-income trap. Could China, in the long run, settle contract, regulatory decree, or court judgment in the interests down to become a giant Peru? An oligarchic elite—de facto of the Proletariat. Chinese corporate governance must take if not de jure permanently above the law—may persist in these ubiquitous official discretionary options as given. Some control of both the state and the economy. That elite may of the arguments above even allow that these options have fear the microeconomic instability associated with growth a constructive function in coordinating economic activity. through creative destruction, and seek to preserve their power Official discretionary options are not uniquely Chinese. to coordinate the economy in the name of a stability that American firms buy property that can be taken by eminent incidentally preserves a political, economic, and social status domain, and American courts can amend business contracts quo advantageous to its members.89 There will be no short- that run counter to public policy. Patents can be limited if a age of justifications for slowing or pausing development: the pressing social problem—a disease like AIDS, for example— loss of jobs in old firms that results from creative destruction
87. See Rajan and Zingales (2003, 2004), Morck, Wolfenzohn, and Yeung (2005) Yeung (2000); Rajan and Zingales (2003, 2004); Morck, Wolfenzon and Yeung (2005); and others. Academoglu and Robinson (2012); and others. 88. North et al. (2006). 90. See Davis (2014). 89. There is now a large literature on this topic, see, e.g., Morck, Stangeland and
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 35 often precedes the growth in employment associated with level planning. Once real decisions are made at the firm the rise of new firms, creating unemployment and political level—and without oversight or central guidance—corpo- pressure to bail out the old firms or constrain new competi- rate governance will become central to how China allocates tors.90 In addition to slowing creative destruction, bailouts capital, labor, and resources. Investors’ expectations about can lead to financial crises as the debts of old firms become how firms are governed will determine the cost of capital sovereign debts. China’s current crop of SOEs, whether their for entrepreneurs setting up new firms, and thus the pace privatization is completed or not, would likely be destroyed of creative destruction. Experience in going through the quickly should creative destruction commence in earnest. motions may make this transition easier. Would this be allowed? Or would ever-rising bailouts trigger China’s reforms since 1978 have been experimental a Chinese financial crisis? Or could an altruistic and vision- and gradual. An officially sanctioned metaphor is “feeling ary leadership lead China peacefully past the middle-income the stones to cross the river.” One interpretation of China’s trap? current policy of emulating the form, if not the substance, of U.S. corporate governance, financial regulation, and so on Conclusions is that this amounts to feeling for a stone that may someday China may indeed be exceptional. Its meritocratic predispo- carry the country’s full economic weight. If so, China’s most sitions, its people’s willingness to obey a legitimate hierarchy, senior cadres are contemplating passing the responsibility for and its very real reforms that reoriented its multiple levels coordinating the economy to market forces and the respon- of government towards enhancing economic growth have sibility for responding to those forces to the top executives worked well to date. China has gone far towards accom- of individual firms. plishing a Big Push—the all-embracing transition from China’s emulation of developed economies’ institu- subsistence agriculture to an industrial economy. That tran- tions probably makes sense. Missing institutions can be sition is a necessary first step on the path to sustainably worked aroundwork in a small country, whose residents can high-incomes for all Chinese. “borrow” foreign institutions. For example, a small European But Big Push coordination is only the first step. The country might do perfectly well without an active stock corporate governance institutions appropriate to overcoming market because its more entrepreneurial residents can list the coordination problems intrinsic to early-stage develop- their firms in London or Amsterdam. However, an economy ment are apt to work ever less well as development continues. of China’s size probably needs a full spectrum of domestic As Hayek and many of his followers have argued, even in institutions that are oriented toward and capable of sustain- economies with minimal amounts of corruption, informa- ing the prosperity of its people. tion and coordination problems tend to grow rapidly as an At present, the greatest challenge confronting China’s economy develops, and central planners are almost certain reformers may well be subjecting its elite—senior cadres in to become overwhelmed by allocation tasks that markets control, “princelings,” and other vested interests—to the have been shown to solve well. And China is not without rule of law. This is difficult because it runs counter to the corruption. Private-sector business groups might already be constitutionally enshrined Leading Role granted the Party. better positioned to advance growth than state-run groups, But all other high-income countries, excepting a few petro- but at some point business groups in general will outlive their states, did likewise, and in the process rethought equally usefulness. Once all the components of a modern economy cherished traditions—for example, the necessity of an are in place, decision-making is better removed to the level of absolute monarch for keeping the peace.91 individual privately owned companies, where market forces Perhaps such changes might come about as China are most keenly felt. At that point, institutions resembling searches for ways to address its problem of inequality. While those in existing high-income countries seem necessary if inequities such as the “hukou” system92 attract increasing China’s rise is to continue, even if this discommodes its elite. attention, the widest inequality is that between the CPC elite When that time arrives, China may benefit from and everyone else. Although their official monetary incomes business leaders, investors, bankers, and regulators accus- were not high under Mao, this elite occupied the Command- tomed to going through the motions of an Anglo-American ing Heights of the economy. Many of their descendants, system of corporate governance. The show of Western China’s “princelings,” lead lives of great privilege and may be governance institutions might gain substance if China emerging in positions of power throughout the economy and successfully transitions to market-driven decentralized firm- government.93 While intelligence is arguably partially inher-
91. See Fukuyama (2011). coastal cities, the gap of economic opportunities between rural and urban location, and 92. China inherited a legacy of real inequality from early Communist reforms that even between rich and poor cities, has widened considerably. See Freeman (2014) for assigned everyone a hereditary “hukou” (household registration) designation. This binds details. people to specific localities, and civil privileges vary substantially by location, and thus 93. See, e.g, Bloomberg News Dec. 26th 2012 at www.bloomberg.com/news/2012- by “hukou.” Because post-1978 economic development centered on cities, particularly 12-26/immortals-beget-china-capitalism-from-citic-to-godfather-of-golf.html.
36 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 ited, their prominence begs uncomfortable questions about cannot pass a law that it cannot repeal—but the British the sustainability of a meritocratic character in the CPC. 94 muddle through. The Canadian constitution preserves the Another potential vested interest is people who succeeded supremacy of its parliament by letting parliament enact a law in the current system based on merit, and who might well be “notwithstanding” the fact that the law itself is unconstitu- top performers in any management or government system. tional. By delineating a process through which this must be They contributed greatly to China’s decades of reform and done, the constitution ensures that it almost never happens, earned commensurate privileges, which spill over to their but ancient traditions are preserved. The United States explic- children, relatives, and associates. They too could become itly gives different parts of it government power over each oligarchs. other with the goal of creating a system of checks and balances. Will descendants of heroes of the decades of reform, like Perhaps China could employ some similar léger de main: those of heroes of the Long march, the Liberation, and the for example, the Party might be allowed to force a measure decades of communism, become a nascent network of heredi- “notwithstanding” its being illegal—but only under specific tary oligarchs, whether consciously or not, working to lock in circumstances and by using a specific procedure.96 Or China their privileges regardless of the social costs to the country? might make its courts entirely independent of Party oversight China currently depends on cheap labor and finan- to create a system of checks and balances. The histories of cial repression, and so is essentially an extractive economy, today’s high-income countries provide a number of options, and therefore subject to what Daron Acemoglu and James and legal scholars could no doubt produce more. Robinson, in their 2012 book Why Nations Fail: The Origins However, the economic histories of all large high-income of Power, Prosperity, and Poverty, call the iron law of oligarchy, countries have much in common. Perhaps most importantly, mutually reinforcing political and economic institutions that all found ways to subject their government to the rule of lock in high inequality and slow growth.95 In their 2004 book, law.97 This was essential, for unlimited governments cannot Saving Capitalism from the Capitalists, Raghuram Rajan and make credible commitments to enforce business contracts or Luigi Zingales provide a compelling account of mid-20th safeguard investors. All passed through periods of laissez-faire century “great reversals” in the financial development of many limited government, when stock markets financed new large countries. They show that, in a remarkable number of econo- firms, when the penalty for falling behind was bankruptcy, mies, after an initial period of rapid development, an aging and when growth rates far exceeded historical norms.98 This cohort of business leaders and their heirs work to undermine includes currently bank-centered economies, such as Germany their countries’ financial system to deny capital to potential and Japan, whose initial industrializations were largely stock entrants, their would-be competitors. This entrusts corpo- market financed.99 All found ways to press the managers of rate governance to decreasingly talented and more entrenched individual firms to align good governance, at least roughly, generations of old-moneyed business families. Is China build- with economic efficiency and successful innovation.100 The ing an enduringly strong financial system that will continue precise mechanisms differ somewhat across high income capitalizing new firms into the distant future? Or are its countries, with different roles for institutional investors, banks and stock markets simply mechanisms for capitalizing shareholder lawsuits, boards of directors, corporate takeovers, an initial set of businesses and providing the well-connected foreign investors, banks, employees, product market compe- with family wealth proportionate to their political influence? tition, and other factors. But the differences are minor Or, most fundamentally, will vested interest benefiting from compared to the difference between China now and any of the present unbalanced access to capital resist, or even reverse, the major high-income countries. liberalization? China’s easier path is to emulate successful Western Perhaps measures that subject individual cadres and their country and corporate governance more faithfully, as Japan, relatives to the rule of law, while preserving the status of Korea, and Taiwan have. This done, state-owned enter- the Party as an institution, could prove politically viable as prises could be fully privatized, Party Secretaries and Party reforms aimed at enhancing equality. Such reforms would be Committees could fade away, and the financial system could reminiscent of how other countries solved similar problems. turn to financing creative new firms of the sort that power For example, Britain preserved the legal supremacy of its creative destruction. The government could then specialize parliament, but subjects all individual members of parlia- in the core competencies of government—public education, ment, including the prime minister, to the rule of law. The health care, and disinterested justice. This obviously neces- situation contains contradictions—for example, parliament sitates rethinking the Party’s role.
94. On Chinese “princelings,” see Brown (2014). 97. See Fukuyama 2005 95. See Acemoglu and Robinson (2012). 98. Morck and Steir (2005). 96. For example, as discussed in the article in this issue by Paul Gillis, the proposed 99. For the case of Germany, see Fohlin (2005) and for Japan, see Morck and Naka- IPO of Alibaba amounts to a direct violation of the spirit (if not the letter) of Chinese law, mura (2005). which restricts ownership of businesses in certain enterprises to Chinese citizens or in- 100. See Roe (1996, 2003); La Porta et al. (1999). stitutions.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 37 The alternative and far more difficult path is to clear a References new trail through the unexplored economic territory between Acemoglu, Daron and James A, Robinson. 2012. Why where China is now and high-income status. The great attrac- Nations Fail: The Origins of Power, Prosperity, and Poverty. tion in discovering an entirely new path is that this might let Crown Business. China retain its current interpretation of the Party’s Leading Acemoglu, Daron and Jim Robinson. 2001. The Colonial Role. The dangers in this strategy are that no such path might Origins of Comparative Development: An Empirical Investi- exist, that such a path might impose other limitations on the gation. American Economic Review 91(5)1369-1401. Party, or that forging such a path might prove beyond the Acemoglu, Daron, Simon Johnson, James A. Robinson. leaderships’ ability. Certainly, clear knowledge of such a path 2002. Reversal of Fortune: Geography and Institutions in the is beyond the current limits of economics. Nonetheless, as we Making of the Modern World Income. Quarterly Journal of conceded at the outset, economics might have more still to Economics 117(4)1231-94. learn from China than China has to learn from economics. Aharony, Joseph, Chi-Wen Jevons Lee and T. J. Wong. 2000. Financial Packaging of IPO Firms in China. Journal of Randall Morck is the Stephen A. Jarislowsky Distinguished Chair Accounting Research 38(1)103-126. in Finance and is Distinguished University Professor of Business at the Allen, Franklin, Jun QJ Qian, Chenying Zhang and University of Alberta’s School of Business in Edmonton, Alberta. He is also Mengxin Zhao. 2012. China’s Financial System: Opportuni- a Research Associate at the National Bureau of Economic Research in ties and Challenges. In Joseph Fan and Randall Morck, eds. Cambridge, Massachusetts, Vice President and Senior Fellow at the Asia Capitalizing China. University of Chicago Press and National Bureau of Finance and Economics Research, Research Associate with Bureau of Economic Research, pp. 63-143. the European Corporate Governance Institute, and Research Fellow with Allen, William T. and Han Shen. 2012. Assessing China’s the Bank of Canada. He has served as Mackenzie-King Visiting Professor Top-Down Securities Markets. In Joseph Fan and Randall at Harvard and Schoen Visiting Professor at Yale. He can be reached at Morck, eds. Capitalizing China. University of Chicago Press [email protected]. and National Bureau of Economic Research, pp 149-95. Almeida, Heitor and Daniel Wolfenzon. 2006. A theory Bernard Yeung is the Dean as well as the Stephen Riady Distin- of pyramidal ownership and family business groups. Journal guished Professor of Finance and Strategic Management at the of Finance 61(6)2637-2680. NationalUniversity of Singapore’s (NUS) Business School. He is also the Almeida, Heitor and Daniel Wolfenzon. 2006a. Should President of the Asia Bureau of Finance and Economics Research, a business groups be dismantled? The equilibrium costs member of the Research Advisory Council of the Centre for Advanced of efficient internal capital markets. Journal of Financial Financial Research and Learning (CAFRAL) in India and the Advisory Economics 79(1)99-144. Council of the Economics and Management School of Wuhan University. Almeida, Heitor, Sang Yong Park, Marti G Subrahman- Before joining NUS in June 2008, he was the Abraham Krasnoff Professor yam & Daniel Wolfenzon. 2011. The structure and formation of Global Business, Economics, and Management at New York Universi- of business groups: Evidence from Korean chaebol. Journal of ty’s Stern School of Business. He was also the Director of the NYU China Financial Economics 99(2)447-47. House, the honorary co-chair of the Strategy Department of the Peking Åslund, Anders. 2007. How Capitalism Was Built: The University Ganghua School of Management, and Advisory Professor at Transformation of Central and Eastern Europe, Russia, and the East China Normal University. Professor Yeung also taught at the Central Asia, New York: Cambridge University Press. University of Michigan and the University of Alberta. He can be reached Åslund, Anders. 2001. Building Capitalism: The at [email protected]. Transformation of the Former Soviet Bloc. Bauer, M., and B. Bertin Mourot. 1994. Les Enarques en entreprise: 30 ans de pantouflage.Paris: CNRS-Boyden. Baum, Richar. 1996. Burying Mao. Princeton University Press. Beason, Richard and David Weinstein. 1996. Growth, Targeting and Economies of Scale in Japan: 1960-1990. Review of Economics and Statistics Beason, Richard and Dennis Patterson. 2004. The Japan that Never Was. SUNY Press. Berliner, Joseph. 1978. The Innovation Decision In Soviet Industry. MIT Press. Blanchard, Olivier, Rudiger Dornbusch, Paul Krugman, Richard Layard and Lawrence H. Summers. 1993. Reform in Eastern Europe MIT Press.
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Environmental Policy,” Capitalism and Society, Vol 9 No. 1 Roe, Mark. 1996. Strong Managers, Weak Owners: The article 2. (NBER WP 18754). Political Roots of American Corporate Finance. Princeton
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 41 2014 CARE Conference on China’s Capital Markets Hong Kong Polytechnic University | June 9, 2014
Welcoming Remarks Roger Huang: Good morning, I’m Roger Peter Easton: Thanks, Roger. And let me hear from people outside academia is, Huang, Dean of the Mendoza College say a few words about CARE. CARE what impact does CARE have in practice? of Business at the University of Notre was designed to encourage and support The best answers have come from the Dame. Notre Dame is proud to be the young faculty by providing venues to practitioners themselves. To cite just one home of the Center for Accounting discuss and develop accounting research example, Doug Dwyer of Moody’s KMV Research and Education, or CARE for that affects the way both undergraduate has reported about our conferences, “I short. For the last decade, this annual and graduate students are trained and found it to be a great opportunity to find conference has been the impetus for educated. The research also affects the out what people were doing in the field, future research, policy, and practice, practice of accounting and the uses of and to see the linkages between practi- and I’m confident it will continue to accounting information, and it is relevant tioner and academia. I got several useful be so for years to come. And I’m very to accounting standard setters by virtue ideas I could use in my work.” pleased to be providing the welcoming of the fact that it strengthens the bridges We also owe a great deal of thanks to remarks at the 2014 CARE Conference. between accounting research, education, our supporters and sponsors. Cambridge CARE has the reputation of taking and practice. Business Publishers in particular has the conference to the epicenter of the One of our main vehicles for carry- generously supported our mission for topic, and this year’s conference is no ing out this goal has been our annual the last decade, and we cannot thank different. Hong Kong continues to be conferences. Starting with our first in them enough. But given our primary the financial mecca of Asia, bridging Atlanta in 2006, we have held confer- goal of fostering the growth and exposure the gap between East and West, new ences in each of the last nine years. Along of young faculty and their research, the and old. And there is no better place with our standard subjects of financial direction of cutting-edge researchers, like to conduct a discussion of how best to statement analysis and valuation, the Joseph Piotroski of Stanford University, understand China’s capital markets. main topics have ranged from “Cross- has also been critical to our success. Joe This conference has brought together border Issues” to “Forecasting Firm and was both my collaborator in organizing leading experts, regulators, capital market Industry Fundamentals” to “Account- this conference, and has played a major participants, and academics to provide a ing for Uncertainty and Risk”—and the role in the CARE experience since its vibrant setting for discussing the valua- venues have included places like Singa- beginning; and as he was kind enough to tion of Chinese companies and the pore and London as well as New York, say at our last conference, “It’s important current state and the future of China’s Miami, and Washington DC. Some for us to recognize CARE’s leadership equity markets, a few of which will be conferences have been co-hosted by other and vision in creating and sustaining covered in a special edition of the Journal universities, including the University of this wonderful series of conferences for of Applied Corporate Finance. On behalf Chicago, National University of Singa- the past ten years—and to applaud the of the Center, and the Mendoza College pore, Columbia Business School, and the University of Notre Dame’s generous of Business at the University of Notre London Business School. And today we support of the Center’s mission.” Dame, I urge you to take the time to are being generously co-sponsored by the CARE is also guided by an active dwell on the sessions covered here. If Hong Kong Polytechnic University. advisory board, which includes senior you find yourself contemplating a new Cutting edge research requires you faculty from around the world, invest- research project, I encourage you to to not only ask the right questions, but ment professionals, and editors from contact the Center. to ask yourself on a regular basis, “Is three of the top four accounting journals. And with that, I will turn things our research catering to a limited set of They keep us honest—and relevant. over to Peter Easton, Professor of academic colleagues or are we providing This year’s conference on China’s capital Accounting at Notre Dame, and information that gives perspective and markets exemplifies our quest to stay the Director of CARE for the past new directions for accounting and finance honest and relevant. I hope you enjoy ten years. practice?” The question we most often the presentations you’re about to see.
42 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Challenges for China—Beyond Minority Listing of SOEs CARE Conference | Hong Kong Polytechnic University | June 9, 2014
A Presentation by David Webb, Founder of Webb-site.com
I think the biggest mistake that China probably made was thinking that they could be just like Singapore forever. They thought that they could have their own conglomerate like the GIC or like Temasek, where the state controls big chunks of the economy because it thinks it knows best for the good of all. That sort of centralization can work on a small scale like Singapore—but I don’t think it scales to a country with 20% of the world’s population and a massive geography. — David Webb
Gary Biddle: Good morning everyone. It’s my honor to intro- as a “Star of Asia” in the “Opinion Shapers” category. In duce you to our next speaker, Mr. David Webb. I first met 2001 the World Economic Forum identified him as a “Global David 16 years ago when we were introduced by a mutual Leader for Tomorrow.” In 2002, CFO Magazine named him friend who was a member of the Hong Kong chapter of to its “Global 100 Who Shaped Finance.” In 2005 he was Mensa, which David then happened to be the chairman of. among the World Economic Forum’s first cohort of Young What impressed me even more at the time was that even Global Leaders. In 2007 World Business named him in the 16 years ago—when he was scarcely in his 30s—David was “Top 20 Asian Progressives.” In 2009, Finance Asia named already retired from a successful career in investment bank- him one of the 50 most influential people in Asian financial ing. And, David, you’ve never failed to impress me since. markets. And in 2012 he received the IFLR Asia “Market David is well known in Hong Kong for the consistently Reform Award.” David is also a prominent supporter of the high “alphas” produced by his investment strategy and portfo- Hong Kong Philharmonic. He’s a mathematics alumnus of lio. But he is even better known for his remarkable passion for Oxford University, and before he graduated he was a best- corporate governance. You’ve heard several speakers here at selling author of books and games for early home computers. the conference mention David’s “Webb-site.com,” which he Then came his career in investment banking. For several started in 1998. It’s a treasure trove of corporate governance years, David’s “Christmas picks” of well-governed compa- data, news, discoveries, and exposés that are quoted in the nies in Hong Kong caused stock prices to jump to start the financial and broader media both regionally and globally. And holiday season. It’s also safe to say that if you’re a director of a you can get it for free! It’s a public service, if you will. In 2003 company and David shows up at your shareholders’ meeting, David was elected as an independent non-executive director it is not to bring you a gift—and you should be ready to of Hong Kong Exchanges and Clearing Limited, which owns answer some questions. Without question David Webb is the the local monopoly stock and futures exchanges, over three foremost corporate activist in Hong Kong, someone who is incumbents who had been nominated by the board. And both lauded and feared. he resigned from that board in 2008 over concerns about Ladies and gentlemen, please welcome David Webb. governance. Since 2001, David has also been a member of the Takeovers and Mergers Panel of the Securities and The Future of Chinese Governance Futures Commission, and has been a Deputy Chairman of David Webb: Thanks, Gary. I’m going to talk about two topics the panel since 2013. In 2000 he was named by BusinessWeek today. The first one is, where does China go from here? The
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 43 second is the reality of China’s financial system, and the payment of interest on shares was “entirely optional.” I said ways in which it’s different from the perception they try to to him, “In fact, you don’t have to pay interest at all if you promote. don’t want to. You can pay what you feel like at the end of China has made great progress in the past 30 or 40 years. each year.” But when you start from a completely Communist, centrally- He felt that was rather good. But what was clear from the planned command economy, it’s not difficult to improve chairman’s comments was that he had no concept of shares people’s livelihoods. You can make a lot of mistakes along the as conferring some kind of ownership to investors—and no way, but if you just allow people more freedom to negotiate sense that some sort of fiduciary duty might be attached to prices and to choose where they work rather than assigning issuing these instruments. them to a work unit—just by liberalizing the low end of the Now, two decades later, most of the major Chinese state- economy in this way—you can produce quite a lot of prosper- owned enterprises, or SOEs, have been listed, although not all ity. And that’s important when you’re a one-party state. Even of them. Some defense and strategic companies remain wholly without an electoral mandate, you must have the consent of state-owned. But the floating alphabet soup of banks—ABC, the people. If you can’t keep delivering on that economic CCB, BOC, and ICBC—are all now public companies.1 And promise, then your legitimacy starts to be undermined. China now has got the semblance—though not, as I will be I first came to Hong Kong in 1990 for a two-week assign- telling you, the substance—of a market economy. ment, but settled here permanently in 1991. In hindsight, that Having grown up in the U.K. in the 1970s, and as a was a tremendously interesting time to work in investment teenager with some interest in finance, I can vividly remember banking in Asia. It was a very interesting time to be in Presi- how many British companies were state-owned enterprises, dent Suharto’s Indonesia; and it was an interesting time to be or SOEs. There was British Leyland, the biggest car maker, in South Korea, just after they were thinking of consolidating British Gas, British Airways, British Telecom, British their accounts for the first time, and it was fascinating to be Aerospace, and British Petroleum. And then there were all of in China, when they began to open their stock market. It the electricity generators and the water authorities and so on. took them 11 years after Deng Xiaoping’s decision to open But when Margaret Thatcher came to power in 1979 after up China to actually get around to re-opening the Shanghai a decade or more of poor economic management, she set Stock Exchange, which had been closed since 1949. about returning most of these companies to the market. The One of the first deals I did was a B-share issue. You don’t market couldn’t have absorbed it all in one go, so the govern- hear much about B shares now except in the context of dual- ment engaged in a stage-by-stage sell-down that began with class shares, or “second-class” shares as I call them. But back minority stakes in the SOEs. I remember as a young student then, the B-shares were the U.S. dollar-denominated stocks getting on my bike and filling in a check from my computer of companies listed on the Shanghai Stock Exchange—and royalties to buy British Telecom shares for 50 pence each. my B-share deal got done a year before the first H shares were They were actually one pound 50, but they allowed retail issued in Hong Kong. investors to pay for them in three installments. So, I was up there at the Shanghai Refrigerator Compres- After selling off minority interests, the government sor Works, as it was formally known. In those days, it took proceeded to sell the remainder, but they often retained a two hours to get in from the old airport into Shanghai; there golden share in many of these industries because there was were no motorways. The only international phone line in a political perception that you might need to protect the the entire company of several thousand people was in the companies against a foreign takeover. This perception is chairman’s office attached to the fax machine. So when I evident in China today, where there are much more obvious was negotiating the pricing of the share issue and needed to restrictions on foreign ownership. In the U.K., the golden call back to Hong Kong for instructions, I had to borrow shares had a finite life, so that companies were eventually the fax line. subjected to a real market for corporate control. And the The primitive understanding of markets then—which result of this wave of privatization has been a pretty success- I don’t think has much changed in many Chinese compa- ful U.K. economy compared to the socialism of the 1970s. nies—was that shares were just another kind of bank loan. I Although China embarked on a similar privatization path, finally got to meet the chairman at a very important equity progress has stalled without companies becoming subject to a pricing meeting. Speaking through a translator, he said to me, market for corporate control. The leaders of these companies “I want you to understand that I won’t be paying as much are appointed by the central government through something interest on my shares as I do on my debt.” I said, “Okay, Mr. officially called SASAC (i.e., State-owned Assets Supervision Chairman, we can arrange that.” Then I explained that the and Administration Commission of the State Council); it’s
1. These banks are: Agricultural Bank of China (ABC), China Construction Bank (CCB), Bank of China (BOC), and Industrial and Commercial Bank of China (ICBC).
44 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 basically the very senior leadership appointing their friends well as one or two industrial companies. But the challenge and trusted parties to run the companies. And they shuffle for investors in such cases is to understand the legal rights them around. Periodically, Monday morning announcements these firms have to their main operating assets. Land and in Hong Kong will report to us that the head of Airline A exploration rights are often rather short-dated. The company now runs Airline B, and vice versa. The head of Airline C has a five-year mining permit. Did they get that legitimately? has gone off to become the minister for aviation, or the head Will it be renewed; have they paid the right people to get it of a bank has gone off to become governor of a province, renewed after the company is listed? So you have to put a big and the bank chiefs have been shuffled around again. When discount factor on emerging private companies of China to you see all this, you realize that there isn’t any real strategic reflect uncertainty about both property rights and access to competition at work. So, as an investor, you may be buying the credit system. into a sector or into a set of government policies, but you’re Bank capital tends to get diverted to fund politically not really buying into a competitive market economy. There favored projects such as a railway to Tibet intended to increase are no market forces at work in these companies despite the the assimilation of the Tibetan people into the rest of China. often stated reason for listing them in the first place, which Profitability, if considered at all, is generally not the main was to provide some sort of market discipline. consideration of such projects. A high-speed train may be What’s more, the executives are not paid properly. able to get from Hong Kong to Beijing in about eight hours By “properly,” I mean not even close to modest Western at 300 kilometers per hour, but people will still prefer to take standards. A typical CEO of a multi-billion dollar Chinese the plane. company will earn only $100,000 a year. And of course that So there are a lot of grandiose projects that can line the introduces the temptation to line your pocket some other way. pockets of the local construction people, things like build- ing airports that they don’t yet need for flights that aren’t yet The Chinese Financial System: coming. And despite the popular myth of China’s market Perception and Reality economy, the state still has a lot of control over capital The workings of a command economy were also demonstrated movements in and out. There was much fanfare recently by the activity of Chinese banks in 2009. In response to the when the Shanghai and Hong Kong exchanges said that international financial crisis, banks in the U.K. and U.S. they were going to start allowing their investors to invest in became very risk averse and reluctant to lend. But in China each other’s markets. But this change is being introduced it’s been the opposite. State-controlled banks lend money on in a very controlled way. There’s a quota on such trades that command. Hundreds of them prop up the local state-owned has been set at the equivalent to about 1½ % of the market enterprises. At much lower levels than the head office, there cap of Hong Kong, which may or may not be raised. And are favorite relationships between local officials and the people this Shanghai-Hong Kong Stock Connect, by the way, is not who the run the bank branches. They tend to approve loans so much a through train as a shuttle because you can’t get to projects that can’t be justified on a commercial basis. And off. You can put your money in at Shanghai and buy Hong so “go forth and lend” was the command in 2009. But by the Kong stocks, but you can’t then sell those stocks and send the end of April in that year, the banks had already made their money to New York. A Chinese shareholder can sell Hong quota. And thus when the banks were listed, the govern- Kong stocks, but must then repatriate the money back to ment took out the bad loans and replaced them with what China. Faced with these restrictions, many Chinese investors was basically a bundle of government bonds. But although will prefer to launder their money through Macau instead they took the bad loans onto the national balance sheet, they and get it out free and clear. I think Macau is now actually a didn’t take out the bad lenders. So the banks are continuing bigger financial center than Hong Kong in sheer volume of to accumulate bad loans. trade. It doesn’t have a stock exchange, but it has hundreds of China is home to several very large enterprises. The 40 billions flowing through it every year through the casinos and largest companies with listings in both Hong Kong and the underground money transfer system. If China eliminates Shanghai have a collective market capitalization of $2 trillion, capital controls, then a big chunk of the VIP rooms in Macau which is equal to over 20% of last year’s GDP. On the 24th will just vanish. of January this year, government officials announced that So, the Chinese authorities control capital flows, and the combined revenue of 110 state-controlled enterprises, not they control the media. There’s a propaganda department including the financial sector, was about $4 trillion, equal that makes very clear to newspapers what you can and cannot to over 40% of GDP. And that total also excludes major write about. The Internet is censored, and Facebook is not companies like China Tobacco, which has about $100 billion available in China. Wikipedia is periodically available, but of revenue. usually not in Chinese. They don’t mind so much the English There have also been great success stories among privately text version. They assume that people who can read English held companies such as Tencent and other Internet stocks, as probably have access anyway to overseas media through their
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 45 travels. And then there’s the great firewall of China, which has One other drawback of the Chinese system I should turned out to be incredibly efficient. I didn’t think it would mention is the inflexibility of the labor market. China isn’t be; I assumed that, with the Internet development over the really just one country; it’s an assembly of provinces and a last 20 years, people would just easily find their ways around city-based system. The differences in the permits allotted city the firewall. But it is relatively difficult still to set yourself up and rural dwellers reflects policies from the Communist era with a proxy VPN system and tunnel underneath it. when they didn’t want farmers flooding into the cities. And The foreign exchange rate has been heavily manipulated, it’s still the case that you can’t formally claim education for but there are signs they are considering allowing it to float your children in a place other than where you’re registered. So more. So you should expect to see more volatility in it, partly you have this massive migration problem. In the U.S., if you because the government does not want people to believe they lose your job in Detroit in the car factories, you can get on a can just pile money into RMB deposits and expect an appre- Greyhound and go and find a job in California or somewhere ciation every year. And they have a cap on interest rates on else. In China that’s much harder because residency deter- deposits, which also tends to drive people out of the banks mines not only education, but your rights to healthcare, the and into other products. welfare system, and the provincial financing system. Reflecting in part this move by some Chinese savers out One other common characteristic of SOEs is their of bank deposits, there are now an estimated $1.8 trillion tendency to try to build empires, happy families of compa- worth of outstanding trust products—or “distrust” products nies that support each other. Now there’s nothing wrong as I like to call them. These products, often distributed by with familial piety and children supporting their parents, banks, are basically bundles of loans to other entities. There’s but there’s everything wrong with listed companies relying no clear capital adequacy or solvency requirements for these on one another for support and channeling the funds they’ve trusts; they pretty much lend out what they receive. And some raised in IPOs back up to their parent companies. Take the of this money is going back into the banking system, into case of Beijing Enterprises, which was one of the great stars the interbank market. But a lot of it is going into big projects of the first red chip bubble of 1997. The company took a that will not pay back. As a result, there will eventually be a large chunk of its IPO proceeds and transferred it to a related day of reckoning when the money coming in is less than the government entity in exchange for a water franchise, without redemption pressure on those trust funds. minority shareholders’ approval, because the Hong Kong The potential for a crisis in these trust products is very Stock Exchange had exempted government entities from its great because they are now held by perhaps 100 million rules on related party transactions. Chinese citizens, maybe even more. Although average house- And these days, companies are even more blatant in hold wealth in China is maybe a fifth of Hong Kong’s, there “redirecting” the proceeds from IPOs. Rather than pretend is now something like $18,000 in trust products for each to buy things, they simply create group finance companies in Chinese household. And my best guess is that the govern- which a bunch of listed companies have equity stakes. These ment will have to arrange for buyouts in the event of major group finance companies take deposits from all the compa- defaults in order to ensure its political stability and legitimacy. nies in the group and then lend them to the loss-making If such losses do materialize and are followed by buyouts, the parent company or to fellow unlisted subsidiaries. China most-likely scenario is that the banks will be told to put the Resources is a good example. They had six listed companies resulting liabilities back on their balance sheets even though in Hong Kong and claimed that because some of them had they’re not explicitly guaranteeing any of the products or “seasonality” in their cash flows, it would be rather handy underlying loans. And when this happens, the banks will if they could lend money to each other. So they went for have to absorb the losses from the defaults and then need to minority shareholders’ approval; and when two of the propos- be recapitalized. als got voted down, the chairman said that the shareholders The process of going public and raising equity in China didn’t understand the situation, and the other four companies has been a charade. Why is it, for example, that Alibaba wants just continued lending money to each other. My own feeling to list in New York, but not in Shanghai or Hong Kong? Well about this is simple: if listed companies are this interdepen- Shanghai wouldn’t let them have their partnership scheme— dent, then they ought to be merged; otherwise their financing and we can come back to that later. The Chinese people should be completely separate. expect to be looked after—that’s the nature of a controlled economy: people expect the government to look after them. What Needs to Be Done As part of that function, the government periodically just For China, then, the easy work is done. The country now stops IPOs, sometimes for a year or more, to prop up the appears to have a vibrant economy—one that generates market. They have a queuing system in which they decide $6,000 or more per capita of GDP in which people now which ones should come first—and they even interfere with have refrigerators, color TVs, air conditioners, motor bikes— the pricing as well. some of them even have cars—and a much better quality
46 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 of life than they had before. But getting to the next stage, and Clearing or HKEx—where I served as a director for five which means allowing real competition within the economy, years—the government in its paranoia made sure that they is not going to happen unless an enlightened leadership in retained control. Only six of the 13 directors were elected Beijing liberalizes much faster than they’re currently doing. by the shareholders; the other seven are appointed by the The Chinese GDP may have doubled roughly every seven government. I was able to get elected by shareholders and or eight years, but to get to Western levels—and I’m talking really did care what they thought as shareholders because they about $50,000 per capita—they will need roughly another could remove me at the next election—which they didn’t do; three doublings, and these will be much harder. as Gary mentioned, I resigned over my conerns about their So what do they need to do? First of all, they need to free corporate governance. But for most listed companies here in up the media in order to genuinely crack down on corruption. Hong Kong, there’s a controlling shareholder. It’s either the China needs to allow local media to investigate local officials state, or it’s a tycoon, or extended family, sometimes second and hold them accountable. If they instead continue to allow or third generation, and the controlling shareholder gets local officials to call up through the propaganda department to vote on the election of so-called independent directors, and shut the media down, then you’re not going to have the thereby determining the outcome. So this system really isn’t necessary checks and balances. working. The requirement that at least one third of the board China also needs to do what Britain did in the 1980s, and be independent came into effect on the 1st of January, 2013. that is to reduce their SOE ownership holdings to zero. And Because there are rounding issues here, a lot of companies some enterprises need to be broken up. For example, I would with ten directors simply got rid of a director so they didn’t take China Mobile and create three baby China Mobiles, have to appoint a fourth independent director. The number each with spectrum, and have them compete for customers. of companies with ten seats dropped from 144 to 66 in a year, So there’s some breaking up to be done. and the number with nine each shot up—and so then, “Hey, Chinese policymakers also need to allow foreign share- presto,” the companies now had three out of nine, the magical holders to invest freely. There is currently, I think, a limit of one third. And so they could say to themselves, we’ve satisfied 20% on foreign ownership of Chinese banks, and there are that listing rule; we can check that box. also limits on foreign ownership of telecoms. So what this all says very clearly is that the companies China also needs to reform its welfare system and abolish themselves don’t see any value in the independent director. the residents’ permits to allow people to move freely around And the data on my website shows you a similar picture the country. They must also free the internet and movement in terms of the clustering you get; the average number of capital, and begin to plant the seeds of democracy with of independent directors is about 3.2, compared with a local-level elections to ensure accountability. And I don’t minimum of 3. We need to just have a simple rule: you must think we have a whole lot more time to get all this done, have one third of your board independent, and the board perhaps just ten years, because if the economy stalls, then the can still nominate candidates, but they must be approved by Party will lose the consensual mandate of the people. And let independent shareholders alone. Shareholders would naturally me also say that I think the recently established Shanghai free reject candidates who are conflicted; they can’t be sitting in trade zone will not accomplish very much. It’s true that land cross-directorship positions as they are in Hong Kong. At has suddenly become much more valuable because it’s now some companies, the CEO of one company sits as a member in a free trade zone. But the reality is that you can’t make a of the compensation committee of another company and vice small hole in a balloon. If you’re going to create free markets versa. So they approve each other’s pay, they approve each in that little piece of land and then wall it off from the rest of other’s accounts on their audit committees, and so on. China, it just becomes like another Hong Kong, a little free I also think that independent directors should have to say market bump on a much bigger entity. So they need wholesale in the annual report whether or not they are satisfied with the liberalization across the economy. Will China get someone company’s performance during the year and with its corporate like Gorbachev in Russia or F.W. De Klerk in South Africa? governance in particular. If those directors have gone on the I hope so, because it would be a smoother progression to a record to say that they are satisfied and it later turns out that real free market economy than a general uprising leading to there are huge problems, they should be held accountable. uncertainty and a power vacuum. And you can bet that the As an investor, I screen companies both for good gover- holdouts in the party will fight tooth and nail to defend their nance as well as for valuation based on fundamentals. On SOE empires. some occasions I’ve been able to flag governance issues or As for corporate governance, the term “independent outright fraud in advance. One example was Egana Goldpfeil, director” is really something of a misnomer in China because where they’d been converting their receivables into loans and directors are only as independent as the controlling share- investing in all sorts of dodgy financial products. I called holder wants them to be. For example, although there was them out on this, and the market cap collapsed from about no controlling shareholder per se at Hong Kong Exchanges US$1 billion to zero in one month.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 47 And one last thing before I close: on Webb-site.com, we The problem, however, is that any rule change has to be have a complete total return system for HK-listed stocks since proposed by the listing committee and then approved by the 1994, and so we now have over 20 years of stock price and SFC. But the SFC can’t direct the listing committee to make adjustments. So if you’re looking to do academic research, changes unless it goes all the way with the so-called “nuclear you should regard our data as your Chicago price series for option” and takes back the listing regulatory powers. HK is the Hong Kong Stock Market; and for governance scholars, the last market in Asia not to require quarterly reporting, and we also have a complete database of directors and corporate they still allow three months to produce full-year results, so advisers in Hong Kong since 1990. So that’s the big picture information flow is inadequate; although if a company has a of Hong Kong. dual listing in HK and Shanghai, then the Chinese regulator Any questions? requires it to report quarterly. So it’s a gradual reform process. Investors can’t make laws Public Debt in China and regulations by themselves; only legislators and regulators Question from Audience: David, what do you think about the can. We also don’t have the kind of investor pressure that future of public debt in China? you see in the U.S. from the Council of Institutional Inves- tors or in the U.K. from the Association of British Insurers Webb: Well, my overall impression is that the debt markets and National Association of Pension Funds, because in Hong are inaccessible to retail investors and the only way to get Kong institutions are all minority shareholders who can only to them is through private banks. This is very unfortunate really vote with their feet. because Hong Kong could have a large and liquid market for either government issued or corporate issued bonds. It’s Privatization in China (and Associated Risks) just shameful that banking regulators have tended to protect Question from Audience: I want to hear your thoughts on banks rather than investors in Hong Kong. There isn’t any how massive privatization in China would work out, given best execution obligation on banks, for example. Bid-offer the relatively weak legal system here. Could it end up resem- spreads are very wide. So I think the regulators should over- bling the Russian experience where state assets were sold at come political resistance from banks and allow savers to invest very low prices to a handful of oligarchs? I ask because I don’t in commercial paper and bond markets with low transaction think the Chinese people would accept the sort of thing that costs. happened in Russia or Romania.
Where are the Investor Activists in Hong Kong? Webb: I don’t see that as a material risk, especially when set Question from Audience: David, in the second part of your against the likely benefits of privatization. If you have open discussion you talked about corporate governance problems processes and market-driven pricing, either through book- in Hong Kong. Why don’t investors themselves try to kind building or, better yet, through open tender, then you should of find solutions to those problems and regulators, why they get fair prices. If you have freedom of capital movement inter- are not acting? Do you have any conjectures? nationally, then foreign buyers will step in and bid up the market to roughly the right level for those assets. Webb: I would describe it as a structural problem in Hong The real risk arises if the local manager of the company Kong. We have a defective regulatory system here. The list- has persuaded the local branch of SASAC or some other entity ing rules are made by a Thursday afternoon committee at the to give him the shares on the cheap and in exchange for stock exchange that is dominated by issuers and their paid God knows what under the table. In the current system, it’s advisers: lawyers, investment bankers, and accountants. They much easier to achieve those kinds of underpriced asset sales don’t get paid by investors, at least not directly. The system or grants of exploration rights over minerals and oil wealth does not favor investor interests. It’s been hard to get things than in a more transparent economy. It wasn’t until, I think, changed. I’ve managed to force a few things like the one about ten years ago that the government in China started share, one vote poll voting. I did this by simply turning up conducting regular open land auctions—and that seems to in 2003 at the shareholders’ meeting of every member of the have ended what was until then a big problem of land being Hang Seng Index with five shareholdings of two shares each sold under-priced in city centers. in my pocket: one for me, one for my wife and one for each Now having said that, a bit of underpricing at the priva- of three BVI companies I set up. Five shareholders under tization stage may actually be a good thing if the benefits are Hong Kong company law can require a poll. So now we have spread widely enough. For example, in the U.K., the Royal one share, one vote in Hong Kong. And the blue chips didn’t Mail was one of the last remaining privatizations, and they prevent the listing committee from changing the rules in did underprice it. I called up my parents and my sister and 2009 to make poll voting mandatory, because I had already said, “If you’ve got 1,000 pounds to spare, put it to work here. ended their show-of-hands meetings. It’s a way to make a bit of free money.” But the real benefits
48 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 of privatization come from introducing real market forces to economy. There are plenty of ways to manage that process, these entities. Slightly discounted privatizations can create and there are plenty of countries that have been through it a feel-good factor and, if that is spread as widely as possible that can provide expertise. I think the biggest mistake that across the community, then you get buy-in, you get popular China probably made was thinking that they could be just support. British Gas ended up with three million sharehold- like Singapore forever. They thought that they could have ers after its IPO and so helped create an equity culture. So, their own conglomerate like the GIC or like Temasek, where surely it’s a good thing for Chinese people to retain a stake the state controls big chunks of the economy because it thinks in Chinese national enterprises or local enterprises, and to it knows best for the good of all. That sort of centralization be able to invest in good, reliable companies that are run can work on a small scale like Singapore—but I don’t think on free market bases that hire their own boards rather than it scales to a country with 20% of the world’s population and having them appointed by the party. I don’t worry that we a massive geography. might have something like the Russia voucher privatization problems, where you literally just distribute free shares in the companies to everybody, and then somebody comes around David M. Webb is the founder of Webb-site.com. A Hong Kong resi- and buys them all up before the stock market really gets dent since 1991, he retired from investment banking to focus on his going, because most of these companies are already listed investments in HK-listed small-caps and to establish Webb-site.com, a with a market price for their minority interests. I don’t think non-profit platform for better corporate and economic governance in Hong we would end up in China with anything like the kleptocracy Kong, which now has over 20,000 subscribers to its free newsletter. The that you saw in Russia. site includes Webb-site Reports, with news, analysis and opinions on HK So, China should not be afraid to privatize. They don’t affairs, and Webb-site Who’s Who, a database on HK organizations and have to do it all at once, but they do have to say they are going people, including Webb-site Total Returns on all HK-listed stocks since to do it. Beginning with the best ones, you could sell down 1994 and all directors and advisers of HK-listed companies since 1990, the state shareholdings to zero over a five to ten year period— all available for free. He has been a member of Hong Kong’s Takeovers and the banks would probably come last because they’re the and Mergers Panel since 2001 (a Deputy Chairman since 2013), and was most problematic. They’re going to have to be nursed and an elected independent director of Hong Kong Exchanges and Clearing Ltd gradually made more market-based and gradually reduced from 2003 to 2008, when he resigned over corporate governance issues. in size as well. They’re too big, they’re too dominant in the
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 49 Asian Corporate Governance—and the Case of Dual-Class Shares CARE Conference | Hong Kong Polytechnic University | June 9, 2014
A Presentation by K.C. Chan, Secretary for Financial Services and the Treasury, Hong Kong
Given the number of distinguished academics in this audience here today, I want to share some of my own thinking about the important topic of corporate governance while expecting to learn a good deal from your insights. Corporate governance is a broad subject, and there are many experts at this CARE conference who will be talking about vari- ous aspects of it. My comments this afternoon will focus on one issue that our market has been confronted with recently: the proposed dual- class share ownership structure of Alibaba, the large Chinese company whose IPO has been scheduled to take place in the next few months.
hose of you who have been following the case will fifteen minutes, I will provide some historical perspective on have noticed that Alibaba was exploring a listing this issue that shows how a divergence of corporate governance T in Hong Kong, but has instead chosen to apply standards has developed between the United States and other for a listing in the United States. Since the delib- economies. I will also talk about the competitive pressure that erations were not public, the market could only infer that the this divergence brings about, and the policy questions that we decision had to do with the issue of corporate control, and need to address when dealing with this pressure. how much control management wanted to retain without sacrificing too much value. A Brief History of One-Share One-Vote Alibaba’s decision to pass over Hong Kong for New York The debate on corporate governance and the one share-one has caused a lot of discussion. There are generally two lines vote standard is not new; in fact, it is an ongoing one with a of argument. On the one hand, some commentators have long history. Take the case of the United States, where there is applauded Hong Kong’s adherence to the high standard no federal law on corporate governance, and where corporate of one-share, one-vote; these people believe Hong Kong governance is thus a matter of state law. At the beginning of should take pride in our refusal to bend our standards to the 20th century, the one share-one vote model had become accommodate a big company like Alibaba. On the other popular and, indeed, the dominant practice. But it was not hand, many practitioners have criticized Hong Kong’s compulsory, since each state had its own incorporation stat- inflexibility, urging our regulators to remain “innovative” ute and adopted different models. or risk the loss of many more potential deals to the American Then, in the decades that followed, non-voting common market. Hong Kong, this thinking goes, cannot afford to lag stock was commonly used as a way for founders and manage- behind and must keep pace with changes in the preferences ment to retain corporate control. But after a vocal movement of the market. advocating equal voting rights emerged in response, the Which view seems to be more common? My own NYSE began in 1926 to discourage unequal voting rights attempts to gauge the general sentiment suggest that the in its listing process. And in 1940, when the NYSE banned majority here wants Hong Kong to continue to uphold its non-voting common stock, disparate voting rights plans governance standards. In my remarks over the next ten or became rare in that market. Interestingly, NASDAQ and
50 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 AMEX chose not to follow, but rather to compete with the rights. Such shares are particularly popular in a number NYSE by attracting companies with dual-class shares. of European countries and Sweden. For example, as a way Then, in the 1980s, when battles for corporate control to encourage long-term investment, investors in France are broke out everywhere, many corporate managements issued awarded double voting rights if they keep their shares for classes of shares with differential voting rights as defenses at least two years. But even so, according to one study, the against hostile takeovers. In response, the Securities and fraction of dual-class listed companies in Europe dropped Exchange Commission (SEC) in 1988 promulgated new sharply from 41 per cent in 1995 to 22 per cent in 2001, rules intended to limit corporations’ ability to adopt share probably due to increasing investor preference for the single structures with differential voting rights. class structure. But the SEC’s rules were struck down by the courts. In 2007, the European Commission published an impact In 1990, the DC Circuit ruled in Business Roundtable v. assessment of the proportionality between capital and control the SEC that corporate governance regulation is primarily in listed companies. The study was commissioned with a view a matter for state law. The role of the SEC, as established to bringing the one share-one vote standard to the entire under the Securities Exchange Act of 1934, was limited to the European Union (EU). But since the study did not produce regulation of the trading of securities and the requirement of conclusive empirical evidence that unequal voting rights have suitable disclosures. It has no authority to adopt rules affect- any effect on firm value, whether positive or negative, the EU ing substantive aspects of corporate voting rights. ultimately decided that there was no need for action at the Today, share classes with disparate voting rights are EU level. Interestingly, the idea of giving long-term investors popular among media and technology companies in the more votes—with a view to promoting long-term sharehold- United States. But as we have seen, the U.S. regulatory system, ing—was brought up again by the EU Commissioner Michel with its emphasis on disclosure, is the result not of conscious Barnier in 2013, but the issue was not followed up. design by regulators, but of the U.S. political system. In Australia, a public consultation was launched in 2007 The U.S. courts recognize the role of states in corpo- on the introduction of non-voting common shares. But the rate governance as an opportunity for experimentation with matter was dropped after there was no conclusive response. alternative solutions to the difficult problems arising from corporate law. As Justice Brandeis wrote almost a century ago, So Where Do Things Stand? “It is one of the happy incidents of the federal system that From this quick review, the one clear conclusion we can draw a single courageous State may, if its citizens choose, serve as is that the debate around the one share-one vote standard is a laboratory and try novel social and economic experiments a longstanding one, with persuasive arguments both pro and without risk to the rest of the country.” con. The pro argument is relatively straightforward: the one And so U.S. federalism is responsible for the differences share-one vote standard is simple and transparent, with voting in corporate governance laws among U.S states. But in the power proportional to shareholding. The argument against present day, we may wonder what effects such competition the one share-one vote standard seems to be gaining traction among states is expected to bring about when commerce and lately because of concern about the short termism of stock investor participation have extended well beyond the borders markets. Some informed and impartial parties have begun of one state or one country. U.S. regulators and policymakers to ask whether differential voting rights should be allowed to need to think about whether the competition among states encourage longer-term behavior. At the same time, it is diffi- has brought about a race to the top or a race to the bottom. cult to strike the right balance as we try to guard against the entrenchment of management and controlling shareholders Evidence from Outside the U.S. at the same time. In countries other the U.S., the debate over the one share- It is also fair to say that institutional investors are never one vote standard is also very much alive. Across the Atlantic, impressed by the arguments against one share-one vote. the active market for hostile takeovers that emerged in the They believe that as professionals they have the necessary 1960s led to a rise in the use of dual-class share structures in knowledge, information, and expertise to have a voice in the U.K. But when opposition from institutional investors corporate decision-making, and they would prefer to retain arose, the limitation of voting rights, although not outlawed, the right to influence management by making full use of was discouraged by investing institutions and the London their votes. Stock Exchange, leading to the one share-one vote standard So what are the policy choices? Hong Kong did not becoming the norm in the market today. More recently, the arrive at its one-share, one-vote standard without consider- Financial Conduct Authority has proposed rules that require able discussion and deliberation. There is a history behind it, each share to have equal voting power. and if you are familiar with Hong Kong’s market, you would The situation is a bit different in continental Europe, understand why there is such strong concern about corporate where many countries allow shares with unequal voting governance. It is not a good idea to transplant policies from
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 51 one market to another without understanding their respective My hope is that the experts here today will be able to historical backgrounds. shed further light on this matter. Once again I would like Nevertheless, the debate is going to continue. With the to thank the organizers for holding this event to help us in largest stock market in the world, the U.S. carries huge influ- addressing some of the most challenging issues related to ence over the global market. The U.S. regulatory approach corporate governance. and standards of corporate governance also matter for Thank you. competitive reasons, as companies will always shop around and decide where to get listed. But I for one don’t foresee a global convergence of K. C. Chan is Secretary for Financial Services and the Treasury in Hong standards since different jurisdictions do approach the issue Kong. Before accepting that appointment in July 2007, Professor Chan of corporate governance very differently. The Alibaba case was Dean of Business and Management at the Hong Kong University of has made clear this divergence in global listing standards, Science and Technology (HKUST). Before joining the HKUST Business pointing to some potential risks, such as the possibility of School in 1993, Professor Chan spent nine years teaching at Ohio State a race to the bottom in regulatory standards. But I do not University in the United States after earning both an MBA and PhD at detect that kind of race at the moment as global regulators the University of Chicago’s Graduate School of Business. The main focus are sticking to high governance standards—though this risk of his research was asset pricing and the evaluation of trading strategies cannot be ignored. and market efficiency. At the same time, Hong Kong is not completely opposed Before joining the government, Professor Chan also held a number of to changes in its one share-one vote standard. But when I public service positions, including Chairman of the Consumer Council, look at the various proposals, I realize that it is a very difficult director of the Hong Kong Futures Exchange, and member of the Commis- task to come up with deviations from one share-one vote sion on Strategic Development, the Commission on Poverty, the Exchange that can be readily justified to investors. For example, should Fund Advisory Committee, the Hang Seng Index Advisory Committee, and long-term investors or the management get more votes? And the Hong Kong Council for Academic Accreditation. He has also served how many more votes? What about a sunset clause or other as President of the Asian Finance Association and President of the Asso- limitations? It is not easy to form a rational basis to support ciation of Asia Pacific Business Schools. a particular deviation.
52 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Financial Reporting Practices of China’s Listed Firms* by Joseph D. Piotroski, Stanford University Graduate School of Business
he last two decades have witnessed a profound Transparency in China” at a recent conference sponsored by transformation of China’s capital markets. Since the University of Notre Dame and hosted by Hong Kong BT the reopening of the Shanghai and Shenzhen Polytechnic University. As the chair of that session, I will draw stock exchange in the early 1990s, these two upon these three presentations and relevant prior research markets have grown to become the seventh and eleventh to present a brief overview of the information environ- largest stock exchanges in the world, respectively, based ment of Chinese listed firms and to highlight the primary on market capitalization, and the fourth and fifth largest forces affecting the financial reporting incentives of these exchanges based on the total value of shares traded (at the companies. The key conclusion from this summary is that, end of 2013). When combined with the Hong Kong Stock although Chinese financial reporting and governance require- Exchange, the Chinese exchanges are second only to the ments look good “on paper” and have been slowly improving U.S. exchanges (NYSE and Nasdaq) in terms of market over time, the information environment of Chinese listed capitalization and trading volume. The growth and devel- companies, can best be described as “opaque.” Strong politi- opment of China’s equity markets was initially fueled by cal forces, weak investor protections, limited capital market the partial privatization of China’s state-owned companies, pressures, and the prevailing set of business arrangements and, more recently, by the growth in China’s non-state busi- and practices have acted as major deterrents to transparency, ness sector. Moreover, a significant number of Chinese firms and will likely continue to do so absent reforms that funda- have listed and raised capital overseas through direct share mentally alter key aspects of China’s economic environment. issuances and cross-listings (e.g., H-Shares; N-Shares; Red To that end, the paper concludes with a few brief thoughts Chips) or via reverse mergers. As such, Chinese compa- about the future of financial reporting in China, and about nies now represent viable investment opportunities for both the kinds of reforms that are necessary to enable China’s listed domestic and foreign investors. companies to meet the reporting and governance standards The long-term success of financial markets is dependent set by their Western peers. upon the widespread availability of high quality financial information. More importantly, individual investors depend Descriptive Evidence on the Financial Reporting critically upon companies’ regulatory filings and voluntary Practices of China’s listed firms disclosures to accurately assess their long-run risks, payoffs, In order to foster the development of world-class stock and ultimately, intrinsic values. However, a recent string exchanges in Shanghai and Shenzhen, the Chinese Securities of accounting frauds among Chinese companies listed on Regulatory Commission (CSRC) enacted financial report- overseas markets, such as Oriental Paper, RINO Inter- ing and governance standards and regulations drawn from national, Sino-Forest, Real Gold Mining, and Longtop developed economies, most notably the U.S. and U.K. Thus, Financial Technologies, among others, has revealed the on the basis of standards and regulation alone, the informa- accounting and governance risks associated with investing in tion environment of China’s listed firms should be strong. such firms. Understanding these risks is a first-order concern Chinese listed firms face demanding requirements for timely of market participants investing in Chinese securities. disclosure and, as is the case on U.S. and U.K. exchanges, In the pages that follow, I will summarize and elabo- these periodic reporting requirements reflect a trade-off rate upon three presentations—by Professor T.J. Wong of between timeliness and precision (as generally evaluated by the Chinese University of Hong Kong, Professor Bin Ke the amount and quality of external scrutiny—that is, are they of Nanyang Business School in Singapore, and Professor audited, and if so, by whom?). Annual reports are required to Kevin Chen of the Hong Kong University of Science and be audited and released within four months of the fiscal year Technology—that were made during a session on “Corporate end. “Interim reports” must be released within two months of
*This article reflects and elaborates upon the presentations and comments made dur- June 9th and June 10th. The author would like to thank the session’s three panelists, ing the “Corporate Transparency in China” session at the 2014 Center for Accounting Kevin Chen, Bin Ke, and T.J. Wong, for their presentations and participation and the Research and Education Conference hosted by Hong Kong Polytechnic University on editor, Don Chew, for his comments and suggestions.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 53 Table 1 Reported Earnings and Dividends per S&P Index Share, 2007-2013 (Monthly Data, Current US Dollars)
This table presents descriptive survey evidence on the quality of China’s financial reporting, disclosure and auditing standards and practices. The Opacity Index, published by the Milken Institute, rates five components of the financial market system that hinder transparency: legal system inadequacies, economic enforcement policies, accounting stan- dards, corporate governance, and regulation. The Global Competitiveness Report, published by the World Economic Forum, provides rankings based upon the strength of the country’s auditing and reporting standards.
Opacity Index Global Competitiveness Report (Score) (Rank) 2001 2004 2008 2008 2013 China 86 56 41 86 80 United States 25 20 20 20 36 United Kingdom 45 33 10 17 16 Germany - 17 10 14 23 Japan 81 22 21 44 25 Brazil 63 40 37 60 31 India 79 30 29 30 52 Russia 81 40 26 108 107 Hong Kong 53 33 1 1 6 Taiwan 56 40 30 53 20 South Korea 90 30 30 36 91 Singapore 38 50 14 7 4
Sources: Milken Institute’s Opacity Index and the World Economic Forum’s Global Competitiveness Reports the end of the first half of the fiscal year and are only required mandated stricter guidelines—that also became effective in to be audited under specific circumstances, while unaudited January 2007—for auditors in China. Second, the CSRC quarterly reports must be released within one month of the has implemented regulations designed to increase financial end of the third and ninth month of the fiscal year. Addi- reporting penalties, with directors, supervisors, and manag- tionally, listed firms are required to provide “ad hoc” reports ers being “jointly and severally liable for losses” arising from when a major event occurs; these ad hoc filings are analogous “falsehoods, misleading statements or major omissions.” to the Form 8-K filings by U.S. listed companies. Lastly, the CSRC has issued regulations designed to improve Similar in spirit to the certification requirements for U.S. corporate governance and tighten the financial reporting listed companies, senior officers and directors of China’s listed process, such as the mandatory use of independent direc- firms are required to sign their opinion of consent or dissent to tors (the current requirement is one-third of the board), the each periodic report. Additionally, directors of China’s listed mandatory use of an audit committee (with the majority of firms are required to provide a specific explanation or express the members being independent directors and at least one an opinion on modified audit reports. In terms of dissemina- accounting professional), a requirement for the listed firm tion, all reports and corporate announcements are required to to perform an assessment of its internal controls, and strict be published in a government-specified media outlet, which limitations on insider trading activity. If implemented effec- is generally one of the country’s leading financial newspapers; tively, these corporate governance reforms have the potential as a result, these periodic reports are widely disseminated and to improve the quality of Chinese listed companies’ financial easily accessible by the average domestic investor. reports and the overall information environment. In addition to these periodic reporting requirements, the The unfortunate reality, however, is that, despite the CSRC has implemented regulations designed to improve the adoption of high-quality standards and governance regula- financial reporting practices of China’s listed firms. First, tions, the disclosure practices of China’s listed firms—and the the CSRC has focused on convergence with high quality, general reporting and information environment in which they globally-accepted standards. Chinese Accounting Standards operate—remain opaque. Media reports in recent years have (CAS) were harmonized with International Financial Report- provided numerous examples of opacity in China across a ing Standards (IFRS), with all listed firms required to comply wide-range of settings, including much-publicized failures to with the new CAS effective January 2007. Similarly, the provide timely information about health and environmental CSRC adopted International Auditing Standards, which issues (such as SARS and bird flu viruses and the widespread
54 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 consumption of contaminated milk powder), biased economic in turn implies that the flow of firm-specific information is data (for example, growth data during the Asian Financial the weakest—for companies (1) with few foreign investors, Crisis), and censorship of the internet (“Great Firewall of (2) for which the state is the controlling shareholder, and (3) China”). More relevant for investors, these prevailing incen- that hire low quality auditors.4 In other words, stock return tives for opacity appear to spill over into China’s capital synchronicity is greatest among firms that either garner little markets and the financial reporting practices of listed firms. benefit from transparency or face strong countervailing incen- Survey data on global financial reporting, disclosure and tives to preserve opacity (that is, transparency is especially auditing practices (presented in Table 1) provides comparative costly for them). evidence on the relative position of China’s exchanges and Consistent with this survey and market-based evidence, listed firms along these dimensions.1 The data from these empirical research provides compelling evidence of the weak surveys highlights two key characteristics about the infor- financial reporting practices of Chinese listed firms. This mation environment of China’s listed firms. First, financial evidence includes extensive earnings management around reporting and disclosure practices have been improving over securities issuances, deviations between financial reporting time. This trend is generally consistent with the gradual intro- standards and practices, and the preferential use of small, duction of high quality standards and regulations and the local auditors by Chinese listed firms. This evidence, along increase in the overall depth and breadth of China’s markets with the underlying incentives shaping China’s weak informa- (both in terms of the quantity and quality of listed firms and tion environment, is discussed in the next section. the extent of investor participation) that has occurred over the same time period. Second, despite these improving trends, Factors Shaping the Financial Reporting Practices China’s exchanges and listed firms continue to lag behind not of China’s Listed Firms only developed economies (notably, the U.S., U.K., Japan and The reporting practices of China’s listed firms ultimately Germany), but also other large developing economies (specifi- reflect a trade-off of prevailing incentives for and against cally, Brazil and India, two of China’s emerging market peers) transparency and strong corporate governance practices. As as well as developed economies in Asia (including Hong highlighted in the conference presentation of Professor T.J. Kong, Singapore, Taiwan and South Korea). Wong of the Chinese University of Hong Kong, and as we The result of this weak financial reporting environment is discussed in an article I published with Professor Wong in a stock market where company-specific stock returns display 2012,5 the weak financial reporting and governance prac- an extraordinarily high degree of co-movement with market tices of Chinese listed firms can be viewed as an “equilibrium returns. As discussed in a paper published by Randall Morck, outcome” that is driven by China’s social, legal and political Bernard Yeung and Wayne Yu in 2000,2 such co-movement— institutions. China’s institutional environment is character- the authors use the term “synchronicity”—is attributable ized by strong political forces, a weak judicial system, and in large part to a limited flow of firm-specific information cultural and social norms that emphasize the maintenance of getting incorporated into securities prices. Morck, Yeung and social relationships and conformity. These institutional forces Yu report that Chinese securities display the second highest shape and reinforce the dominant characteristics of China’s level of co-movement (only Poland’s exchanges exhibited business environment, which include: the limited protec- higher levels) among a sample of 41 countries, with market tions of property and investor rights; significant government returns explaining almost half of the variation in weekly ownership and control of economic assets (directly through returns of individual Chinese stocks and nearly 80% of all state-owned entities and indirectly through bureaucracy, Chinese stocks moving together in the same direction—up application of regulation, licensing, etc.); concentrated owner- or down—in an average week. By comparison, they find ship arrangements; group business structures; importance of that in the case of U.S. stocks, market returns explain only relationship-based contracting and related party transactions; 2.1% of the variation in weekly returns, with 58% of stocks strong reliance on state bank financing; politicized access to moving together during their sample period. Later studies external capital and investment opportunities; and, as a result have confirmed the highly synchronized nature of Chinese of and exacerbated by most of the preceding arrangements, equity returns,3 suggesting that a high degree of co-movement significant agency problems and weak corporate governance among stocks continues to be an important characteristic of practices. today’s Chinese equity markets. As discussed by Professor Wong and others during the Perhaps even more revealing, a recent study has found conference, the combination of political, legal, and economic that the synchronicity of stock returns is the greatest—which arrangements predictably fails to provide the necessary incen-
1. Data on country-level scores and rankings are provided from the Milken Institute’s 3. For example, see Jin and Myers (2006); Gul, Kim and Qiu (2010). Opacity Index and the World Economic Forum’s Global Competitiveness Reports, respec- 4. Gul, Kim, and Qiu (2010) tively. 5. Piotroski and Wong (2012) 2. Full references to all citations are provided at the end of the article.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 55 tives to support strong financial reporting practices. First, connected firms garner smaller benefits from transparency the limited protection of investor and property rights, which and are expected to be very sensitive to political incentives arises from both the weak legal system and the existence of for opacity. Non-state-controlled firms without strong politi- strong political forces, hinders, if not prevents, the devel- cal connections are expected to have greater incentives for opment of robust external markets (including capital, input transparency as a result of their greater dependence upon and output markets), the use of arms-length contracts, and, external sources of capital and weak political incentives. ultimately, the diffuse shareholder ownership arrangements Across provinces, incentives are generally expected to be observed in Western markets. To overcome these frictions, the shaped by the degree to which local politicians are granted owners and managers of Chinese companies respond through autonomy and rewarded for market development activities the use of concentrated ownership arrangements, group and by the extent to which property rights are protected in business structures, relationship-based contracting, and the the province. And, over time, one would expect to observe a use of related party transactions. In this environment, there general improvement in financial reporting practices if gover- is limited need for costly, high quality external accounting nance and financial reforms are effective, or if companies reports from a contracting perspective, because monitoring respond to the increased demands of foreign investors for occurs directly and contracts are enforced through reputation reliable information. and other social mechanisms. In general, the existing empirical research supports these Second, concentrated ownership arrangements, weak arguments about the effect of Chinese institutions on corpo- legal protections, and strong political forces can also create rate reporting. The most striking finding is that, despite the incentives for opacity that are driven by the incentives and widespread adoption of world class auditing and accounting rent-seeking tendencies of both majority shareholders and standards, the prevailing incentives created by China’s institu- politicians.6 Unlike the traditional agency conflict between tional environment encourage and reinforce opacity and weak managers and shareholders observed in Western markets, most financial practices. For example, among the earliest studies agency conflicts in China are between the majority and minor- of Chinese reporting practices, a 2001 paper by Ray Ball, ity shareholders, with majority shareholders using their control Ashok Robin, and Joanna Wu showed that, despite the intro- rights to capture private benefits at the expense of minority duction and adoption of international (Western) accounting shareholders and, in the extreme, engaging in the outright standards among listed firms following the re-opening of expropriation of corporate resources (for example, through China’s stock exchanges in the early 1990s, the loss recogni- related party transactions and self-dealing arrangements). tion practices of Chinese companies during the period 1992 Additionally, when the state is the controlling shareholder, to 1998 significantly lagged behind the reporting practices of the decisions of the listed firms are frequently not aligned with their peers in common law countries. More recently, there is value maximization and instead reflect policy objectives (such mixed evidence on the impact of China’s convergence towards as achieving full employment) or the “rent-seeking” tenden- IFRS-based standards, especially among state-controlled cies of local politicians. Given these conflicting interests, both entities. Although a few studies have reported an improve- local politicians and the controlling shareholders of China’s ment in the “value-relevance” and “contracting-relevance” of listed firms have an incentive to withhold information that the new accounting numbers,7 other studies either fail to find highlights inefficiencies, governance weaknesses, expropriation these effects or document an increased use of “discretion” in activities, and/or policy failures. the reporting process.8 This mixed evidence stands in stark Third, although it is well documented that transparency contrast to research that consistently documents improve- can generate significant benefits for both listed firms and the ments in financial reporting practices around the adoption of economy in the form of better monitoring, more efficient IFRS (and related regulatory changes) in other global settings, resource allocation, and a lower cost of capital, many of these most notably in the European Union over the last decade. benefits are minimized because of Chinese firms’ reliance Focusing on the auditor choices of Chinese listed firms, on state bank financing and relationship-based contracting Professor Wong’s presentation began by highlighting the activities. These forgone benefits are especially pronounced findings of a study by DeFond, Wong and Li (2000), which for SOEs as well as politically-connected private firms with showed that the introduction of generally accepted interna- preferential access to financing and investment opportunities. tional auditing standards in China was accompanied by a Of course, the extent to which these institutional general move away from the use of large, independent top arrangements influence Chinese financial reporting incen- 10 auditors. This flight away from high quality auditors is tives is expected to vary across firms and provinces and, quite consistent with the common observation that Chinese firms likely, over time. As mentioned above, SOEs and politically neither value high quality reports (i.e., limited demand for
6. For example, see Shleifer and Vishny (1997). 8. For example, DeFond, Gao, Li and Xia (2014); He, Wong and Young (2012). 7. For example, Lee, Walker and Zeng (2013).
56 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 information) nor are willing to supply reports that are more cal events, such as meetings of the National Congress of likely to identify material weaknesses in their reporting the Chinese Communist Party and provincial-level politi- practices and inefficiencies in their operations. Building upon cal promotions, that raise the political cost of revealing bad this relationship between prevailing incentive and auditor news. With respect to the adverse incentives created by state choice, a 2008 study by Professor Wong, Qian Wang, and control and the rent-seeking tendencies of local politicians, Lijun Xia9 concludes that average local SOE has a clear and studies by Jian and Wong (2008) and Jiang, Lee, and Yue rational preference for hiring a small, local auditor instead (2009) have documented the widespread use of related party of a high quality, top 10 domestic or international auditor, transactions and intercompany loans to facilitate “propping” especially in regions with weaker market development and, and the tunneling of resources in state-controlled firms. And, presumably, limited capital market-based incentives for trans- as discussed earlier, there is extensive evidence suggesting that parency. The same study also finds that local SOEs are more the financial reporting practices and information environ- likely to switch to a higher quality auditor when the firm is ments of state-controlled companies are significantly weaker partially privatized through a share issuance—a finding that than those of non-state-owned firms. is consistent with the argument that firms seeking to credibly Interestingly, given China’s current institutional arrange- commit to better governance practices will voluntarily hire ments, maintaining political relationships appears to be more a high quality auditor.10 However, not all auditor choices are valuable than being transparent for Chinese listed firms. strictly designed to improve financial reporting quality. For Presenting evidence from his own research with Mingyi example, Yang (2013) finds that the stronger the political Hung and Feng Zhang, Professor Wong showed how pure connections of the firm’s auditor, the greater the likelihood accounting-based corporate scandals in China destroy more of the company receiving an approval for an IPO. value than corporate scandals that damage ties with govern- The main implication of Yang’s finding, of course, is ment in China.11 Specifically, they find that pure accounting the value and importance of relationships—both social and scandals are associated with an average market reaction political—in China. Although the CSRC has implemented of -15%, while accounting scandals that damage political bright-line listing requirements to prevent unqualified firms connections have been accompanied by average price declines from raising capital on China’s stock exchanges, several of -35%. This contrast sharply with the market reaction studies, including Chen and Yuan (2004) and Du (2011), to accounting scandals in the U.S., where firms experi- have shown that the likelihood of a firm receiving approval ence average price declines of greater than 40% following to issue equity and public bonds is influenced by the strength the revelation of accounting fraud. The relative difference of the firms’ political connections, suggesting that the in valuation consequences reflects the fact that relation- regulatory listing process is unduly influenced by political ship-based contracting—in both its political and social incentives and personal relations. Similarly, there are concerns dimensions—is more important in China than market-based that China’s independent director requirements are under- contracting activities that depend upon the reputation and mined by social forces, with majority shareholders selecting credibility of the listed firm. independent directors on the basis of personal relationships. Finally, in the U.S. environment, incentives for earnings Given the relationship-based nature of Chinese society, such management are typically shaped by capital market valua- appointments create incentives for independent directors to tion pressures and accounting-based contract incentives. align with the majority shareholder despite their regulatory From a valuation perspective, earnings management typically mandate to protect minority shareholders. Consistent with involves the use of discretionary accruals to “meet or beat” this concern, two recent studies—Lin, Piotroski, Yang and market expectations, such as last year’s earnings benchmark Tan (2013) and Ma and Khanna (2013)—report evidence or growth targets, or to use accruals to simply avoid a loss or that the social connections of independent directors influ- to inflate (or deflate) earnings in advance of specific capital ences their decisions to publicly disagree with management market activities or transactions, such as share issuances or in the firm’s regulatory filings. the pricing of option grants. These same events can also create The dominant role of the state and local politicians incentives to time the issuance of voluntary disclosures to effectively ensures that political forces play a significant maximize the relevant valuation-related benefits. From role in the financial reporting practices and transparency a contracting perspective, the incentive is to manipulate of Chinese listed firms. For example, in a study completed accruals to either avoid a costly contracting outcome (such within the last year, Professor Wong, Tianyu Zhang, and I as violating debt covenants) or to gain a specific contractual have found evidence that negative information about listed benefit (say, the reward from meeting a bonus threshold). firms is temporarily suppressed in advance of visible politi- These market and contracting forces, however, exert
9. Wang, Wong and Xia (2008). 11. Hung, Wong and Zhang (2013). 10. See Fan and Wong (2005) for a study examining the hiring of a high quality audi- tor as a credible governance commitment mechanism in China.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 57 weaker pressures in China due to the prevailing institutional The Influence of Market Forces and Cross-Listing arrangements discussed earlier. Instead, companies are more Activities on the Financial Reporting Practices of likely to use earnings management practices to meet the Chinese Firms bright-line CSRC regulatory benchmarks required to engage The Hong Kong stock exchange (HKEx) is a primary desti- in rights issuances and other capital-raising activities (such nation for Chinese companies seeking to raise capital in as an IPO or seasoned equity issuance) or to maintain listing overseas markets. As noted during the conference, Chinese status (because, after two years of losses, firms are categorized firms account for nearly 56% of the total market capitaliza- as “special treatment” and can be subject to delisting). tion of companies listed on the HKEx and for 67% of its For example, to engage in security offerings, domestic trading volume. As of May 2014, such listed firms include Chinese firms must file an application package with the 166 H-share companies (i.e., PRC incorporated firms), 123 CSRC for approval. This package contains both financial “red chips” (state-owned Chinese firms incorporated over- and nonfinancial information used by the Issuance Examina- seas, mostly in Hong Kong), and 505 private enterprises. As tion Committee to determine whether the applicant meets a result of this exposure, Hong Kong is an important setting the regulator’s listing criteria. Such criteria include minimum for researchers to examine and for investors to understand average return on equity performance in the preceding three how market forces and strong institutions impact the finan- years, a size requirement based on total assets, and strict cial reporting incentives and practices of Chinese companies. asset composition guidelines (which specify a maximum The second of our three panelists, Professor Bin Ke of allowable percentage of intangible assets). Because approval Nanyang Business School, began by presenting his own recent is contingent upon meeting these criteria, many applicant research on the effect of China’s weak institutional environ- firms engage in earnings management that makes use of ment on the quality of Big Four audits. Specifically, a study both discretionary accruals and related-party transactions to by Ke, Lennox, and Xin (2014) examined whether mainland meet these CSRC “bright line” regulatory requirements. For Big Four audit firms provide the same audit quality for pure example, the inflation of earnings through the use of abnor- A-share and AB-share firms (that is, those companies listed mal positive accruals in advance of IPOs was documented by on mainland exchanges only) versus AH-share firms (those Aharony, Lee and Wong (2000), while Chen and Yuan (2004) listed on both mainland and HK stock exchanges). From a document abnormally high levels of non-operating income reputation perspective, the global, Big Four audit firms should being reported by companies seeking to meet the require- be expected to provide the same quality of service regardless ments of a rights offering. Jian and Wong (2008) document of location or listing venue. In contrast, if there are differ- the prevalent usage of related party transactions to artificially ences in the ability, strictness, or scrutiny of local regulators improve—or “prop”—the financial performance and balance between the two markets, audit quality could vary across sheet position of China’s state-controlled firms in advance these two regimes. of rights issuances, with the resulting earnings management Consistent with this latter argument, the authors find effects most pronounced in those provinces characterized by that Big Four firms assign less experienced auditors to compa- weak legal and market institutions. The result—and another nies that are listed only in China as compared to clients clear indication of the prevalence of such accounting manipu- cross-listed in Hong Kong. Moreover, the study finds that lation in China—is a distribution of ROE realizations that these Big Four audit firms are less likely to issue modified are clustered just above the CSRC’s regulatory benchmarks audit reports and charge lower audit fees for clients that are of zero, six and ten percent. Several of these examples were listed only in China. At the same time, such China only discussed by the conference panelists. companies have greater earnings “inflation” (that is, they In summary, the financial reporting practices of Chinese make greater use of positive discretionary accruals) than listed firms are, on average, sub-standard, certainly when companies cross-listed in Hong Kong. The main conclusion evaluated by Western practices. These outcomes reflect from these findings, then, is that sufficiently strong exposure prevailing incentives that are created principally by the to market forces backed by credible enforcement mechanisms current state of China’s fundamental legal, political, market is capable of influencing the domestic financial reporting and social institutions. That said, many Chinese firms have environment of Chinese listed firms. voluntarily decided to expose themselves to strong legal insti- Professor Ke’s presentation also discussed the potential tutions, strict enforcement regimes, and heightened capital effect of market-based versus government-based IPO pricing market pressures through an overseas listing, primarily in mechanisms on the quality of financial reporting. Since Hong Kong (in the form of H-shares and as a Red Chip) or 1997, Chinese regulators have experimented with different New York (in the form of N-Shares or direct listings). The IPO pricing mechanisms on domestic exchanges. During next section will discuss the influence of increased market the periods January 1997-February 1999 and November forces and cross-listing activities on the financial reporting 7, 2001-December 31, 2004, IPO pricing was capped by practices of Chinese firms. P/E multiples that were set by regulators. But, during the
58 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 interim period between these two regimes and after 2004, mainland auditor or differential pricing attributable to the a market-oriented approach to IPO pricing prevailed. In a brand value of Hong Kong auditors? recent study, Chen, Ke, Wu, and Yang (2014) used this time- As a matter of government policy, the PRC’s Ministry of series variation in pricing regimes to examine whether these Finance created “Guidelines for the development of Auditing alternative pricing mechanisms have an impact on financial Industry” in China.12 The stated goal of this plan, which was reporting quality. The authors find evidence that the finan- made public in 2009, is to cultivate ten domestic mainland cial reporting quality of IPO firms is higher when offering auditors to become large multinational firms in five years. prices are determined by the market-based approach, and Professor Chen’s research, however, suggests that the success that the longer-term financial reporting quality of such firms of the government’s plan to guide overseas listed Chinese is heavily influenced by reporting quality at the time of the firms towards domestic auditors has been quite limited. IPO. At the same time, the authors find no evidence that the Instead, market forces driven by auditor reputation and market-based pricing mechanism leads to greater inflation expected capital market benefits are continuing to guide the of IPO offering prices than the P/E capped approach, thus audit decisions of large overseas-listed Chinese firms despite casting doubt on one of the primary arguments in favor of a the enactment of these regulatory changes and reforms. government-mandated pricing scheme. When viewed as a whole, the research summarized by Future of Financial Reporting in China Professor Ke provides insights into how reforms that increase This article has attempted to summarize, as briefly as possi- China’s listed firms’ exposure to capital market forces may ble, the state of financial reporting among China’s listed firms create the necessary long-term incentives to provide higher and to highlight the institutional forces that have shaped, and quality financial information. are continuing to influence, financial reporting behavior. A The third and final speaker in our panel, Professor Kevin common theme that emerges from the studies reviewed in Chen of HKUST, began by asking whether the “visible hand” this article is that the adoption of world-class standards and can guide auditor choice in China. They key question raised regulation is insufficient to generate necessary incentives for in his presentation is which accounting firms should audit transparency. Instead, transparency and the long term health Chinese companies listed in Hong Kong (that is, H-share of China’s capital markets are dependent upon the govern- companies). Historically, all Chinese firms listed on the Hong ment engaging in reforms that: Kong stock exchange have been required to be audited by a (1)strengthen investor protections, including credible Hong Kong audit firm. For mainland firms with both A and regulatory enforcement activities and the establishment of H shares, this rule until recently produced a “dual audit” an effective, independent judiciary court system that protects situation where the firm had two auditors (one mainland property rights and promotes private enforcement activities; auditor and one Hong Kong auditor) and two sets of financial (2)encourage the development of the domestic capital statements. However, due to a change in Hong Kong regula- market, especially with respect to the participation of foreign tion in December 2010, Chinese H-share firms now have the investors and foreign auditors; option to hire either a Hong Kong auditor or an approved (3)deregulate the local business environment and depolit- mainland auditor (which consists of the Big 4 in the mainland icize access to capital and investment opportunities; and and the next largest 8 mainland domestic auditors) and no (4)discourage rent-seeking behavior by local politicians longer be subject to the dual audit requirement. and their affiliates. Somewhat surprisingly, this change in regulation has Together, such reforms have the potential to improve produced only a minimal change in audit coverage. Of the corporate governance among China’s listed firms, better 152 H-share companies examined by Professor Chen, only align the incentives of the state and majority shareholders 37 (24%) had switched from a Hong Kong to a mainland with minority shareholders, increase the ability of account- auditor by the end of 2013, and most of these 37 firms were ing to serve a contracting function, and increase the demand small, dual audit clients. In contrast, larger firms continue to for timely information for valuation purposes. In the long view a Hong Kong Big 4 audit as valuable, suggesting that run, such improvements should increase the long-run perfor- auditor reputation matters in the Hong Kong market. And, mance of Chinese firms (especially state-owned enterprises), interestingly, those H-share firms that switched from a Hong lower these firms’ cost of capital, raise corporate valuations Kong to a mainland auditor experienced an approximate 20% through both improved cash flows and lower risk premiums, reduction in audit fees. The question raised by Professor Chen and, ultimately, improve the functioning of China’s capital is whether this reduction reflects reduced audit work by the markets as a resource allocation mechanism.
12. “Document 56,” issued in 2009.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 59 Gul, F., Kim, J., Qiu, A., “Ownership concentration, Joseph Piotroski is an Associate Professor of Accounting at Stan- foreign shareholdings, audit quality and stock price synchron- ford University’s Graduate School of Business, and was the inaugural icity: Evidence from China,” Journal of Financial Economics 95 Center for Global Business and the Economy Research Fellow. Prior to (3) (2010), 425-442. arriving at Stanford in 2007, he spent eight years as an Assistant and He, X., Wong, T.J., Young, D., “Challenges for implemen- Associate Professor of Accounting at the University of Chicago’s Gradu- tation of fair value accounting in Emerging Markets: Evidence ate School of Business. from China,” Contemporary Accounting Research 29 (2) (2012), Professor Piotroski’s research focuses on the economic impact of 538-562. different financial reporting and governance practices around the world, Hung, M., Wong, T.J., Zhang, F., “The value of political and on how capital market participants use financial accounting infor- ties and market credibility: Evidence from corporate scandals mation for valuation and investment purposes. His recent work focuses in China,” Working paper, University of Southern California, on the influence of legal, regulatory, and political forces on transparency, 2013. corporate governance, and the efficiency of equity markets in interna- Jian, M., Wong, T.J., “Propping and Tunneling through tional settings, most notably in the context of China. Professor Piotroski Related Party Transactions,” Review of Accounting Studies 15, is well known in the investment community for his influential research 70-105 (2010). paper “Value Investing: The Use of Historical Financial Statement Infor- Jiang, G., Lee, C.M.C., Yue, H., “Tunneling in China: The mation to Separate Winners from Losers,” which was published while he surprisingly pervasive use of corporate loans to extract funds was a faculty member at the University of Chicago. This research has from Chinese listed companies,” Journal of Financial Economics been featured in numerous popular press publications, such as Forbes, 98 (1) (2010), 1-20. Fortune, Business Week, Smart Money, Investors Business Daily, and Jin, L., Myers, S., “R2 around the world: New theory and Business Today (India), and is implemented on many individual investor- new tests,” Journal of Financial Economics 79, (2006), 257-292. oriented websites, such as the AAII, Seeking Alpha, and Portfolio 123. Lee, E., Walker, M., Zeng, C., “Does IFRS convergence affect financial reporting quality in China?,” The Association of Chartered Certified Accountants, Research Report 131, 2013. References Lin, K., Piotroski, J., Yang, G.Y., Tan, J., “Voice or exit: Aharony, J., Lee, J., Wong, T.J., “Financial packaging of Independent director decisions in an emerging economy,” IPO firms in China,”Journal of Accounting Research 38 (1) Working paper, Stanford University, 2013. (2000), 103-126. Ke, B., Lennox, C., Xin, Q., “The effect of weak institu- Ball, R., Robin, A., Wu, J., “Accounting standards, the insti- tional environments on the quality of Big Four audits,” Working tutional environment and issuer incentives: Effect of timely loss paper, Nanyang Business School, 2014. recognition in China,” Asia-Pacific Journal of Accounting and Ma, J., Khanna, T., “Independent directors’ dissent on Economics, 2001 boards: Evidence from listed companies in China,” Working Chen, J., Ke, B., Wu, D., Yang, Z. “IPO offer price regula- paper, Harvard Business School, 2013. tion, financial reporting quality, and IPO overpricing,” Working Morck, R., Yeung, B., Yu, W., “The information content paper, Nanyang Business School, 2014. of stock markets: Why do emerging markets have synchronous Chen, K., Yuan, H., “Earnings management and capital stock price movements?,” Journal of Financial Economics 58, resource allocation: Evidence from China’s accounting-based (2000) 215-260. regulation of rights issues,” The Accounting Review 79 (3) Piotroski, J., Wong, T.J., “Institutions and the Informa- (2004), 645-665. tion Environment of Chinese Listed Firms,” in Joseph Fan and DeFond, M., Gao, X., Li, O., Xia, J., “Did China’s adoption Randall Morck, eds., Capitalizing China (University of Chicago of IFRS attract more foreign institutional investors,” Working Press, 2012). paper, University of Southern California, 2014. Piotroski, J., Wong, T.J., Zhang, T., “Political incentives to DeFond, M., Wong, T.J., Li, S. “The impact of improved suppress negative information: Evidence from Chinese listed auditor independence on auditor market concentration in firms,” Working paper, Stanford University, 2014. China,” Journal of Accounting and Economics 28 (2000), Shleifer, A., Vishny, R., “A Survey of Corporate Gover- 269-305. nance,” Quarterly Journal of Economics 109 (1997), 995-1025. Du, F., “Political connections and access to bond capital: Wang, Q., Wong, T.J., Xia, L., “State ownership, institu- Reputation or collusion?,” Dissertation, University of Southern tional environment, and auditor choice: Evidence from China,” California, 2012. Journal of Accounting and Economics 46 (1) (2008), 112-134. Fan, J., Wong, T.J., “Do external auditors perform a corpo- Yang, Z.. “Do political connections add value to audit rate governance role in emerging markets? Evidence from East firms? Evidence from IPO audits in China,” Contemporary Asia,” Journal of Accounting Research 43 (1) (2005), 35-72. Accounting Research 30 (3) (2013), 891-921.
60 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Son of Enron: Investors Weigh the Risks of Chinese Variable Interest Entities by Paul Gillis, Peking University, and Michelle René Lowry, University of Hong Kong
hinese companies are once again the darlings of Chinese regulations control foreign investment in certain Wall Street. Over 200 Chinese companies have industries through their classification of all industries into listed on U.S. stock exchanges. New listings of one of three foreign investment categories: encouraged;4 BC 5 6 Chinese companies slowed to a trickle in 2011 restricted; and prohibited. Many of the sectors of greatest after a parade of accounting scandals chilled investor interest. interest to foreign investors, including e-commerce and educa- But Chinese IPOs are back, with Alibaba currently planning tion, fall within the restricted category and require permission an autumn IPO that may raise $20 billion and rank as the that is difficult, if not impossible, to obtain. The restrictions largest technology listing in history. on foreign investment create an obstacle for private compa- Chinese IPOs often use an unusual corporate structure nies seeking foreign capital. Those operating in restricted or called a variable interest entity (VIE) that has enabled compa- prohibited sectors cannot accept foreign investment without nies to circumvent Chinese restrictions on foreign investment. permission that is widely perceived to be unobtainable. But as foreign investors have learned the hard way, such VIEs Four reasons have been advanced as to why Chinese create significant risks. The Alibaba offering makes use of the enterprises may want to be “packaged” as foreign investments: VIE structure, and has focused the investment community (1) to obtain preferential tax status;7 (2) to avoid the burden- on the unusual risks it creates.1 some registration and approval of a foreign invested firm each VIEs involve control of companies through contracts time there are changes in ownership, capital, or articles of instead of through ownership. And because the VIE structure incorporation; (3) to ease the way to overseas listing; and (4) introduces significant risk for investors, the recent resurgence to allow for Facebook style dual-share class structures, thereby in Chinese IPOs has heightened investor concern about the allowing founders to remain in control of companies with viability of the structure. The New York Times reports that lower stockholdings.8 some have called the VIE structure “bigger than Enron” and Beyond foreign investment restrictions in particular indus- “a bit of a Ponzi scheme.”2 An American lawyer specializing tries, all foreign investment is explicitly controlled through in China called the VIE structure “one of the greatest invest- a PRC approval process that, while purportedly ensuring ment frauds ever perpetrated in the U.S. market.”3 adherence to the foreign investment regulations, implicitly But such bad press notwithstanding, Chinese compa- discourages foreign investment because of its arduous and time- nies have flocked to U.S. capital markets over the last 20 consuming nature.9 For example, while foreign investment is years, resulting in NASDAQ and the New York Stock technically allowed in the telecommunication industry—where Exchange becoming the most important markets for it is restricted to 50 percent equity ownership—the reality is privately owned Chinese companies. These companies have that licenses to foreign invested corporations are almost never been attracted to U.S. markets by their liquidity, the greater granted. While privately held Chinese companies are permitted expertise of U.S. investors with technology companies, and to operate in restricted industries, without foreign capital they the ability of issuers to use dual-share classes to ensure typically cannot compete, leaving the market to large state- founder control. owned enterprises.10
1. Steven Davidoff Solomon, “Alibaba Investors Will Buy a Risky Corporate Structure,” 6. Examples of prohibited industries are tea manufacturing, weapons manufacturing, The New York Times, July 21 2014. news agencies, and compulsory education. Ibid. 2. Sue-Lin Wong, “China Court Ruling Could Threaten Foreign Investments in Coun- 7. Prior to reforms effective January 1, 2008, foreign invested enterprises were taxed try,” ibid., June 17 2013. at a lower rate than domestic enterprises. 3. Joy Shaw and Lisa Chow, “China Vie Structure May Hold Hidden Risks,” Financial 8. Wei Shen, “Deconstructing the Myth of Alipay Drama—Repoliticizing Foreign In- Times, November 11 2011. vestment in the Telecommunications Sector in China,” Telecommunications Policy 36, 4. Examples of encouraged industries include electronic equipment manufacturing, no. 10 (2012). automobile manufacturing, and pharmaceuticals. Some investments in encouraged in- 9. David Schindelheim, “Variable Interest Entity Structures in the People’s Republic of dustries require joint ventures with a Chinese partner. See PRC [MOFCOM] Ministry of China: Is Uncertainty for Foreign Investors Part of China’s Economic Development Commerce, “Catalogue for the Guidance of Foreign Investment Industries (Amended in Plan?,” Cardozo Journal of International and Comparative Law 21, no. 1 (2012). 2011),” (Beijing: Ministry of Commerce, PRC, 2012). 10. U.S. Department of State, “2014 Investment Climate Statement - China,” (Wash- 5. Examples of restricted industries are mining for precious metals, real estate, bank- ington D.C.: Bureau of Economic and Business Affairs, 2014). ing, retail, e-commerce and education. Ibid.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 61 Creative Compliance Figure 1 Structure of a Variable Interest Entity The VIE is a solution that allows foreign investment to circumvent China’s foreign investment restrictions. VIE structures (detailed in the next section) are designed such that Chinese regulators will view the operations of the company Public as owned by Chinese investors, while foreign investors will view them as effectively owned by a foreign corporation in which they may purchase shares. Use of the VIE structure satisfies the regulators’ requirement that operations that are Cayman Islands restricted from foreign ownership are held in Chinese corpo- rations owned by Chinese individuals. But once established as domestically controlled entities, VIEs can then obtain the necessary licenses and permits to operate in sectors restricted Hong Kong Chinese Owner or prohibited to foreign investment, and the VIE structures enable foreign investors to own an interest in companies oper- ating in restricted sectors, provided they trust the structure to Contracts replicate most of the payoffs from direct ownership. WFOE However, for the VIE structure to work to attract foreign VIE capital, it needs to meet two objectives. First, as already suggested, the VIE must offer a credible promise to foreign Service Fees investors of providing the same economic benefits as direct ownership. Second, the VIE operations must be consolidated into the financial statements of the entity in which foreign Source: Paul Gillis investors hold shares. The importance of accounting consoli- dation is that, by presenting the VIE structure as a single In reaction to the Enron debacle, the FASB in 2003 operating entity, it obscures the reality that significant parts released a principles-based approach to the consolidation of the business may not be owned. of SPEs.12 Under the new standards that came out of this The first objective is addressed by entering into a series of approach, many SPEs that were previously unconsolidated contracts that place the VIE under the control of the public due to the lack of majority ownership are now categorized as entity and provide a mechanism for transferring profits from variable interest entities and consolidated. The rules require the VIE to the public entity—and, by so doing, replicating the consolidation of a VIE into the accounts of the “primary the benefits of direct ownership. beneficiary” of the VIE provided the following two condi- The main effect of the accounting consolidation of VIEs tions are met: is to reinforce foreign investors’ perception that they have • The primary beneficiary has the power to direct the some control over their investment when a VIE is consoli- activities of a VIE that most significantly impact the entity’s dated. Ironically enough, the consolidation of VIE structures economic performance. has been made possible by the innovative application of the • The primary beneficiary has an obligation to absorb accounting standard that was created to stop perceived abuses losses of the entity that could potentially be significant to the of off-balance sheet debt like Enron’s. When the company VIE or the right to receive benefits from the entity that could collapsed in 2001 under allegations of accounting impropri- potentially be significant to the VIE (emphasis added). 13 eties, Enron, like many other corporations, had placed debt into special purpose entities (SPEs) in which it held no owner- Typical VIE Structure ship interest. In Enron’s case, Andy Fastow, Enron’s treasurer, A VIE structure essentially divides a company into a owned many of these SPEs. And because Enron owned no segment that is restricted from having foreign ownership shares in the SPEs, accounting standards at the time did not and a segment that is permitted to have foreign invest- require the entities, and their debt, to be consolidated into ment. As illustrated in Figure 1, the typical VIE structure Enron’s financial statements, even though Enron indirectly places the “restricted” segment into the VIE, while the controlled the entities and was at risk for their performance.11 segment permitted for foreign investment is placed in a
11. See Al L. Hartgraves and George J. Benston, “The Evolving Accounting Standards 12. In the form of FIN 46, which was revised and reissued later that year as FIN 46R. for Special Purpose Entities and Consolidations,” Accounting Horizons 16, no. 3 (2002) FIN 46R was revised again in 2009 by Statement of Financial Accounting Standards for a discussion of consolidation rules of SPEs pre-FIN 46R. Also, the pre-FIN 46R rule- (SFAS) 167 and codified as Topic 810. based approach is nicely summarized in Christopher W. Nobes, “Rules-Based Standards 13. ASC 810-10-05-8A and the Lack of Principles in Accounting,” ibid.19, no. 1 (2005).
62 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Chinese subsidiary of a public company that is known as Technical Service Agreement a “wholly foreign owned enterprise,” or WFOE. Foreign Foreign parties access the residual profits of VIEs through tech- investors acquire shares in an offshore holding company, nical service agreements. Technical service agreements typically usually domiciled in the Cayman Islands, which then owns allow for the WFOE to provide services to the VIE that include the WFOE.14 Because the WFOE is owned by foreigners, website maintenance, sales service, training, and administrative it is not allowed to directly operate in restricted indus- support. The WFOE may also license intellectual property such tries. According to the legal fiction that surrounds VIEs, as patents, trademarks, and software to the VIE. In general, restricted operations are conducted in the VIE, and the the WFOE is permitted to set the fees for the services unilat- WFOE obtains control over the VIE through contractual erally in an amount equal to the net income of the VIE. This agreements rather than through equity ownership. allows profits to be transferred from the VIE to the WFOE.
Conventional VIE Contractual Agreements Risks Associated with Chinese VIEs Control of a VIE is generated through a series of contractual But as we noted at the outset, the foreign investors in compa- agreements that attempt to replicate the benefits of equity nies that use the VIE structure face serious risks, which we ownership. The most common mélange of contracts includes classify into three categories: regulatory risks, agency risks, the following: a loan agreement; an equity pledge agreement; and operational risks. We will discuss investors’ exposure to a call option agreement; a power of attorney agreement; and each of these risks and present illustrative examples where a technical service agreement. investors have been burned by investing in a VIE group.
Loan Agreement Regulatory Risks The loan agreement and the equity pledge agreement provide As we also noted earlier, the main purpose of the VIE struc- capital for the VIE and transfer control to the WFOE. In a ture is to circumvent Chinese regulations that restrict foreign typical loan agreement, the WFOE provides the VIE share- ownership in certain sectors. A circular issued in 2009 by the holder with an RMB-denominated, long-term interest-free Ministry of Industry and Information Technology prohib- loan that is used to capitalize the VIE. As part of the loan ited the use of the VIE structure by companies in the online agreement, the Chinese VIE shareholder typically assigns gaming industry, but this has not stopped the use of VIEs voting rights, dividends rights, and managerial rights to the by companies in this sector, which have argued that the rules WFOE, effectively transferring control of the VIE to foreign are unclear and have been thus far unenforced.15 Because investors through the WFOE. most of China’s gaming and internet sectors are held in VIE structures, regulators may be reluctant to challenge the VIE Equity Pledge Agreement structure directly because of the potential for undesirable The Chinese owners of the VIE owner typically pledge widespread disruption. Chinese regulators clearly know that their equity in the VIE as a form of collateral for the loan the VIE structure is widely used. And in fact the ambiguity of agreement, but the pledge may also be triggered upon nonper- the situation may even serve their interests: Just the threat of formance of the other agreements. The equity pledge is a being shut down for circumventing foreign ownership restric- security interest and may not be legally enforceable if the tions could coerce managers into submitting to government pledge has not been recorded. demands for censorship. The U.S. Securities and Exchange Commission (SEC) has Purchase Option Agreement been actively examining VIE arrangements as a component The purchase option agreement allows the WFOE to purchase part of the comment letter process where the SEC conducts the VIE at a preset price, often the amount of the interest-free desk reviews of corporate filings.16 The SEC’s aim appears to loan to the VIE shareholder. be to enhance corporate disclosures of the risks associated with the VIE structure. To date, none of the SEC examina- Power of Attorney tions of the VIE structure has led to deconsolidation of a VIE. The shareholders of the VIE assign their shareholder rights to the WFOE in a power of attorney agreement, including the Agency Risks right to vote at shareholder meetings and to implement the The greatest risk to VIE arrangements, however, has been the call option if exercised. possibility that the owner of the VIE will simply disregard the
14. Corporate structures can be more complex, often including intermediary holding 16. E.g., multiple SEC comment letters to New Oriental Education & Technology companies in Hong Kong in an attempt to secure lower withholding taxes on dividends. Group Inc., from May 2009 to through early 2013, wherein requests for more detailed 15. Shen, “Deconstructing the Myth of Alipay Drama—Repoliticizing Foreign Invest- disclosures regarding the VIE structure were emphasized (https://www.sec.gov/cgi-bin/ ment in the Telecommunications Sector in China.” browse-edgar?action=getcompany&CIK=0001372920&type=upload&dateb= &owner=exclude&count=40).
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 63 VIE contracts and appropriate the profits and assets of the VIE. Alibaba founder, and VIE agreements were put in place. Each of the three examples outlined below involve the risk Sometime in 2010, however, the VIE agreements appear to of owner-managers ignoring the contractual agreements with have been terminated, and Alipay was no longer included foreign investors, and thereby taking control of the VIE. Such in the consolidated financial statements of Alibaba. Yahoo!, potential agency conflicts between the Chinese national owners which owned 40% of Alibaba Group, discovered this in early and the foreign investors are more serious than in traditional 2011 and protested. Yahoo!, the Alibaba Group, and Jack owner-manager relationships. First, legal protections for foreign Ma reached a settlement to give the Alibaba Group 49% of investors are relatively weak in China, making the contrac- the profits of Alipay until a monetization event, at which tual agreements difficult to enforce for institutional reasons. time Alibaba Group would receive between $2 billion and Second, the contracts may be deemed unenforceable if brought $6 billion of any proceeds.21 This agreement was modified in to a PRC court because they violate the spirit of Chinese laws. 2014 in preparation for the IPO of Alibaba.22 Companies can and do mitigate the risk of the VIE’s Challenges in Enforcing VIE Agreements owner abrogating the VIE contracts by maximizing business The VIE structure rests on the enforceability of the contractual activities in the WFOE and minimizing the business arrangements, and that has proved to be a shaky foundation. conducted in the VIE. When critical components of the China is a civil law jurisdiction, but it has borrowed a concept business are conducted in the WFOE, the VIE’s owner from common law that says that contracts that conceal illegal cannot seize the business and operate it independently. All intentions in a legal form are unenforceable.17 of the Alipay business was in the VIE, which enabled Jack In several cases, investors have incurred significant losses Ma to take it out of the group and operate it independently. when VIE owners failed to respect the contracts that estab- Alibaba appears to have structured its pending IPO to lish control over the VIE. For example, a dispute between respond to this concern. The VIEs in the Alibaba Group the management of Chinachem and its foreign investors IPO hold only 17% of the consolidated assets of the Alibaba turned into a legal case that made it all the way to China’s Group.23 Supreme Court, which decided that VIE-like contracts were unenforceable because they concealed an illegal intention Operational issues (foreign ownership) in a legal form.18 Defenders of the VIE Beyond the highly visible regulatory and agency risks, VIE structure have argued that Chinachem’s contractual arrange- groups also have operation risks that can make the VIE struc- ments were different than those used in most VIEs.19 But this ture less effective. Two related issues involve foreign exchange cannot be said of Gigamedia, whose case was decided by a controls and tax issues. Shanghai arbiter who reached the same conclusion about a VIE with a conventional structure.20 Foreign exchange controls China controls conversions of the Yuan to and from foreign The Cautionary Tale of Alipay currency, which makes it difficult for companies using the Chinese e-commerce conglomerate Alibaba Group was at the VIE structure to transfer funds into or out of the VIE. Capi- center of a VIE scandal that caused great concern among tal is typically raised in the offshore holding company and investors. Alipay, which is often considered to be the Chinese then transferred to the WFOE if needed in China. Recent equivalent of PayPal, was a wholly owned Chinese subsidiary rules prohibit the WFOE from contributing cash from capital of the Cayman Islands-incorporated Alibaba Group. In 2009, infusions to a VIE or from making loans to a VIE.24 Chinese regulators began a process of requiring third-party And once the cash is in the VIE, it is difficult to get it payment processors to register and to subject themselves to back out. Because the VIE is owned by a Chinese individual, regulation. Concern about whether the government would any dividends must be paid in Yuan to that individual. VIE register a foreign-controlled company led Alibaba to put contracts typically require the individual VIE owner to turn Alipay into a VIE arrangement. The shares in Alipay were over any dividends to the WFOE, but that results in a high transferred to an entity controlled by Jack Ma and another level of taxation since the WFOE will be taxed on receipt.
17. PRC, “Contract Law of the People’s Republic of China,” ed. Ninth National Peo- 21. Yahoo! was notified of the Alipay VIE unwinding on March 31, 2011, and the ple’s Congress (China.org.cn, 1999). Article 52. settlement by related parties was signed on July 29, 2011. Mark Lee, “Alibaba Says 18. Neil Gough, “In China, Concern About a Chill on Foreign Investments,” The New Alipay Move Was ‘Lawful’ after Yahoo Says It Was Blindsided,” Bloomberg May 14, York Times, June 2, 2013. 2011; Wang Shanshan, “Alibaba Reaches Settlement with Yahoo, Softbank,” Caixin 19. Chinachem’s form is an incipient form of VIE. See Charles Comey et al., “China Online (2011), http://english.caixin.com/2011-08-01/100286251.html. Yahoo!’s stock Vies: Recent Developments and Observations,” Client Alert (2013), http://media.mofo. price dropped from $16.68 to $13.10 during that time. com/files/Uploads/Images/130716-Variable-Interest-Entities-China.pdf for a description 22. Telis Demos, Rolfe Winkler, and Juro Osawa, “Alibaba Restructures Agreements of how Chinachem’s contractual arrangements differ from typical VIE arrangements and with Alipay,” The Wall Street Journal, August 12, 2014. for argument of why VIE risks may not change despite the Supreme Court ruling against 23. Alibaba Group Holding Limited, “Amendment No. 4 to Form F-1 Registration Chinachem. It should be noted that the underlying premise of the ruling—disallowing Statement under the Securities Act of 1933,” (2014), https://www.sec.gov/Archives/ legal forms that facilitate illegal substance—may be applied to VIEs. edgar/data/1577552/000119312514306647/d709111df1a.htm#toc709111_30. 20. Ibid. 24. SAFE Circulars 45 and 142.
64 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Tax Issues to foreign investment because of the concern over foreigners The VIE structure can also cause additional tax-related prob- influencing society. And Chinese regulators may even favor the lems. The VIE structure contemplates taking profits out ambiguity of the VIE structure, since the potential for shutting through service charges or royalties. In practice, however, the structures down gives them great leverage over the manage- many VIEs do not distribute their profits to the WFOE ment of these companies. The greatest risk to foreign investors through services charges. In some situations, the cash is in VIE structures is social instability in China, which could needed to be kept as working capital in the VIE. Tax concerns lead the government to seize control of sensitive companies. also encourage companies to retain profits in the VIE. The headline risk that investors have focused on is that China formerly charged a 5% business tax on the gross the VIE owner, who is typically the founder of the company, amount of the service charge, which discouraged many may unilaterally abrogate the VIE contracts and take the companies from taking out profits through service charges. VIE. China has an underdeveloped legal system, and basing The business tax has been replaced by a valued added tax, a structure on contracts of dubious enforceability is especially meaning that the VIE may be able to use the input VAT risky. Most of China’s entrepreneurs are still young, and on the service charges as a credit against their output VAT, investors have yet to face the untimely death or scandalous resulting in no overall increase in its tax burden. activity of a VIE owner that will test the ability of the public The other tax concern with VIEs is that the tax authori- company to replace him or her. ties may challenge service charges that are unilaterally set by The difficulty and expense of extracting profits from the the WFOE in amounts up to the net income of the company VIE illustrates the growing contradictions of the structure. as not representing an arms-length price. The resulting trans- As companies using the VIE structure mature, the trapping fer pricing adjustment could significantly increase the tax of profits and cash within the VIE will undermine the use of liability of the group. and prices produced by valuation models that assume that the Because of the uncertain and adverse tax consequences cash will be ultimately returned to shareholders. of taking profits out of the VIE through service contracts, The best hope for investors in VIE structures is reform many VIEs choose to accumulate profits in the VIE. This that makes the structure obsolete. Fortunately, that may is at odds with the interests of public shareholders, since it be coming. In the Third Plenum meeting of the Chinese deprives them of a cash return on their investment, and casts Communist Party, reforms to the rules for foreign invest- doubt on the appropriateness of Chinese VIE consolidation. ment in e-commerce and education were promised. These A few companies have provided deferred taxes for the are the sectors where most VIE structures are deployed, and potential tax costs of getting money out of the VIE to the relaxed rules enabling foreign investment could possibly make WFOE.25 The amount of deferred tax appears to be calculated the VIE structure unnecessary. That would be an excellent based on an assumption that the cash would be paid as a outcome for investors in Chinese stocks. dividend to the individual shareholder, who would pay a 20% individual tax, and then be donated to the WFOE, which would pay a further 25% corporate income tax. Most compa- Paul Gillis is Professor of Practice at the Guanghua School of Manage- nies have not taken this approach and provide no deferred ment at Peking University. A leading expert on accounting and auditing tax for the potential costs of extracting profits from the VIE. issues in China, he is the creator of the “China Accounting Blog” and was named “Market Reformer of the Year” by the International Financial Law Summary Review. Before joining Peking University, he was a partner of Pricewa- The VIE structure has enabled foreign investment into several terhouse Coopers in the United States, Singapore, and China. He was a of China’s high growth sectors. It is likely China owes its member of the Public Company Accounting Oversight Board from 2011 impressive success in the internet sector to access to foreign to 2013, and was formerly a director of Nasdaq-listed Pansoft Co. Ltd. capital that the VIE structure made possible. He has lived in Beijing since 1997. But are investors taking unacceptable risks when invest- ing in companies using the VIE structure? The structure Michelle René Lowry, CPA is a PhD student of Accountancy at the rests on the faith that China will not strictly enforce rules University of Hong Kong Business School, where she holds a Hong Kong against foreign investment in sensitive sectors. So far, Chinese Ph.D. Fellowship. Before reentering academia, she was a tax manager regulators have not taken widespread action against the VIE at a regional CPA firm, Hawkins, Cloward & Simister, LC in Provo, Utah. structure, leading many investors to conclude that the struc- Her research focuses on U.S. listed Chinese firms and corporate gover- tures have tacit approval. Sectors where the VIE structure is nance. She has lived in Hong Kong since 2011. widely used, including education and internet, are restricted
25. See Paul L. Gillis, “Deferred Taxes and Vies Revisited,” ed. Paul Gillis, China Accounting Blog (2014), http://www.chinaaccountingblog.com/weblog/deferred-taxes- and-vies-2.html for a discussion of VIE deferred tax liabilities and example firms.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 65 References Schindelheim, David. “Variable Interest Entity Struc- Alibaba Group Holding Limited. “Amendment No. 4 tures in the People’s Republic of China: Is Uncertainty for to Form F-1 Registration Statement under the Securi- Foreign Investors Part of China’s Economic Development ties Act of 1933.” (2014). https://www.sec.gov/Archives/ Plan?” Cardozo Journal of International and Comparative Law edgar/data/1577552/000119312514306647/d709111df1a. 21, no. 1 (2012). htm#toc709111_ 30. Shanshan, Wang. “Alibaba Reaches Settlement with Comey, Charles, Paul McKenzie, Sherry Yin, and Yahoo, Softbank.” Caixin Online (2011). Published Michelle Yuan. “China VIEs: Recent Developments and electronically 8-1-2011. http://english.caixin.com/2011-08- Observations.” Client Alert (2013). Published electroni- 01/100286251.html. cally August 15, 2013. http://media.mofo.com/files/Uploads/ Shaw, Joy, and Lisa Chow. “China VIE Structure May Images/130716-Variable-Interest-Entities-China.pdf. Hold Hidden Risks.” Financial Times, November 11, 2011. Demos, Telis, Rolfe Winkler, and Juro Osawa. “Alibaba Shen, Wei. “Deconstructing the Myth of Alipay Restructures Agreements with Alipay.” The Wall Street Drama—Repoliticizing Foreign Investment in the Telecom- Journal, August 12, 2014. munications Sector in China.” Telecommunications Policy 36, Financial Accounting Standards Board [FASB]. “Consoli- no. 10 (2012): 929-42. dations (Topic 810).” Norwalk, CT: Financial Accounting Solomon, Steven Davidoff. “Alibaba Investors Will Buy Foundation, 2009. a Risky Corporate Structure.” The New York Times, July 21 Gillis, Paul L. “Deferred Taxes and VIEs Revisited.” 2014. China Accounting Blog (2014). Published electronically March State Administration of Foreign Exchange [SAFE]. 7. http://www.chinaaccountingblog.com/weblog/deferred-taxes- “Circular on the Relevant Operating Issues Concerning and-vies-2.html. Administration Improvement of Payment and Settlement Gough, Neil. “In China, Concern About a Chill on of Foreign Currency Capital of Foreign-Invested Enterprises Foreign Investments.” The New York Times, June 2, 2013. [Circular 45].” In Circular 45. Beijing, 2011. Hartgraves, Al L., and George J. Benston. “The Evolv- “Circular on the Relevant Operational Issues Concerning ing Accounting Standards for Special Purpose Entities and the Improvement of the Administration of the Payment and Consolidations.” Accounting Horizons 16, no. 3 (Sep 2002 Settlement of Foreign Currency Capital of Foreign Invested 2002): 245-58. Enterprises [Circular 142].” In Circular 142. Beijing, 2008. Lee, Mark. “Alibaba Says Alipay Move Was ‘Lawful’ after U.S. Department of State. “2014 Investment Climate Yahoo Says It Was Blindsided.” Bloomberg May 14, 2011. Statement - China.” Washington D.C.: Bureau of Economic Ministry of Commerce, PRC [MOFCOM]. “Catalogue and Business Affairs, 2014. for the Guidance of Foreign Investment Industries (Amended Wong, Sue-Lin. “China Court Ruling Could Threaten in 2011).” Beijing: Ministry of Commerce, PRC, 2012. Foreign Investments in Country.” The New York Times, June Nobes, Christopher W. “Rules-Based Standards and the 17, 2013. Lack of Principles in Accounting.” Accounting Horizons 19, no. 1 (2005): 25-34. PRC. “Contract Law of the People’s Republic of China.” edited by Ninth National People’s Congress: China.org.cn, 1999.
66 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 The State of Asian Corporate Governance: A Presentation by Jamie Allen CARE Conference | Hong Kong Polytechnic University | June 9, 2014
A Presentation by Jamie Allen, Secretary General of the Asian Corporate Governance Association of Hong Kong
ood afternoon, I’m Jamie Allen of the Asian companies in Taiwan. Taiwan is interesting because it chose to Corporate Governance Association of Hong “phase in” requirements for independent directors over time, GB Kong. The organizers of this conference have starting with IPOs around a decade ago and then moving asked me to speak about the state of corporate on to the larger issuers, later medium-sized issuers, and now governance in Asia—and I’m going to do this in very broad all listed firms. Most other parts of the region introduced terms. I want to start with a little bit of regulatory context, them quickly, and for all listed firms at once. Similarly audit a bit of history, and then take a look at both convergence committees have long been required in all markets except and divergence in Asian corporate governance. I will close Japan and Taiwan (although Taiwan has also been phasing by looking at recent reforms in the different Asian markets them in and recently announced they would be mandatory for that we cover. a much larger group of issuers). Japan argues that its Kansay- The Asian Corporate Governance Association, or the aku Board (or “corporate auditor”) system is similar to the “ACGA” as we refer to it, is an independent not-for-profit audit committee model, but we would strongly disagree. organization that tracks corporate governance in 11 markets If you look at indicators of board independence and around the region. We do advocacy work, and we speak with financial reporting requirements throughout Asia, you will regulators, companies, and investors when putting together see convergence around many basic standards in the region. the rankings that we do on corporate governance in these But when you look a little deeper, you also see significant markets. Toward the end I will talk a bit about these rankings, differences. In some countries, company law has a very and then close by focusing on Chinese governance. 19th-century colonial feel about it. And that’s because when If you had looked at board independence in Asia around those countries were developing company law, they looked the time of the Asian financial crisis in the late 1990s, you to their colonial masters for guidance. That has led, most would have seen that there were no codes of best practice on obviously, to differences in board structure. For example, corporate governance (except for a very small one in Hong Chinese companies have two boards, a Board of Directors Kong), nor were independent directors or audit committees and a Supervisory Board. Additionally, there is a Communist on the agenda. But since the Asian financial crisis, there Party Committee, and we’ll talk more about that later. has been a considerable amount of reform. Development of It is useful to think of corporate governance reform in corporate governance codes has taken place in all the markets Asia as proceeding on two tracks. On one track, international we cover, with the single exception of Japan—and Japan has rules are dominant and common accounting and financial promised to produce a code by the second quarter of next reporting standards are essentially accepted as necessary for year. Japan has been the clear outlier in this region in terms trade and investment. On the second track, which takes of developing consensus codes of corporate governance. the behavior of companies into account, you see that local China’s first code was produced in 2002—and it’s impor- cultural norms strongly influence the functioning of the tant to keep in mind that such codes are not laws, but rather boards, the quality of dialogue with shareholders, and the way voluntary models of best practice in terms of board indepen- they manage related party transactions and capital raising. dence and accountability. The China Securities Regulatory And you will see significant differences here among Asian Commission (CRSC) is considering a revision of the 2002 countries. This is where legacy issues and culture, and not code, but it hasn’t come out yet. Hong Kong had a very international standards, are the main driving force behind simple code in 1993, revised it substantially in 2004, and governance. So, while convergence is occurring in certain then revised it again in 2012. In other markets, Indonesia is aspects of governance, it will remain limited, particularly in thinking of revising its code and so is Korea. the functioning of boards and internal governance. So Japan—and it’s true of Taiwan too—has been an outlier in some important ways. Although independent direc- A Brief Look at Asian Governance Reform tors are required in all other markets, they are still optional in Asia has broadly seen four waves of reform in the last two Japan and were only recently made mandatory for all listed decades. The first wave came after the Asian financial crisis in
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 67 1997-98; the second wave came in the mid-2000s; the third these bodies are gradually raising standards of quality control came after the 2007-2009 international crisis; and we’re now in CPA firms and improving the way in which audits are done. in the midst of the latest reforms. So reform tends to go in Investors of course want transparent and detailed cycles and to follow crises. financial reporting, but they also want non-financial report- We have heard that China is developing a new corporate ing—which means that they are looking for reporting on governance code, but it is not clear when it will come out, sustainability, on corporate governance, boards of directors whether this year or the next. What is clear is that the new and so on. Investors are also seeking clarity on related party China Banking Regulatory Commission (CBRC) guide- transactions (RPT). Investors aren’t saying RPTs shouldn’t lines on corporate governance raise the bar significantly for happen and they’re not saying private placement shouldn’t banks by laying down quite specific rules on the roles and happen; what they’re saying is that they want a fair system responsibilities of independent directors (for example, they where their interests are reasonably well protected. are required to spend a minimum of 15 working days physi- Investors also regard transparent shareholder meetings, cally at the banks each year) and on the functioning of board including voting by poll, as important. You may think that committees. shareholder meetings around Asia are all run transparently, In the meantime, Hong Kong’s main priorities have been and with accountability. But this was true only of Hong Kong strengthening standards on the quality of IPO due diligence as recently as eight years ago. Now, more than half the region carried out by investment banks, enhancing disclosure of has transparent shareholder meetings where votes are properly price-sensitive information through a new law that took effect counted and the results publicly disclosed. Some countries in January 2013 and defining the proper role for audit regula- are still challenged, however. In Indonesia, for example, you tion. The government launched a consultation paper on audit don’t get the names of the directors and the commissioners regulation in mid-2014 and is seeking to shift responsibility nominated for election before the meeting. How can one vote from the local accounting industry association to an indepen- if you don’t know who you are voting for?! You also get little dent regulatory body. detail on other agenda items, while trying to ask companies India’s landmark New Companies Act 2013 is in some for more information is a struggle. ways the most radical of its kind in Asia. It mandates CSR In some parts of the region, including Singapore, voting spending and, probably even more unexpectedly, mandates is still by a show of hands rather than by poll, which involves women on boards. all proxy votes as well as those people actually at the AGM. Indonesia has a new regulator, the OJK, which is a single Many listed companies in Singapore, both large and small, regulator for banking, insurance, and securities. It also have now adopted poll voting on a voluntary basis, and it published a major new policy document, the CG Roadmap, will be mandatory from August 2015. Thanks in large part in February 2014. Compiled with the assistance of the World to David Webb’s work in Hong Kong, as well as changes in Bank and IFC, the roadmap is an ambitious and impres- listing rules, voting by poll has been the norm in Hong Kong sive plan to move CG standards towards international best for a long time (and became mandatory in 2009). practices, focusing on the CG framework, protection of Succession planning is high on the agenda for a lot of shareholders, and the roles of stakeholders, boards of commis- companies, particularly family companies where the patri- sioners and directors. What is especially interesting about the arch is retiring. If you follow Korea, you may know that Lee document is its candor in laying out Indonesia’s strengths and Kun-hee, the de facto chairman of Samsung, had a heart attack weaknesses in CG. a couple of weeks ago. What this highlights is that succession In the case of Japan, by contrast, there’s no consensus on planning processes may need to be brought forward in some what “corporate governance” actually means. The Keidan- Asian companies faster than the market expects. ren, which is the Japanese equivalent of the U.S. Business The more sophisticated companies are also thinking more Roundtable, has lobbied hard against common standards on about board diversity, board composition, and how they corporate governance. They’ve been successful in the past evaluate their boards. Many companies are strengthening in blocking efforts to create a consensus around corporate their accounting and internal control systems. This is being governance, but now the tide is turning and the Abe govern- driven partly by shareholders, and partly by regulators; but ment is trying to mandate independent directors and a code it also reflects management’s growing understanding that if of corporate governance. you have a decent internal ERP system, you’re going to get much better management information, and more quickly. Reporting and Other Issues A lot of companies still look at corporate social responsi- One corporate governance reform effort that should be of bility as mainly a philanthropic rather than a strategic matter. particular interest to people in this audience is in the area When you ask them, “How do you integrate CSR into your of auditing and audit regulation. Most Asian markets have operations, into your business strategy?,” they say, “Well, we moved towards creating an independent audit regulator, and give money to schools, we give money for forestry develop-
68 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 ment and beach clean-ups.” But when you then ask, “Yes, but Corporate Governance in China do you integrate it into your strategy and operations?,” they Let’s move to the case of China. Corporate governance usually have little idea what you’re talking about. Yet this is reform in China started in earnest when the China Securi- an important issue for a lot of global investors. They want to ties Regulatory Commission (CSRC) got going with its 2001 see companies thinking about this substantively and not just guidelines for independent directors. For several years thereaf- spending money on CSR so as to have a lovely picture in their ter, there was such a flurry of rule-making—a national Code annual report; they want companies to think hard about how of Corporate Governance in 2002, and a Directive on Quar- to incorporate CSR into their business in a way that promises terly Reports in 2003—that people in Hong Kong used to to protect against risk and, ideally, increase corporate value enjoy saying that China’s corporate governance standards over the long run. were higher than Hong Kong’s. While that may have been At the same time, however, we are also seeing more short- true on paper, the reality was quite different. sighted companies driving down audit fees through auditor Nevertheless, China has continued to produce new “rotation.” While changing auditors has some benefits, it is reforms, the most recent of which is the CBRC’s new corpo- hard to see how you are you going to get an improvement rate governance guidelines for commercial banks, as discussed in audit quality if companies keep cutting their fees. This is earlier. something that investors, audit committees, and independent Enforcement is one area where we believe the China directors should be asking questions about. Securities Regulatory Commission (CSRC) could improve its work, and indeed it is now hiring more people to improve The Rankings enforcement. We also believe that coordination between As I mentioned at the outset of my talk, we provide rank- different government agencies in China on corporate gover- ings of 11 Asian markets in the Corporate Governance (CG) nance policy could improve. Watch Survey that we publish every two years in collabora- As for the quality of auditing and audit regulation, those tion with CLSA, a stock broking firm and research house. things are hard to assess. There is a limited amount of public To give you a little more insight into our ranking system, information on the activities of audit regulators, but clearly we consider five different categories: CG rules and practices; concerted efforts are now being made to raise standards, enforcement; political and regulatory environment; account- educate more CPAs, and give guidance to auditors on audit ing and auditing standards; and CG culture. engagement deficiencies. Nevertheless, it is much harder to Our survey reports the overall scores for each market— assess the state of play on auditing in China than in many expressed as percentages from 1 to 100—from our last three other markets in the region—say, in Singapore, Malay- surveys, which came out in 2007, 2010, and 2012. It is signifi- sia, Thailand, and Japan—where audit regulators produce cant that although Singapore and Hong Kong scored highest detailed analyses of the industry and audit quality. in the region (with 69% and 66%, respectively), their scores What you have in China, then, is “corporate governance were not particularly high in absolute terms—after all, these with Chinese characteristics.” Or to put it another way, two are both international financial centers. You might also China is developing its own system of corporate governance. be surprised to know that Thailand came in third with a 58% The word “unique” is overused, but in the same way that score—though, again, this looks high on a relative, but not Japan has certain highly distinctive aspects in its corpo- an absolute, basis. rate governance system, so too does China. For example, Some countries have done better than others, but we are it has a board structure that draws both from English and skeptical that they will all continue to improve. Singapore from German company law. As in Germany company law, has improved, but its closed culture for corporate governance Chinese companies have a supervisory board; but unlike a and somewhat opaque regulatory system are clearly limiting German supervisory board, a Chinese supervisory board factors. And in Thailand, corruption clearly continues to be doesn’t have the power to hire and fire the management a major problem. board. And you don’t have management boards in China, In most countries, corporate governance rules tend to you have boards of directors with executive directors, be rated higher than their enforcement; but in the cases of non-execs, and independents. Hong Kong and Japan, we’ve viewed their enforcement as Then there’s the Communist Party of China (CPC), better than their rules. And the consistently low corporate which plays an important role in the governance of state- governance culture scores throughout the region reflect our owned enterprises. The political system and company law perception that many companies are mainly just complying both require a party committee in SOEs, and you also now with rules, instead of trying to implement the rules in the see these committees in private companies too. The CPC spirit in which they’re intended. It’s the triumph of form over Organization Department controls major SOE personnel substance—and so we’re not seeing notable improvements in appointments, including that of chairmen and CEO/Presi- governance culture in the region. dents, while other arms of government decide on who will
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 69 become independent directors on SOE boards. The board of There have also been some promising changes in China’s an SOE in China, therefore, is constrained in selecting its relations with international capital markets. There’s been own non-executive and independent directors. some degree of interest rate liberalization, a lot of focus on SASAC is the State-owned Asset Supervision and capital convertibility, and the launch of the QFII program, Administration Commission. It is the entity that owns whose aim is to attract Qualified Foreign Institutional Inves- the State’s interests in the large central SOEs. But you also tors. The Shanghai Free Trade Zone is in many ways a pilot have SASACs at the provincial and city level. They super- program for helping achieve capital account convertibility. vise some 117 central SOEs. SASAC’s role is to help these And there’s also the Hong Kong-Shanghai Stock Connect, organizations improve their management and governance, which is a trading program between Hong Kong and China essentially to make them more competitive. So it’s not a priva- that allows Hong Kong investors to buy A shares in China tization mandate but rather a competitiveness mandate. And through their local brokers in Hong Kong (and vice versa). you might be interested to know that many of these SOEs, When we started the Asian Corporate Governance although they are the parents of subsidiary companies listed Association about fifteen years ago, there was a lot of focus on in Hong Kong or elsewhere, did not until quite recently have the need to build an institutional base in China. But foreign boards of directors. institutions are still a much smaller part of the market than SASAC therefore set up a program for creating boards people were hoping. Since the Third Plenum, there has been of directors in the central SOEs. The first one was Baosteel a renewed focus on SOE reform, in particular on creating in 2005, and there are now over 50 of the central SOEs that new “mixed ownership” structures—ones that are created by have boards. It is still a learning experience for all concerned, taking assets out of SOEs, creating new unlisted companies as we understand it. and bringing in outside investors, including private equity, As for the role of the Party Committee, you now see with the aim of improving corporate governance and perfor- annual reports that mention who is the party secretary in mance. Instead of having one dominant shareholder in a the company and who are the members of the committee; listed entity, you have a more balanced shareholding group but there is still no description of what the Party Commit- in an unlisted entity. We are not quite sure how this will work tee actually does. Our view is that more transparency would in practice, but it will be interesting to watch. actually be a good thing because it would allow more infor- Other important reforms, such as establishing the rule of mation into the market—but making that happen is going law and development of an independent judiciary, will take a to be a challenge. long time. Media freedom is always a challenge and so too is On a positive note, the China Banking Regulatory fighting government corruption. The new leadership clearly Commission now exerts tight supervision over commer- is bringing in certain reforms that will free up the economy cial banks and plays a very strong role in interviewing and to a degree and improve corporate governance, but clearly vetting directors, particularly independent directors. If you many challenges remain. are appointed as an independent director of a state bank in So, with that I will conclude. Thank you. China, you will have to go to Beijing and sit for an exam. This does not happen in Hong Kong. Jamie Allen is the founding Secretary General of the Asian Corpo- The mandate of the CSRC, meanwhile, is as much rate Governance Association, which was incorporated in Hong Kong in about investor protection as market development. One way 1999. He is responsible for overall management of the Association, as to understand the CSRC’s policies is to recognize that their well as directing ACGA’s research, advocacy, and educational work in fundamental mandate is to protect retail shareholders. China 11 Asian markets. has around 80 million retail shareholders, so the authori- Mr. Allen has more than 27 years’ experience as a writer, editor, ties are acutely concerned about their reaction to changes and analyst covering the economies of Greater China and East Asia from in share prices. The CSRC’s assumption is that institutional Hong Kong. From 1992-1995 he worked for the Economist Intelligence investors can largely look after themselves, while the political Unit (EIU) as editor of Business Asia, and was a contributor to the Econ- pressure for regulation comes more from retail than institu- omist magazine from 1994-1996. Between 2001 and 2007, Mr. Allen tional interests. was a member of the Public Shareholders Group, a committee formed by After the third plenum of the CPC late last year, there is the Hong Kong Securities and Futures Commission to advise it on share- now more talk about SASAC being less of an administrative holder rights and corporate governance. In 2013, he was appointed to two controller of state enterprises and more of a capital manager, committees under the Financial Reporting Council, a statutory agency in along the lines of Temasek in Singapore. But we don’t see Hong Kong that investigates financial reporting and auditing irregularities. administrative control being removed completely.
70 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 CARE Conference Hong Kong Polytechnic University, June 9, 2014 Equity Financing for Early-Stage Companies in China
A Presentation by Ning Jia, Tsinghua University
ood morning, I’m Ning Jia, Associate Professor games. This move effectively differentiated Baidu’s products of Accounting and Deputy Director of the China from traditional search engines, particularly Google. And by GB Business Case Center at Tsinghua University in so doing, it created a distinctive brand image and recognition Beijing. We have heard a good deal at this confer- of Baidu among China Internet users as the domestic search ence about how Chinese companies raise equity capital from engine, providing more suitable and locally relevant services the public capital markets. But, of course, not all companies for the Chinese audience. in China are able to access the IPO market. The bulk of the So it was this kind of local adaptation that made Baidu a smaller private-sector companies that are still in the entrepre- very successful company in China. And it was the return of neurial stage need external capital to fuel their growth. And people like Robin Li that stirred up China’s venture capital it is mostly venture capital and private equity firms in China market as many foreign VC firms started to follow those that provide capital to these smaller entrepreneurial compa- returnees into China. nies. Today I’d like to share with you some of my thoughts and research findings on the development of venture capital The Development of Chinese VC Markets and private equity in China, as well as the role they play in VC investment in China can be classified into three main the growth of early-stage companies. phases. During the first phase, which took place during Although China’s VC industry is much younger than the late 1990s, VCs in China were primarily interested in that of the United States, it has been on a high growth trajec- start-ups that were copying business models that had proven tory since 1998. Several things happened in that year. The themselves in the U.S. Most VC investments back then were first was the dot.com fever and NASDAQ bull market in concentrated in the TMT sector, and applications of exist- the United States, which also had a significant impact on ing technology were much more common than attempts to China’s entrepreneurial sector. The second was the return develop new technologies. from the U.S. of Chinese entrepreneurs, a group we like to The second phase took place during the early to mid refer to as “sea turtles.” Sea turtles are people who were born 2000s. In addition to continuing investment in the TMT and raised in China but finished their higher education in sector, VCs also started to move into traditional industries the West. After finishing their education in western countries for a number of reasons. First of all, competitive and even and seeing—and in some cases participating in—success crowded conditions in the TMT sectors limited the return stories like Google and eBay, they wanted to return to their potential. Second, in contrast to more developed or mature homeland and establish their own ventures. economies, in China many traditional sectors outside of high Robin Li, the founder of Baidu, is a good example. He tech were seen as providing high-return opportunities, thanks came back from the U.S. around 1998-99 to set up a company to the high growth rates in the Chinese economy. China’s in China with a business model similar to Google’s—and VCs showed a particular preference for start-ups in tradi- that was how Baidu got its start. Though the initial business tional sectors that were using either cutting-edge technology models of Baidu and Google were very similar, Robin did or introducing a new business model. As one example, MJ a much better job of adapting the model to local require- Life, a provider of healthcare check-up services, attracted ments and circumstances. Baidu was the first search engine capital from VCs after adopting an advanced, streamlined in China to launch an MP3 search product—that was in manufacturing process from Taiwan and applying it to its November 2002, and the launch followed an extensive healthcare business. market research on its target customers. At the time, about During this phase, the Chinese government developed 70 percent of China’s Internet users were under the age of 30, several new policies to encourage more domestic capital and far more interested in entertainment than news, books, or to participate in the VC sector. Of particular importance other education-related information. Baidu quickly delivered was an amended version of the Partnership Enterprise Law products that were tailored specifically toward the interests of that went into effect in June of 2007. This new version this Internet user group, including MP3s, images, video, and of the Law provided much more clarity about the kinds
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 71 Figure 1 2014 GP Survey – Industry Preference
Healthcare 78%
TMT 76%
CleanTech 75%
Consumer Service 63%
29% Manufacturing
27% Finance
17% Agriculture
11% Resources
6% Logistics
0% 20% 40% 60% 80% 100%
Source: CV Source
Figure 2 2014 GP Survey – Investment Criteria
1st Potential Market Size
Leader in a Niche Market
2nd Produce/Service, Technology, or Business Model Innovation
Founding Team 3rd High Historical Growth
4th Clear IPO Timeline
Policy Related Opportunities and Risks
5th Current Revenues and Profitability
0% 20% 40% 60% 80% 100%
Source: CV Source of entities could that serve as partners in venture capital rate form, as well as reducing the potential legal liability firms or transactions, while for the first time differentiat- associated with the trust structure. ing between limited partners (LPs) and general partners And that brings us to the third phase of Chinese venture (GPs). Since that time, Chinese PE firms, like their foreign capital, which begins with the global financial crisis. From counterparts, have been permitted to choose the limited 2008 to the present, the market has had pronounced ups and partnership structure as the third organizational option in downs. The Chinese government has continued to encourage addition to the two options previously available to them— VC development. For example, the government has gradually the corporation and the trust. One of the big attractions of relaxed policy restrictions on financial and asset management the limited partnership structure is, of course, its ability to institutions, permitting insurance companies to invest in the eliminate the double taxation associated with the corpo- private equity market for the first time, and allowing securi-
72 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Figure 3 Average P/E Ratio between Q4’09 and Q1’14
120
110
100
90
80
70
60
50
40
30
20
10
0 Q4’09 Q1’10 Q2’10 Q3’10 Q4’10 Q1’11 Q2’11 Q3’11 Q4’11 Q1’12 Q2’12 Q3’12 Q4’12 Q1’13 Q2’13 Q3’13 Q4’13 Q1’14
ShenzhenSME A-share SME ChiNext
Source: Compiled by author; data obtained from Shanghai and Shenzhen stock exchange ties trading institutions to also participate in the market. Other Recent Developments As a result of these kinds of changes, coupled with the I’d like to also comment on several key features of China’s strong expectation of the launch of the Growth Enterprise VC market today. Board (GEB, also known as ChiNext) in 2009, domestic First is a fairly recent notable shift from offshore U.S. RMB VC and PE funds began to see new options for both dollar investment to onshore RMB investment. Prior to 2008, financing and exit. The GEB is a Nasdaq-like exchange China’s VC market was dominated largely by global firms that lists high-growth entrepreneurial Chinese companies, with U.S. dollar-denominated funds. Such firms saw the and thereby provides them with the financing necessary for emerging economy of China as the next frontier for private the build-up of business scale and profit-making capability, equity investment and brought with them unparalleled particularly ventures with distinctive technological innova- funding, international connections, and expertise that many tions and business models. Companies listed on the GEB Chinese entrepreneurs craved. In contrast, domestic VC firms have maintained relatively high PE ratios—well above the with RMB-denominated funds were much less active, due average PE ratio of the SME and A-share board—ever since largely to organizational challenges—such as the unavail- the launch of the new exchange. ability of the limited partnership structure—and limited In addition to the new funding options, industry prefer- onshore exit options. ences have also changed. ChinaVenture, a leading research Since 2008, however, foreign capital has been experienc- institute, recently surveyed a group of Chinese GPs and asked ing increasing competition from Chinese investors with the them what industries they now find most attractive. The top gradual improvement of the Chinese policy environment and three choices were healthcare, TMT, and clean tech. Perhaps capital markets. RMB-denominated funds have become the we shouldn’t be surprised that healthcare ranks at the top. new driving force behind China’s VC industry, accounting It’s estimated that by 2020, ten percent of Chinese popula- for almost two thirds of overall capital commitments in 2010. tion will be above the age of 65; and in addition to aging, A second important change has been increased focus by the effects of increasing pollution are expected to raise the VCs on later-stage deals. demand for health care. In order to quickly establish a track record, many Chinese ChinaVenture also surveyed GPs on their investment VC firms have a strong tendency to focus on start-up compa- criteria. The number one investment criterion appears to be nies in later stages of development—either in the expansion potential market size. Number two was whether or not the stage or contemplating an IPO. This was particularly true company is a leader in a niche market. The third criterion prior to the suspension of new IPOs in China in late 2012. was whether you have an innovation in product or service But, again, it is such early-stage companies that have the offerings or whether it’s a new business model. greatest need for external capital. And so as a partial solution,
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 73 Figure 4 Post-IPO Performance of Chinese Companies
0.60 VC-backed Companies Non-VC backed Companies 0.40
0.20
(0.00) 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47
(0.20)
(0.40)
(0.60) Number of Months After IPO
Source: Author’s own research the Chinese government set up government-backed funds to listed on China’s small and medium enterprise (SME) board help fund the really early-stage companies. between 2004 and 2008. I split the sample between those This focus on later-stage companies initially increased the IPOs that were backed by VC firms and those that were not returns of VCs by enabling to capitalize on the remarkably high to see if I could find a difference in their post-IPO stock valuations in the capital markets. But, as the P/E multiple on market performance. China’s capital market has come down gradually, the arbitrage Consistent with this grandstanding hypothesis, I found opportunity between pre-IPO market valuations and post-IPO that Chinese IPO companies underperformed the overall market valuation is now almost gone. As a result, VC firms are Chinese stock market, and that the VC-backed companies now moving more towards early-stage deals. performed the worst. Moreover, the difference in perfor- A third important development has to do with the inves- mance does not become statistically significant until about 12 tors in Chinese venture capital funds. Unlike Western VC months after the IPO. What’s the significance of 12 months? markets, where institutional investors, such as pension funds It’s the expiration of the lock-up period in the SME board. and endowments, have been the main providers of capital, the After that point, strategic investors, including the VCs, have lion’s share of venture capital in China has come from private the right to liquidate their shares in the open market—and business owners and high net worth individuals. Chinese they typically have fully exited their investments within two LPs, as new players in the market, have been generally less years’ time. sophisticated than their foreign peers and less accustomed Another interesting finding is that, around 36 months to the idea of entrusting their capital to fund managers for after the IPO, the performance of IPO companies starts to a lengthy period of time. For this reason, they have tended rebound. After 36 months, the controlling shareholders in to have a shorter investment horizon and demanded a faster China are allowed to sell their shares in the open market, so return of capital and profits. As a result, most domestic VC they have incentives to hype the stock price in anticipation funds have been set up with a life span of 5 to 7 years, signifi- of selling out. cantly shorter than the fund length of 10 to 12 years that A fourth trend in the Chinese VC market worth noting in has been the norm in Western markets. Such shorter fund recent years is the increasing role of social media in VC deal durations have in turn imposed greater liquidation pressure sourcing, which had previously relied on traditional word-of- on VC firms, forcing them to push portfolio companies to mouth referrals. Articles about new companies and business the public market as soon as possible. And the pressure on models appear on the Internet every day and, in this way, VCs for early IPOs may well have had negative effects on the they come to the attention of VC and PEs. Entrepreneurs companies they have invested in. are increasingly trying to use the web as a path to financing. To explore this possibility, I conducted a large-sample And fifth and last, due diligence has also changed in study on the post-IPO stock performance of 273 companies significant ways. Investors offer incubation and training
74 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 programs to the companies they’re interested in. It used to funds would also benefit from greater participation by institu- be that a round of due diligence would take only a few weeks. tional investors—a goal that can and likely will be promoted But you can’t really discern the quality of a company within through government inducements. a few weeks; and by extending the process through, say, a Thank you. four-month training program, VCs can learn a lot more. Well-known entrepreneurial training programs include those Professor Ning Jia is an associate professor of accounting and asso- offered by Innovation Works and Lenovo Star. ciate director of China Business Case Center at Tsinghua University School of Economics and Management. Professor Jia’s research focuses on the Closing Thoughts role of accounting information in capital markets, venture capital/private To sum up, then, China’s VC and PE market has offered, equity, public offerings, and the growth and valuation of entrepreneurial and will continue to offer, opportunities for global investors companies. Professor Jia has written more than twenty cases on manage- as China transitions into a more innovation-based economy. ment practices of Chinese and Non-Chinese companies across a wide But at the same time, this sector still faces many challenges. spectrum of sectors. Professor Jia holds an undergraduate degree from For example, the supervisory system and legal environ- the University of Minnesota, a master’s degree from Stanford University, ment continue to be a work in progress, with expectations and a doctorate from Stanford Graduate School of Business. of further improvement. The composition of LPs in Chinese
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 75 The State of Sustainability in China by Peijun Duan, China Central Party School, and Robert G. Eccles, Harvard Business School1
he term “sustainability” has entered the common discusses the need for a greater focus on sustainability in lexicon, although its meaning is ill-defined and China, both for its own sake and for the world’s. The T will probably always remain so. Sometimes it is second summarizes the key government policies regarding used interchangeably with the term “corporate sustainability. The third and final part looks at some broad social responsibility” (or “CSR”), which is the more common sustainability indicators of the largest 100 Chinese companies term in China. Broadly speaking, sustainability and CSR and compares them to their U.S. counterparts. both refer to the growing recognition that companies and investors must take more account of environmental, social, The Need for Sustainability in China and governance (ESG) issues in producing economic returns. China is one of the world’s most important and controversial Sustainability is a global concern and, as such, it is the countries for a wide range of political, economic, social, and responsibility of everyone—from citizens to companies to environmental reasons. China’s economic growth has been governments. However, it is the world’s largest countries phenomenal. In 1960, China’s GDP was just $59.2 billion.4 and companies that will largely determine whether we have Deng Xiaoping’s economic reforms in the late 1970s were a sustainable society or not. Of the 191 reporting countries the catalyst for years of rising prosperity.5 Since 1980, China in the world, the top 10 countries account for over 64% of has enjoyed a compound annual growth rate of over 12.5%. global GDP. 2 Similarly, the largest 1,000 companies in the In 2013, this rapid expansion secured China’s position as the world (the “Global 1000”) account for almost 80% of the second largest economy in the world. China’s 2013 GDP of sales of all publicly listed companies.3 Most large global $9.2 trillion places its economy behind the U.S. ($16.8 tril- companies today profess their commitment to sustainability, lion) but ahead of Japan ($4.9 trillion) and Germany ($3.6 sometimes in the language of “corporate social responsibility,” trillion).6 While this growth is expected to slow to 7.75% over although it is difficult to separate rhetoric (“greenwashing”) the next six years, China is expected to surpass the U.S. in from reality, which means taking hard decisions around the GDP as early as 2019, although U.S. GDP per capita will be negative externalities produced by a company’s operations and about six times that of China.7 a longer-term perspective over which corporate performance is This economic growth has come at high environmental evaluated. This article examines the state of sustainability in and social costs. Since 1960, China’s CO2 emissions have grown China from a policy and company perspective, with a focus at a rate of 4.8%, as compared to a U.S. compound annual on its largest 100 companies. What China does to address growth rate of 1.3% over the same period. From 2008 to 2010, the environmental and social issues that are a consequence China’s CO2 emissions grew by over 17%. During that same of its economic growth is important not just for China but period, U.S. CO2 emissions actually decreased by 3.8%. In for the world as a whole. 2010, China’s CO2 emissions were 2.85 million kilotons above This article is organized into three parts. The first total U.S. emissions.8 Electricity production from coal resources
1. The authors would like to thank Shannon Gombos, Nancy Lin, and Qiwa Tang for 6. “GDP (Current US$) | Data | Table,” The World Bank, accessed August 2014, expert research assistance on this article. It would not have been possible without them. http://data.worldbank.org/indicator/NY.GDP.MKTP.CD/countries. 2. “GDP (Current US$) | Data | Table,” The World Bank, accessed August 2014, 7. S.R. and D.H., “Chinese and American GDP Forecasts: Catching the Eagle,” The http://data.worldbank.org/indicator/NY.GDP.MKTP.CD/countries. Economist, August 22, 2014, accessed August 2014, http://www.economist.com/blogs/ 3. Datastream marks total sales for all publicly listed companies in December 2013 graphicdetail/2014/05/chinese-and-american-gdp-forecasts. The IMF predicts that Chi- at $45.6 trillion. “World-DS Market, Sales (Revenue),” available from Datastream, ac- na’s GDP per capita in 2019 will be $10,586 while the US’s GDP per capita will be cessed August 2014. The Global 1000’s total sales are $36 trillion. “tf. Sales USD,” $66,633. “Report for Selected Countries and Subjects,” International Monetary Fund, available from Thomson Reuters via Thomson ONE, accessed August 2014. According accessed September 2014, http://www.imf.org/external/pubs/ft/weo/2014/01/weodata/ to the World Federation of Exchanges, there were 43,407 publicly listed companies in weorept.aspx?pr.x=56&pr.y=12&sy=2019&ey=2019&scsm=1&ssd=1&sort=countr December 2013. “Monthly Reports,” World Federation of Exchanges, accessed August y&ds=.&br=1&c=924%2C111&s=NGDPDPC&grp=0&a=.
2014, http://www.world-exchanges.org/statistics/monthly-reports. 8. In 2010, China’s total CO2 emissions were 8,286,891.95 kilotons (kt) while the
4. All data are from 2013 unless otherwise noted. “GDP (Current US$) | Data | Ta- U.S. CO2 emissions were 5,433,056.54 kt. “CO2 emissions (kt) | Data | Table,” The ble,” The World Bank, accessed August 2014, http://data.worldbank.org/indicator/ World Bank, accessed August 2014, http://data.worldbank.org/indicator/EN.ATM.CO2E. NY.GDP.MKTP.CD/countries. KT/countries/1W?display=map. 5. Barry Naughton, “Deng Xiaoping: the economist,” The China Quarterly 135 (1993): 491-514.
76 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 grew at a similar rate, 17.7%, whereas the U.S. witnessed a putting aside any questions about legal rights . . . [The worker negative growth rate of 5.9% over the same period.9 What’s interviewed] was not aware that her wages and hours violated more, China now uses more energy than the U.S.10 local labor regulations.”18 More recently, the Chinese govern- Increased emissions have resulted in massive pollution of ment has issued policies designed to combat income inequality China’s growing cities. According to the 2010 Global Burden and improve workers’ conditions—and some workers have of Disease Study, China’s “outdoor air pollution contributed been successful in protesting factory conditions and forcing to 1.2 million premature deaths ... nearly 40 percent of the company officials to the negotiating table.19 According to global total.”11 In 2012, the Chinese government introduced SAWS, the Chinese equivalent of OSHA20 in the U.S., there new air quality standards for its major cities. But, as of were 336,988 workplace accidents in 2012, though this was August 2014, only nine out of 161 cities (under six percent) down by 3.1% from the year before.21 These accidents resulted had met the new standards.12 In the Jingjinji area—which in over 70,000 fatalities (down 4.7% from the year before), counts Beijing among its major cities—only 37.5% of the or an average of 200 worker deaths per day,22 as compared to days of the year met minimum quality standards.13 The U.S. 4,628 workplace fatalities in the U.S. in the same year.23 Environmental Protection Agency sets standards to measure Urbanization has been both a cause and a consequence air quality from 0 to 500—with a measurement of 500 being of economic growth, as well as a source of social problems. 20 times the safe level for particulate matter in the air. In The World Bank credits China’s GDP growth—aided by rapid January 2013, Beijing reported an unprecedented reading of urbanization—with lifting 500 million people out of poverty 755. (In contrast, New York City’s level was recorded at 19 over the past 36 years.24 In 2011, the number of people living the following day.)14 The statistics for water pollution are no in urban areas surpassed those living in rural areas.25 By 2030, better. An April 2014 report released by Xinhua estimated projections estimate that one billion Chinese people, or around that 59.6% of underground water was not potable—and this 70% of the total population, will live in cities.26 Although The number had increased 2.6% from its 2012 report (57.4%).15 Economist estimates that 54% of China’s people currently live There have been social costs as well. China is now the in urban areas, only 36% of China’s population has an urban most populous country in the world, with 1.36 billion people, hukou, an official household registration system that qualifies followed by India, the United States, and Indonesia.16 Much residents for social benefits in their designated demographic of China’s economy is based on labor-intensive manufactur- area. 27 Under the bifurcated system, residents holding an urban ing.17 Working conditions and workers’ rights are often below hukou are provided for by the state sector—they enjoy access Western standards, and worker safety is a major issue. A 2001 to subsidized health care, food, housing, education, and retire- article in The New York Times described factory working condi- ment benefits—whereas ruralhukou holders receive little, if any, tions as follows: “[Chinese factory workers] are willing to work support from the state. If a rural resident wished to move to a 12 hours a day or more for a pittance, living 12 to a room and city, she would have to obtain a moving-in certification from
9. “Electricity Production from Coal Sources (kWh) | Data | Table,” The World Bank, 18. Erik Eckholm, “Worker’s Rights are Suffering in China as Manufacturing Goes accessed August 2014, http://data.worldbank.org/indicator/EG.ELC.COAL.KH. Capitalist,” The New York Times, August, 22, 2001, accessed August 2014, http://www. 10. “China: Overview,” U.S. Energy Information Administration, February 4, 2014, nytimes.com/2001/08/22/world/workers-rights-are-suffering-in-china-as-manufactur- accessed August 2014, http://www.eia.gov/countries/cab.cfm?fips=ch. ing-goes-capitalist.html. 11 Edward Wong, “Air Pollution Linked to 1.2 Million Premature Deaths in China,” 19. Vikas Bajaj, “Chinese Workers’ Rights” The New York Times, February 8, 2014, The New York Times, April 1, 2014, accessed August 2014, http://www.nytimes. accessed August 2014, http://takingnote.blogs.nytimes.com/2013/02/08/chinese-work- com/2013/04/02/world/asia/air-pollution-linked-to-1-2-million-deaths-in-china.html?_ ers-rights/. r=1&adxnnl=1&adxnnlx=1409781720-+LkBaVbcfszRTA05H3RFCw. 20. SAWS is the acronym for the State Administration of Work Safety. SAWS’ website 12. Bree Feng, “Only 9 Chinese Cities Pass Clean Air Test,” The New York Times, describes itself as a “[Chinese] agency directly under the State Council for overall super- August 7, 2014, accessed August 2014, http://sinosphere.blogs.nytimes. vision and regulation for work safety.” “State Administration of Work Safety,” Gov.cn, com/2014/08/07/only-9-chinese-cities-pass-clean-air-test/. accessed August 2014, English.gov.cn/2005-10/20/content_80531.htm. 13. Sun Xi and Gu Bowen, “Asia Insight: Air Pollution in China: A Hazy Future?” OSHA is the acronym for the Occupational Safety and Health Administration and its Sustainalytics, August 2014, pg. 6, accessed August 2014. website describes itself as “the main [US] federal agency charged with the enforcement 14. Edward Wong, “On Scale of 0 to 500, Beijing’s Air Quality Tops ‘Crazy Bad’ at of safety and health legislation.” “Occupational Safety & Health Administration,” United 755,” The New York Times, January 12, 2013, accessed August 2014, http://www.ny- States Department of Labor, accessed August 2014, www.osha.gov. times.com/2013/01/13/science/earth/beijing-air-pollution-off-the-charts.html. 21. “SAWS: Mainland per day 200 people were killed in accident,” CCTV, January 15. Mu Xuequan, “China’s Underground Water Quality Worsens: Report,” Xhinhua, 18, 2013, accessed August 2014, http://news.ifeng.com/mainland/detail_2013_ April 22, 2014, accessed August 2014, http://news.xinhuanet.com/english/china/2014- 01/18/21340127_0.shtml. 04/22/c_126421022.htm. 22. Ibid. 16. “Population, total | Data | Table,” The World Bank, accessed August 2014, 23. “Injuries, Illnesses, and Fatalities,” Bureau of Labor Statistics, accessed August http://data.worldbank.org/indicator/SP.POP.TOTL. In 2026, the World Databank esti- 2014, http://www.bls.gov/iif/oshcfoi1.htm. mates that China will have a population of 1.427 billion, India with 1.430 billion, U.S. 24. “China Overview,” The World Bank, April 1, 2014, accessed August 2014, http:// with 348.6 million, and Indonesia with 284.4 million. 2026 is the first year India’s www.worldbank.org/en/country/china/overview. population is expected to surpass China’s. “Health Nutrition and Population Statistics: 25. “Web CEIC Data Manager,” CEIC Global Database, accessed August 2014, http:// Population estimates and projections,” World Databank, accessed August 2014, http:// webcdm.ceicdata.com/cdmWeb/dataManager.html?languageCode=en. databank.worldbank.org/Data/Views/VariableSelection/SelectVariables. 26. “China: A New Approach for Efficient, Inclusive, Sustainable Urbanization,” The aspx?source=Health%20Nutrition%20and%20Population%20Statistics:%20Popula- World Bank, March 25, 2014, accessed August 2014, http://www.worldbank.org/en/ tion%20estimates%20and%20projections. news/press-release/2014/03/25/china-a-new-approach-for-efficient-inclusive-sustain- 17. Karel Eloot, Alan Huang, and Martin Lehnich, “A new era for manufacturing in able-urbanization. China,” McKinsey Quarterly, June 2013, accessed September 2014, http://www.mck- 27. “China’s Cities: The Great Transition,” The Economist, March 22, 2014, ac- insey.com/insights/manufacturing/a_new_era_for_manufacturing_in_china. cessed August 2014, http://www.economist.com/news/leaders/21599360-government- right-reform-hukou-system-it-needs-be-braver-great.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 77 the designated city’s police force, a difficult process that limits ronmental and social issues were more implied than stated. movement for many rural residents—which is the intended This changed on January 1, 2006, when the amended purpose of the hukou system.28 However, in March 2014, the Company Law came into effect and CSR was officially Chinese government announced its “National New-type Urban- adopted as part of the Chinese legal system regarding corpo- ization Plan (2014-2020),” which sets a target for the expansion rations. In the words of Article 5 of the Company Law, “when of full urban hukou benefits to 45% of its population by 2020. undertaking business operations, a company shall comply Chinese authorities are counting on the influx of an estimated with the laws and administrative regulations, social morality 100 million rural workers into their cities to boost consumer and business morality. It shall act in good faith, accept the spending and contribute to Chinese economic growth.29 It supervision of the government and the general public, and remains to be seen if the subsequent massive movement to bear social responsibilities.”33 Two months later, in March cities will smooth or strain China’s urban vs. rural social divide. 2006, the State Grid Corporation of China, a Central State- Owned Enterprise (CSOE),34 published the first CSR report Support for Sustainability in China in China. Rapid development followed in the next decade. In China, CSR or sustainability is being supported in a According to the Blue Book, there were only 32 CSR reports variety of ways, including laws, pronouncements by Party in 2006. By 2013, there were 1,231 reports, representing a political leaders, and guidelines issued by regulators, stock 40-fold increase in eight years.35 exchanges, trade associations and think tanks. According to the Blue Book of Corporate Social Responsibility (referred Pronouncements by the Party, Its Leaders, to hereafter as the “Blue Book”), the concept of corporate and Researchers social responsibility (CSR) was introduced to China as early Although the amended Company Law is China’s only legally as the 1980s.30 However, it was only in the 1990s that CSR binding document that bears on CSR, Article 5 functions more started to become understood and at least partially accepted as a suggestion or aspiration than a requirement because it by companies, in large part because of changes in regulation. does not impose any specific legal obligations on corporations and is too vague and ambiguous to give companies guidance Laws on what they need to do in practice regarding CSR. Never- The first version of The Company Law of the People’s Repub- theless, some recent developments supplement the Company lic of China (Company Law) was promulgated on December Law by providing support through their political importance 29, 1993.31 It established the legal basis for companies and the and social influence, such as a report from the Third Plenary role of companies in Chinese society. Subsequent laws gave Session of the 18th Central Committee of the Communist Party further clarity to the role of the corporation in society in terms of China (CPC) regarding the obligation of SOEs for CSR.36 of encouraging eco-friendly operations, advocating basic labor At this Third Plenary Session, which was held near the rights for employees, and standardizing national charity and end of 2013, the CPC also decided to focus on giving the philanthropy regulations.32 But since none of these laws even free market a decisive role in allocating resources as part mention CSR, a company’s obligations with respect to envi- of the process of economic reform. Moreover, a number of
28. Tiejun Cheng, and Mark Selden, “The origins and social consequences of China’s pany Law,” The International and Comparative Law Quarterly, Vol. 48, No. 1 (Jan., hukou system.” The China Quarterly 139 (1994): 644-668. 1999), 91-92. 29. Dexter Roberts, “China Wants Its People in the Cities” Bloomberg Businessweek, 32. These include: (1) Environmental Protection Law of the People’s Republic of March 20, 2014, accessed August 2014, http://www.businessweek.com/arti- China: Adopted at the 11th Meeting of the Standing Committee of the Seventh National cles/2014-03-20/china-wants-its-people-in-the-cities. People’s Congress on December 26, 1989, promulgated by Order No. 22 of the Presi- 30. Qunhui Huang et al., Blue Book of Corporate Social Responsibility (2013), Bei- dent of the People’s Republic of China on December 26, 1989, and effective on the date jing: Social Sciences Academic Press (CHINA), 2013. of promulgation; (2) Labor Law of the People’s Republic of China: Adopted at the Eighth 31. Scholars offer a variety of interpretations on when China had her first Company Meeting of the Standing Committee of the Eighth National People’s Congress on July 5, law. According to William C. Kirby, prior to the Company Law (Gongsilü) issued by the 1994, promulgated by Order No.28 of the President of the People’s Republic of China Ministry of Commerce (Shangbu) of the Qing government in January 21, 1904, “very on July 5, 1994, and effective as of January 1, 1995; and (3) Welfare Donations Law of little in written Chinese law addressed the regulation of private economic activity.” The the People’s Republic of China: Adopted at the 10th Meeting of the Standing Committee Company Law of 1904 aimed at encouraging and regulating commercial activities. It of the Ninth National People’s Congress on June 28, 1999 and promulgated by Order defined four types of company—partnership, limited partnership, simple joint-stock com- No. 19 of the President of the People’s Republic of China on June 28, 1999. pany, and the company of limited shares. Kirby indicates that the Qing’s Company Law 33. “The Company Law of the People’s Republic of China (revised in 2005),” The of 1904 is relatively along the lines with the development of other country’s company Standing Committee of the National People’s Congress, accessed July 2014, http://www. law: for instance, Code de Commerce of France in 1807, Handelsgesetzbuch of Germany saic.gov.cn/zcfg/fl/xxb/201206/t20120612_126990.html. in 1861, and the Commercial Code of Japan in 1899. As Kirby examines the history of 34. A Central SOE is a state-owned enterprise directly under the central government; China’s company law in the Twentieth Century, Kingsley T. W. Ong and Colin R. Baxter “Corporate Social Responsibility Report 2005,” State Grid Corporation of China, March emphasize its development after 1949. According to Ong and Baxter, the “open door 10, 2006, accessed July 2014, http://www.sgcc.com.cn/images/ywlm/socialresponsiil- policy,” inaugurated by the Communist Party of China in 1978, accelerated the eco- ity/brief/2010/12/13/D39BD4831BDC3C828F7B8579373B5831.pdf. nomic development of China and created “the need for a national company law.” PRC 35. Qunhui Huang et al., “Blue Book of Corporate Social Responsibility (2013),” Joint Venture Law was promulgated in July 1979 and the Company Law of 1993 is Beijing: Social Sciences Academic Press (CHINA), 2013. described as “the first national corporation law of China [that] represents a key element 36 The CPC proposed that SOEs have an obligation to fulfill their social responsibility. in the programme of economic reform that China began in 1978.” William C. Kirby, In the words of the report, “SOEs must adapt modernization and globalization. SOEs “Company Law and Business Enterprise in Twentieth-Century China,” The Journal of should also regulate business decisions, strive for the preservation and appreciation of Asian Studies, Vol. 54, No.1 (Feb., 1995), 43-63; Kingsley T. W. Ong and Colin R. assets, engage in fair competition, improve efficiency, enhance vitality and take social Baxter, “A Comparative Study of the Fundamental Elements of Chinese and English Com- responsibility.” The Third Plenary Session of the 18th CPC Central Commit- >>
78 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 changes to the current evaluation system that now governs the with social policies underpinning macroeconomic policies, planned economy were proposed, including changes designed weave a firm social safety net and promote the transformation to “improve the development outcomes evaluation system; of quantity-oriented to quality-oriented economic growth. We correct the tendency of evaluating official performance simply should coordinate economic and social development as well as based on [the] economic growth rate; pay more attention environmental protection greater opportunities for economic to employment, income, social security, and people’s health development.42 status; and increase the weight of the indexes, such as [those reflecting] resource consumption, environmental damage, Consistent with these expressions of support for sustain- ecological benefits, excess capacity, technological innovation, able economic development by the Party and its leadership, production safety, new debt, and other indicators.”37 These research is now being carried out at the China Central Party goals are all consistent with the intent, articulated two years School under the direction of one of this article’s co-authors ago by then President Hu Jintao, that Chinese policymakers (Duan).43 This work has identified three main challenges that “should leverage to a greater extent … the basic role of the China is now faced with in achieving sustainable develop- market in allocating resources, improve the system of macro- ment: (1) transforming the Chinese economy, which is now regulation, and perfect the open economy to ensure more experiencing slower momentum, from a low-cost manufac- efficient, equitable and sustainable economic development.”38 turer to an economy based on innovation, value-added As with all such high-level pronouncements, making products, and high-end services; (2) reducing the economy’s this goal a reality has been quite a different matter, in large excessive reliance on—and depletion of—environmental part because it requires policymakers to make difficult resources, such as non-renewable energy, water, clean air, and tradeoffs between economic growth and environmental and soil; and (3) halting the increase in harmful products sold by social objectives. During the most recent formulation of its some private enterprises and limiting the counterproductive “Five-Year Plan,”39 the CPC called for a “transformation of behavior of some public institutions. China’s economic development” that emphasizes “the impor- Duan’s proposal to address these challenges begins with tance of building a resource saving and environment-friendly the establishment of a new evaluation system that would society … to save energy, reduce greenhouse emissions and include indices of economic and environmental perfor- actively tackle global climate change.” What’s more, the plan mance, as well as criteria for assessing social responsibility.44 envisions development of “a circular economy and low carbon To achieve a comprehensive evaluation, such a system would technologies” by “striking a balance between economic devel- have to be applied at three levels: national actors, regional opment and population growth.”40 actors, and individual enterprises. In essence, Duan’s proposal More recently, on July 15, 2014, President Xi Jinping gave is a call for mandatory “integrated reporting” by the entire a speech at the Sixth BRICS Summit called “New Start, New country—that is, provinces and cities as well as companies. Prospect and New Impetus,”41 which called for the “unswerving To implement this new evaluation system, the plan offers promotion” of “sustainable economic growth.” Xi went on to say: three specific recommendations: 1. Design an economic performance index on the basis of BRICS countries’ economic growth has recently seen a slowdown. the statistical system of the National Bureau of Statistics and It is a result of both internal economic adjustment and exter- the World Bank, but with certain structural adjustments to nal influences. The next step is to enhance domestic impetus to reflect the relative importance (priority) of economic perfor- maintain stable economic growth through necessary economic mance indicators. reforms. We should insist on the concept of inclusive growth, 2. Establish an environmental performance index in tee was held from November 9 to 12, 2013 in Beijing. Such sessions are held five or six 41. BRICS is an annual diplomatic conference held among five major emerging coun- times at irregular intervals between each CPC National Congress, which is held once tries—Brazil, Russia, India, China and South Africa. every five years. During the plenary session, major issues concerning the direction of 42. Xi Jinpig, “New Start, New Prospect and New Impetus,” accessed July 2014, reforms are discussed, and the Political Bureau reports its work to the CPC Central Com- http://www.china.org.cn/report/2014-08/15/content_33244826.htm. mittee, which is responsible to the National Congress, the highest leading body of the 43. The Central Party School is subordinate to the Central Committee as the party’s Party. “The Decision on Major Issues Concerning Comprehensively Deepening Reforms,” top institution in China. It is one of the most important think tanks and is regarded as the The Third Plenary Session of the 18th CPC Central Committee, accessed July 2014, best training institute where the provincial and ministerial level officers have been http://www.ce.cn/xwzx/gnsz/szyw/201311/18/t20131118_1767104.shtml. trained. 37. Ibid. 44. Peijun Duan and Robert G. Eccles, “Framework for China’s novel sustainable 38. Hu Jintao,“18th Party Congress Report,” 18th CPC National Congress, evaluation system strategy,” Bulletin of Chinese Academy of Sciences, August 21, 2014, November 17, 2012, accessed July 2014, http://news.xinhuanet.com/english/ accessed August 2014, http://www.bulletin.cas.cn/ch/reader/view_full_html.aspx?file_ special/18cpcnc/2012-11/17/c_131981259.htm. no=20140401&flag=1. 39. CPC’s Twelfth Five-Year Plan, which covers the period 2011-2015. The five-year 45. The EPI system is established by Yale Center for Environmental Law and Policy of plans (FYP) of the People’s Republic of China are a range of economic, political and so- Yale University and Center for International Earth Science Information Network of Colum- cial development initiatives for every five-year period since China introduced its first FYP bia University. According to Yale University, the EPI system measures “how well coun- in 1953, under the influence of the Soviet Union. tries perform on high-priority environmental issues in two broad policy areas: protection 40. “China’s Twelfth Five-Year Plan (2011-2015),” The National People’s Congress of human health and protection of ecosystems.” The latest issue, 2014 EPI Report, can (NPC), accessed July 2014, http://www.britishchamber.cn/content/chinas-twelfth-five- be accessed at http://issuu.com/yaleepi/docs/2014_epi_report. year-plan-2011-2015-full-english-version.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 79 accordance with the international EPI system.45 It might also Shanghai Stock Exchange (SSE) began to require SSE-listed be helpful to redistribute the weights of existing indicators of companies—especially those companies in the steel, metal- the Ministry of Environmental Protection and to systematize lurgy, and electric power sectors—to file “social responsibility these indicators into a comprehensive assessment system that reports” along with their annual reports. Moreover, as the covers regional actors and individual enterprises. SSE noted in its 2013 report, “If a listed company discloses its 3. Encourage the study of existing CSR standards, social responsibility report, its directorate should discuss the standardize the social responsibility reporting of enterprises report separately and disclose the report on the SSE’s website and public institutions, and establish a transparent social in the form of separate reports.”49 Nevertheless, publication responsibility evaluation mechanism. of a CSR report is not mandatory.50 The Shenzhen Stock Exchange (SZSE), in its “Guide- Regulation lines for the Social Responsibility of Listed Companies,”51 Because State-Owned Enterprises (SOEs) play such a domi- stipulates that “listed companies, as social members, shall nant role in the Chinese economy, those organizations that bear due responsibilities to such relevant parties of interest as coordinate and oversee the activity of SOEs have a key role workers, shareholders, creditors, suppliers and consumers.” In to play in implementing sustainability. The main responsi- addition to measures designed to protect shareholders’ inter- bility for supervising SOEs falls to SASAC, which is short ests and rights, the guidelines encourage listed companies to for the State-owned Assets Supervision and Administration formulate environmental protection policies that reflect the Commission.46 In a 2008 pronouncement, SASAC called effect their operations have on the environment. And, where for all SOEs directly under the central government (CSOEs) appropriate, the guidelines also suggest that the companies to “actively implement CSR” by seeking to be models of “appoint concrete personnel to be responsible for the setting- “legal and honest business operation” that also emphasize up, implementation, maintenance and improvement of the the conservation of resources and protection of the environ- environment protection system” while providing “essential ment. CSOEs are also urged to become “human-oriented manpower, material resources, technology and financial and harmonious” enterprises that promote the goals of CSR support to environment protection tasks.”52 But, as in the while at the same time strengthening the Chinese economy.47 case of the SSE, the guidelines for the SZSE are voluntary.53 Thus, along with its calls for CSOEs to remain profitable and strive for continuous improvement in product quality and Trade Associations and Think Tanks service, SASAC places considerable emphasis on the goals Finally, government think tanks and industry associations of sustainability: workplace safety, protection of the legal are also playing an important role in supporting sustainabil- rights of employees, and participation in social public welfare ity in China. Unlike SOEs, private enterprises do not operate programs, as well as the conservation of resources and envi- under a central supervisor. Moreover, until recently private ronmental protection. enterprises have not had legal supervisory documents like the “Guidelines.” But, on December 18, 2013, the China Associ- Stock Exchanges ation of Small and Medium Enterprises (CASME) published The country’s two stock exchanges also support sustainability, its “Guidelines to Small and Medium Enterprise on Corpo- primarily through setting and enforcing disclosure require- rate Social Responsibilities.”54 This is the first document to ments for their listed companies.48 In 2013, for example, the provide instructions to small and medium-sized enterprises
46. According to the Constitution of the PRC, the State Council (that is, the Central Limited, when preparing and publishing their CSR report. Each year SSE also publishes People’s Government of PRC), is the executive body of the highest organ of state power “Notice on Doing Good Job in Listed Companies’ Annual Reports.” SSE issues the Notice and state administration. Its function and power includes the authority of administrative every year to guide its listed companies to file annual reports with special attention to legislation, the right to submit proposals, the power of administrative leadership, the certain important issues. The Notice of 2013 was prepared according to the “Rules No. power of diplomatic administration and so on. Directly under the State Council, SASAC 2 on Contents and Format of Information Disclosure by Companies Publicly Issuing Se- is a special commission that has the responsibility as an investor: to supervise and to curities—Contents and Format of Annual Reports” of the China Securities Regulatory enhance the management of the state-owned assets, to guide the reform and reconstruc- Commission (CSRC) and the “SSE Stock Listing Rules.” tions of SOEs and so on. For a more detailed explanation see: “Main Functions and Re- 49. “Notice on Doing Good Job in Listed Companies’ Annual Reports of 2013,” sponsibilities of SASAC,” accessed July 2014, http://www.sasac.gov.cn/n2963340/ Shanghai Stock Exchange (SSE), accessed July 2014, http://english.sse.com.cn/ n2963393/. On January 4, 2008, SASAC published “Guidelines for State-owned Enter- aboutsse/news/c/c_20140108_3762103.shtml. prises directly under the Central Government on Fulfilling Corporate Social Responsibili- 50. “The social responsibility report should be released (if applicable).” Ibid. ties,” accessed July 2014, http://www.sasac.gov.cn/n2963340/n2964712/4891623. 51. “Guidelines for Social Responsibility of Listed Companies,” Shenzhen Stock Ex- html. On the same day, SASAC published Answer Questions from the Press on “Guide- change (SZSE), accessed July 2014, http://www.szse.cn/main/zxgx/9300.shtml. lines to the State-owned Enterprises Directly under the Central Government on Fulfilling 52. “SZSE Promulgates Guidelines for Social Responsibility of Listed Companies,” Corporate Social Responsibilities” explaining the Guidelines in detail, accessed July Shenzhen Stock Exchange (SZSE), accessed July 2014, http://www.szse.cn/main/en/ 2014, http://www.sasac.gov.cn/n1180/n1566/n259760/n264866/3621552.html. AboutSZSE/SZSENews/9641.shtml. 47. Ibid. 53. SZSE encouraged “adopted the voluntary information disclosure system for imple- 48. In May 14, 2008, the Shanghai Stock Exchange (SSE) published “Guidelines of mentation conditions of social responsibility of listed companies.” Ibid. Shanghai Stock Exchange for Environmental Information Disclosure of Listed Compa- 54. “Guidelines to Small and Medium Enterprise on Corporate Social Responsibili- nies,” accessed July 2014, http://www.sse.com.cn/lawandrules/sserules/listing/stock/a/ ties,” China Association of Small and Medium Enterprises (CASME), accessed July sseruler20080514a.pdf, and on December 12, 2012 it published “Guidelines for the 2014, http://www.baidu.com/link?url=BuzXcRkFkSm6_nGhin28d51Rs8ZCwa- Preparation of the “Report on Performance of Corporate Social Responsibility.” These two gRa0uCXLzVgtpwqXcJB-j0N2GWwghEHS_Llplphgf48H1pbXCCFp7BFK. documents offer considerable support to corporations, like Commercial Bank of China
80 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 (SMEs) with the aim of raising the awareness of CSR. Based and “cross-cutting themes” (like ecosystems, technological on the core interest of stakeholders of SMEs, these guide- innovation, risk management, and the “circular economy”). lines urge enterprises to recognize four main categories of The CBCSD was the first organization in China to initiate social responsibility: employment, environment, market, and the compilation of a sustainable development report. During community.55 each of the last 10 consecutive years, the CBSCD has held an According to this report, SMEs account for over 99% annual workshop on the latest trends in sustainable develop- of the total number of enterprises in China, represent about ment. Other industry associations have also announced their 60% of the total economy, and generate about 50% of fiscal own guidelines that have had a profound influence in their revenue. At the same time, they have created nearly 80% of respective industries.58 These standards have been playing an urban jobs, while developing more than 60% of the country’s important role in helping enterprises to develop sustainable invention patents and 75% of its technological innovations.56 business models and to prepare CSR reports with respect to Thus, their role in sustainable development is as important as the unique features of different industries. that of the CSOEs, although changing their practices will be Government think tanks are also playing an important more difficult given that CASME does not have the author- role in supporting sustainable development in China. For ity of the Chinese government in the way that SASAC does. example, the Research Center for Corporate Social Responsi- An especially important industry association is the bility, which is part of the Chinese Academy of Social Science CEO-led and member-driven China Business Council for (CASS-CSR), is a strong advocate of CSR reporting and Sustainable Development (CBCSD). Founded in October the criteria on which such reports should be based. Besides 2003,57 the CBSCD is a coalition of 72 leading Chinese publishing the Blue Book59 from 2009 to 2013 and the White and foreign enterprises registered and operating in China Book of Chinese CSR Reports60 from 2011 to 2013,61 CASS- and is a national organization sponsored by the Ministry CSR also published (in March 2011) the “China Corporate of Civil Affairs. Its three major objectives are: (1) to be the Social Responsibility Reporting Guidelines” (known as leading business advocate on issues related to sustainable “CASS-CSR 2.0”), which are now followed by many Chinese development; (2) to provide input to the government and companies.62 assist in policy development in order to create a framework CASS-CSR 2.0 is based on a “four-in-one” model that, that allows business to effectively contribute to sustainable in turn, derives from the traditional “triple bottom line” and development; and (3) to promote exchange and coopera- “stakeholder” concepts. The implementation of CASS-CSR tion between Chinese and foreign business enterprises on a 2.0 involves the monitoring of 21 indicators of “responsibility broad range of issues related to sustainable development and management” that cover each of the six major aspects of CSR: corporate social responsibility. In pursuing this third objec- strategy, governance, integration, performance, communi- tive, the CBCSD works closely with the World Business cation, and research.63 CASS-CSR 2.0 also recognizes the Council on Sustainable Development by implementing importance of tailoring CSR reporting and requirements to relevant projects in China and co-hosting seminars and reflect differences in industry characteristics. Thus, besides workshops. the general indicators, CASS has established “supplemen- The CBCSD sponsors both industry-specific projects tary” indicators that have been customized for 46 industries, (such as low-carbon eco-cites, smart grid and electrical utili- identifying the different features of each industry with respect ties, and sustainable development in mining and minerals) to CSR.64
55. Ibid. from different industries according to China Corporate Social Responsibility Reporting 56. Ibid. Guidelines (CASS-CSR 2.0) and analyzes the characteristics of the current CSR develop- 57. Information on the China Business Council on Sustainable Development was ob- ment in China. tained in a meeting with them on August 22 in Beijing and materials sent by Ji Qing, 61. Qunhui Huang et al., Blue Book of Corporate Social Responsibility (2013). Bei- Secretariat Director, on that same day. jing: Social Sciences Academic Press (CHINA), (2013); Zhong, Hongwei et al., White 58. For example, see: “China Industrial Enterprise and Industrial Associations Social Book of Chinese CSR Reports (2013). Beijing: Economy & Management Oyblishing Responsibility Guidelines in 2008,” the China Federation of Industrial Economics (CFIE), House, 2013. accessed July 2014, http://www.csr-china.net/templates/node/index.aspx?nodeid= 62. Huagang Peng, ed. China Corporate Social Responsibility Reporting Guidelines 3596d7f3-799a-4e48-bb94-e492f49538df&page=contentpage&contentid=788421 (CASS-CSR 2.0). Beijing: Economy & Management Oyblishing House, 2011. The sec- 5c-3041-450c-94cc-03091327e56d&l=cn. The Responsible Supply Chain Association tion, “Principle of the CSR Report” in Chapter 2 of CASS-CSR 2.0 is composed with published its own standard “China Social Compliance 9000 for Textile & Apparel Indus- reference to the G3 Gridlines published by GRI in 2006. try” in the same year, accessed July 2014, http://www.csc9000.org.cn/PDF/2008_ 63. Ibid, 130. CSC9000T_CN_Final.pdf; and the China Banking Association issued “Guidelines for 64. The industry-specific method that CASS-CSR chose is very much along the lines Corporate Social Responsibility of Chinese Banking and Financial Institutions” in 2009, of the approach that other organizations in the international society adopt. An indepen- accessed July 2014, http://www.china-cba.net/bencandy.php?fid=42&id=1183. dent 501(c) 3 non-profit organization, the Sustainability Accounting Standards Board 59. In the Blue Book, Research Center for CSR in Economics Division of Chinese (SASB) developed sustainability accounting standards for more than 80 industries in 10 Academy of Social Science (hereinafter referred to as “the Research Center for CSR of sectors. CASS”) discusses the history and current situation of CSR in China, and releases a series 65. “tf. Sales USD,” available from Thomson Reuters via Thomson ONE, accessed rankings of enterprises (SOE, Private Enterprise and FOE) based on their CSR reports’ August 2014. score evaluated by CASS-CSR’s rating committee. 66. “Global 500 2013,” Fortune, accessed August 2014, http://fortune.com/glob- 60. In the White Book, the Research Center for CSR of CASS rates 1,084 CSR reports al500/2013/royal-dutch-shell-plc-1/.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 81 Sustainability in the Top 100 Table 1 Percent of Companies Preparing a As we pointed out at the beginning of this article, the world’s GRI Sustainability Report by Quartile largest companies are as important, if not more important, than governments in creating a sustainable society. Wal-Mart, the largest company in the world, and China Petroleum & Quartile China U.S. Chemical Corp. (Sinopec) each had approximately $475 First (1-25) 76 80 billion in sales in 2013,65 with 2,200,000 and 1,015,039, Second (26-50) 56 68 66 employees, respectively. While governments can make poli- Third (52-75) 44 60 cies, we must rely on individual companies to put them into Fourth (76-100) 40 56 practice. Whether these policies are effective depends on the quality of company implementation and the effectiveness of government monitoring—both of which are often prob- the P/E ratio for this group is 4.81. Although all of the China lematic in China. To compound the issue, companies have 100 companies have outside shareholders, this group may be to make numerous choices about how they use and allocate placing relatively more emphasis on other stakeholders and resources that are not covered by laws and regulations. When objectives beyond profitability, at least in the short term.71 The companies take the initiative to voluntarily support sustain- government owns between 20% and 50% in 16 other China ability, it is an important indicator of company commitment 100 companies, and less than 20% in three others. For this to the movement. group of 19 “shareholder-controlled” companies, the P/E ratio The above section shows that China, at least in terms of is 15.05, close to the U.S. average. The remaining 23 compa- legislation and rhetoric, is increasingly recognizing the impor- nies have little, if any, state ownership. These companies have tance of sustainability. But are actions matching words? We an average P/E ratio of 13.63—which is actually smaller than can offer a crude assessment using some basic indicators that that of the shareholder-controlled group. provide a basis for comparing the largest 100 publicly listed We examined two, admittedly imperfect, indicators of Chinese companies (China 100) with their publicly listed sustainability on the part of these companies: participation U.S. counterparts (U.S. 100). In 2013, the total revenues in the UN Global Compact (Global Compact)72 and publi- of the U.S. 100 were $7.7 trillion, nearly twice that of the cation of a sustainability report that uses guidelines from China 100’s $4.0 trillion.67 The differences in market cap and the Global Reporting Initiative (GRI).73 These indicators are profitability are even larger. Total profits for the U.S. 100 were imperfect because both can be a form of “greenwashing,” $732.7 billion, or 9.6% of sales, as compared to $52.3 billion a practice in which a company presents itself as commit- in profits for the China 100, which amounted to 1.3% of ted to sustainability, while their actual business operations their total sales and less than 10% of the profits of their U.S. belie the claim. As relatively small nonprofit organizations, counterparts. As a further indicator of the profitability of the neither one of these organizations has the authority, let alone U.S. 100, these companies account for 42.6% of the profits the resources, to monitor and ensure that each company is of the Global 1000.68 What’s more, the U.S. companies also following the “spirit” of their intent. Thus, it is possible that dominate in terms of market cap, at a ratio of 3.5 to 1.69 And what a company claims to be doing through its membership they have an average P/E ratio of 16, as compared to about in the Global Compact or in its sustainability reporting may 10 for their Chinese counterparts.70 be at odds with how it is run on a day-to-day basis. These differences in relative profitability and market cap Imperfect is not the same thing as meaningless. If these are partly attributable to the large percentage of SOEs in the two indicators were both easy and costless forms of green- China 100. Fifty-eight of these companies are State-controlled washing, every company would be doing them. One of the in that the government owns 50% or more of the company; objections to sustainability reporting is that it takes resources.
67. The U.S. companies are also larger in terms of employees with an average of ciples in the areas of human rights, labor, environment and anti-corruption. By doing so, 62,335 compared to 31,635. All averages here and below were determined using the business, as a primary driver of globalization, can help ensure that markets, commerce, Thompson Tau technique to remove outliers. “tf. Sales USD,” available from Thomson technology and finance advance in ways that benefit economies and societies every- Reuters via Thomson ONE, accessed August 2014. “tf. Employees,” available from where.” “Overview of the UN Global Compact,” United Nations Global Compact, ac- Thomson Reuters via Thomson ONE, accessed August 2014. cessed August 2014, http://www.unglobalcompact.org/AboutTheGC/index.html. Signa- 68. Net Profit data was available for 997 out of 1,000 top companies; they had a tories to the Global Compact agree to follow 10 principles: two regarding human rights, sum of $1.72 trillion. (Ninety-six companies reported net loses.) Of the G1000, the US four regarding labor, three regarding the environment, and one regarding anti-corruption. accounts for 268 companies. “ws.NetProfit12MonthMovingUSD,” available from Thom- “The Ten Principles,” United Nations Global Compact, accessed August 2014, http:// son Reuters via Thomson ONE, accessed August 2014. www.unglobalcompact.org/AboutTheGC/TheTenPrinciples/index.html. 69. “tf. YrEndMarketCap,” available from Thomson Reuters via Thomson ONE, ac- 73. “The Global Reporting Initiative (GRI) is a leading organization in the sustain- cessed August 2014. ability field. GRI promotes the use of sustainability reporting as a way for organizations 70. “tf. PERatioClose,” available from Thomson Reuters via Thomson ONE, accessed to become more sustainable and contribute to sustainable development.” “About GRI,” August 2014. Global Reporting Initiative, accessed August 2014, https://www.globalreporting.org/in- 71. Ibid. formation/about-gri/Pages/default.aspx. 72. “The UN Global Compact is a strategic policy initiative for businesses that are committed to aligning their operations and strategies with ten universally accepted prin-
82 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Figure 1 Average Quality of G250 Reports by Country1
UN Global Compact LEAD Company Highlights2 How are LEAD companies committing to sustainability? Environmental Social Governance • The Dow Chemical Company made it a company • In 2013, China Development Bank offered small • Sinopec announced that it was the first Chinese priority to reduce their GHG emissions. Dow reports loans to youth entrepreneurs. The loans put over company to build an information sharing platform preventing over 308 million metric tons of GHG, 2,000 women into work, which helped raise their and organizational structures to combat corruption. or the average footprint of 48 million single-family average annual income by 8,000 yuan. homes since 1990. • In 2012, China Minmetals Corporation received • Intel Corporation announced in its 2013 CSR an award from SASAC for “Outstanding Enterprise.” • In 2012, The Coca-Cola Company helped recycle Report that it was able to manufacture microproces- China Minmetals continues to work to improve 371 million pounds of aluminum and PET plastic sers that are 100% “conflict-free.” managements and its services to decrease costs and containers in the US and Canada. Coca-Cola con- improve efficiency. China Minmetal’s Iron Ore and tinues to inspire consumers to recycle through their Steel Strategic Business Unit was able to reduce its various country-specific initiatives, including Zero management costs in 2012 by 16.9%. Waste Scotland and the Keep America Beautiful campaign. 1. Rated by top 250 companies as determined by the Fortune Global 500 ranking for Development Bank: Sustainability Report 2013,” China Development Bank, accessed 2012. “The KPMG Survey of Corporate Responsibility Reporting 2013,” KPMG Interna- September 2014, http://www.cdb.com.cn/english/Column.asp?ColumnId=190. “Intel tional, December 2013, accessed September 2014, https://www.kpmg.com/Global/en/ Look Inside: 2013 Corporate Responsibility Report,” Intel Corporation, accessed Sep- IssuesAndInsights/ArticlesPublications/corporate-responsibility/Documents/corporate-re- tember 2014, http://csrreportbuilder.intel.com/PDFFiles/CSR_2013_Full-Report.pdf. sponsibility-reporting-survey-2013-exec-summary.pdf. “Sinopec: 2012 Communication on Progress for Sustainable Development,” Sinopec 2. “Sustainability Disclosure Database: Dow 2013 Sustainability Report,” Global Re- Corp., accessed September 2014, http://english.sinopec.com/download_center/re- porting Initative, accessed September 2014, http://database.globalreporting.org/reports/ ports/2012/20130324/download/2013032523.pdf. “2012 China Minmetals Sustain- view/21654. “Coca-Cola: 2012-2013 Sustainability Report,” The Coca-Cola Company, ability Report,” China Minmetals Corporation, accessed September 2014, http://www. accessed September 2014, http://www.coca-colacompany.com/sustainability/. “China minmetals.com.cn/upload/attachment/1371430065447a.pdf.
For instance, those companies that choose to become a signa- top 100 in each country, so this should not be a significant tory to the Global Compact must also report through the barrier to companies intent on misleading their investors and required “Communication on Progress.”74 That said, it is the public by wrapping themselves in a “green mantle.” highly unlikely that resource limitations are an issue for the In fact, the decision to participate in the Global Compact
74. “Business participants in the UN Global Compact commit to make the Global supporting broader UN development goals.” “What Is a COP?,” United Nations Global Compact ten principles part of their business strategies and day-to-day operations. Com- Compact, accessed August 2014, http://www.unglobalcompact.org/COP/index.html. panies also commit to issue an annual Communication on Progress (COP), a public dis- The COP may or may not take the form of a sustainability report that applies the GRI closure to stakeholders (e.g., investors, consumers, civil society, governments, etc.) on Sustainability Reporting Guidelines; COP format is at the discretion of the reporting progress made in implementing the ten principles of the UN Global Compact, and in company.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 83 and to issue a GRI-based sustainability report carries commit- U.S., and the percentage difference between the two countries ments beyond fulfilling reporting requirements. Companies grows larger in each succeeding quartile.81 that commit to these organizations create general expecta- The two countries also appear to be similar in terms of the tions on the part of stakeholders and civil society about their quality of their CSR reporting. In a study done by KPMG of behavior. These companies are voluntarily holding themselves corporate responsibility reporting of the largest 100 compa- to a higher standard and can be punished for failing to do so. nies by revenues in 41 countries, an assessment was made The data support the argument that participation in of the quality of reporting by the Global 250. As shown in the Global Compact and issuing a GRI-based sustainabil- Figure 1, China ranks last and the U.S. second-to-last. Both ity report is an important decision for a company to make. of these countries are far below the top ranked countries of The data also show that in terms of the each country’s top Italy, Spain, and the U.K.82 100, China and the U.S. are virtually identical in terms of these indicators of corporate commitment to sustainability. Conclusion Of course, this is not the same thing as saying these sets of China is facing enormous challenges to maintain its economic companies or the countries as a whole are equally committed growth in order to accommodate its ongoing development to sustainable development. This would require a much more and urbanization while doing so in a more sustainable way. detailed analysis at both the country and company level. The country is already suffering enormous environmental and Only 15 of the U.S. 100 participate in the Global social costs, and these will only grow if firm measures aren’t Compact—exactly the same number as the China 100. The taken. The potential consequences for China—and the entire total number of listed U.S. companies in the Global Compact world given China’s increasing importance—are enormous. is 542, and in China it is 285.75 Moreover, Global Compact Nevertheless, there is a high level of awareness in all LEAD convenes a subset of approximately 50 companies that aspects of Chinese society—the government, the private have been invited to participate “because they have a history sector, the press, and its citizens themselves—that sustain- of engagement with the UN Global Compact—locally and/ able development must become a higher priority. Using or generally.”76 Companies that accept the invitation “are some crude empirical indicators, the largest 100 companies challenged to implement the Blueprint for Corporate Sustain- in China appear to be as committed to sustainable develop- ability Leadership” and “to address Blueprint implementation ment as their U.S. counterparts. More sophisticated analysis in the Communications on Progress (COPs).”77 Overall, the comparing these two countries in terms of policies and U.S. has more LEAD members than China: the U.S. has six practices for sustainable development is needed—and we members, followed by China at five. (See the box inset for a plan to start that analysis soon. description of some LEAD companies for both countries.) The U.S. 100 has four members and the China 100 has one.78 Peijun Duan is the director and senior professor of strategic research at The U.S. 100 and the China 100 also look very similar the China Central Party School. He has published over 10 books and 200 in terms of quantity and quality of GRI reporting, although papers, and trained thousands of Chinese senior officials and managers. His more U.S. companies produce reports than their Chinese work has had a significant influence on China’s reforms and modernization. counterparts—66 vs. 54.79 Part of this difference could be He is also a senior research fellow at Harvard’s Kennedy School of Govern- attributable to the fact that the GRI’s presence in China is ment, which suppports his research under its “China Public Policy” program. more recent and that it was not until 2014 that its Guidelines were made available in Chinese.80 However, both countries Robert G. Eccles is a Professor of Management Practice at the are almost identical when it comes to the rate of adoption. As Harvard Business School. He is also a Master of Sustainable Strategies shown in Table 1, the larger the company, the more likely it at the DeTao Masters Academy. His most recent book is The Integrated will have issued a GRI sustainability report. About four-fifths Reporting Movement: Meaning, Momentum, Motives, and Materiality, of the top quartile report in both countries. Each succeed- with Michael P. Krzus and Sydney Ribot. It is scheduled to be published ing quartile has a smaller percentage of GRI reporters than by John Wiley & Sons in November 2014. the one above it, the percentages are always highest for the
75. “Global Compact Participants,” United Nations Global Compact, accessed August org/HowToParticipate/Lead/index.html. 2014. 79. “United Nations Global Compact,” UN Global Compact, accessed August 2014, 76. “Global Compact LEAD,” United Nations Global Compact, accessed August https://www.unglobalcompact.org/. 2014, http://www.unglobalcompact.org/HowToParticipate/Lead/index.html. 80. Versions of the guidelines are available in Simplified Chinese and Traditional 77. Ibid. For more information see: “Blueprint For Corporate Sustainability Leader- Chinese. “G4 Now Available in 10 Languages,” Global Sustain, accessed August 2014, ship,” United Nations Global Compact, 2010, accessed August 2014, http://www.un- http://globalsustain.org/en/story/9788. globalcompact.org/docs/news_events/8.1/Blueprint.pdf. “Designed to inspire advanced 81. “Sustainability Disclosure Database,” Global Reporting Initiative, accessed Au- performers to reach the next level of sustainability, the Blueprint sets targets that all gust 2014, http://database.globalreporting.org/pages/about. companies should work towards in order to ascend the learning and performance curve.” 82. “The KPMG Survey of Corporate Responsibility Reporting 2013,” KPMG Interna- 78. Germany has four LEAD companies, five countries have three, three countries tional, December 2013, accessed September 2014, https://www.kpmg.com/Global/en/ have two, and the remaining 15 countries have one each. “Global Compact LEAD,” IssuesAndInsights/ArticlesPublications/corporate-responsibility/Documents/corporate-re- United Nations Global Compact, accessed August 2014, http://www.unglobalcompact. sponsibility-reporting-survey-2013-exec-summary.pdf.
84 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Politically Connected CEOs, Corporate Governance, and the Post-IPO Performance of China’s Partially Privatized Firms by Joseph P. H. Fan, T.J. Wong, and Tianyu Zhang, The Chinese University of Hong Kong
any scholars have argued that the protection former government bureaucrat—that is, a current or former of local industries from competition and the officer of the central or local governments or the military— MB extraction of “private benefits” are important as a proxy for government intervention in the firm. Because objectives of politicians’ intervention in busi- the Chinese government has the right to appoint the CEO ness activities, and that such intervention tends to be more of a listed company, the CEO’s political affiliation provides intrusive in countries with weak institutional constraints.1 a suitable proxy for government influence. Our analysis of a What’s more, a considerable body of research has shown that detailed database of CEOs and directors of 790 companies countries with weaker property rights and limited protection that went public in China between 1993 and 2001 (nearly 73% against expropriation by politicians and the country’s elite of all IPOs) shows that almost 27% of CEOs were politically have substantially lower income per capita and investment connected. After controlling for other factors that influence rates, as well as less developed stock markets. firm performance, we found that long-term post-IPO stock This article summarizes the arguments and findings returns were significantly worse when a firm’s CEO is politi- of our study of government intervention in China’s newly cally connected. Moreover, this difference in stock return partially privatized firms. Because property rights in China performance was noticeable soon after the initial listing and remain weak and the product and capital markets are far became statistically significant around 40 days after the new from liberalized, one would expect a strong negative relation issue. The operating performance of companies run by politi- between government intervention and the performance and cally connected CEOs was also consistently worse than that governance quality of the affected firms. of otherwise comparable firms. After controlling for other And, indeed, the effects of China’s share issue privatiza- factors, we also found that shareholder returns on the day of tion on corporate performance stand in sharp contrast to the the IPO were negatively related to the CEO’s political connec- experience in other economies, where privatization has gener- tions, which suggests that China’s IPO investors anticipate the ally led to performance improvement.2 Accordingly, our study negative effects of government intervention and hence lower attempted to answer three questions about China’s partial the prices they are willing to pay for these stocks. The evidence privatizations: (1) What was the effect of government influ- also suggests that politically unconnected firms underprice ence on the privatized companies’ longer-term, post-IPO stock their IPO shares more than do politically connected firms, returns and operating performance? (2) Did the post-IPO stock which could serve as a signal to investors that the firms will be market performance reflect the effects, if any, of government less subject to intervention by bureaucrats.3 Finally, we found influence; and if so, when did such effects show up? and (3) that the boards of our sample firms had almost no directors Were the governance and board composition of such firms who represent public stock investors; and that when CEOs are affected in discernible ways by government intervention? politically connected, boards tend to have more bureaucrats In conducting our study, we used the CEO’s “politi- and fewer professionals, and the directors are on average older cal connection,” which we defined as serving as a current or and less likely to be women.
* This is a shorter, less technical version of the authors’ paper that was published in and Simon Johnson, “Unbundling institutions,” Journal of Political Economy 113, 949- the Journal of Financial Economics, Vol. 84 No. 2 (2007), pp. 330-35. 995, 2005. 1. See George J. Stigler, “The theory of economic regulation,” Bell Journal of Econom- 2. See, for example, W.L. Megginson, R.C. Nash, M. Randenborgh, “The financial and ics and Management Science 2, 3-21, 1971; Sam Peltzman, “Toward a more general operating performance of newly-privatized firms: an international empirical analysis,” theory of regulation,” Journal of Law and Economics 19, 211-240, 1976; F.S. Journal of Finance 49, 403-452, 1994; N. Boubakri, J. Cosset, J., “The financial and McChesney, “Rent extraction and rent creation in the economic theory of regulation,” operating performance of newly privatized firms: evidence from developing countries,” Journal of Legal Studies 16, 101-118, 1987; Hernando De Soto, The Other Path, Journal of Finance 53, 1083-1112. 1998; W.L. Megginson, R.C. Nash, J.M. Netter, A. Harper and Row, New York, 1990; P. Spiller, “Politicians, interest groups, and regulators: Schwartz, “The long-term return to investors in share issue privatizations,” Financial a multiple-principals agency theory of regulation, or let them be bribed,” Journal of Law Management 29, 67-77, 2000. and Economics 33, 65-101, 1990; Andrei Shleifer, Robert Vishny, “Politicians and 3. This result corroborates prior research findings that IPO firms in market-oriented firms,” Quarterly Journal of Economics 109, 995-1025, 1994; Andrei Shleifer, Robert economies tend to underprice more than do those in interventionist economies. See E. Vishny, “The Grabbing Hand: Government Pathologies and Their Cures,” Harvard Univer- Perotti, “Credible privatization,” American Economic Review 85, 847-859, 1995; S. L. sity Press, Cambridge, MA, 1998; J.S. Hellman, G. Jones, D. Kaufmann, D., “Seize the Jones, W.L., Megginson, R.C. Nash, J.M. Netter, “Share issue privatizations as financial state, seize the day: state capture, corruption, and influence in transition,” World Bank means to political and economic ends,” Journal of Financial Economics 53, 217-253, Policy Research Working Paper, no. 2444. Washington D.C., 2000; Daron Acemoglu 1999.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 85 Taken together, our findings provide persuasive evidence retained ultimate decision rights concerning mergers and that China’s partial privatizations and ongoing government acquisitions and the disposal of shares and assets of these listed intervention (as reflected in the political connections of firms, as well as decision rights on the appointment of CEOs. the firms’ CEOs) are not conducive to shareholder value It is not difficult to forecast that, with this institutional maximization. The high involvement of bureaucrats and background, the non-transferability of state-owned shares the low participation of professionals in management and and assets would create thorny incentive problems among directorships along with the poor post-IPO performance are both government officials and firm managers. Under these perhaps not surprising results of China’s share issue privatiza- conditions, corporate governance is likely to be ineffective tion scheme.4 and firm value to be dissipated, due fundamentally to the absence of a free market that would release the firms from The Rationale for our Study state ownership.7 Moreover, conflicts of interest between During the economic reforms of the 1980s, the Chinese shareholders and bureaucrats overseeing the firm, with the government launched a program that decentralized manage- latter likely pursuing social objectives or private gains at the rial decision rights of state-owned enterprises (SOEs) from the firm’s expense, are further expected to decrease firm value.8 central government down to the local firm level. The central We assume that an interventionist government is more government’s plan was to promote markets and to gradu- likely to endorse a bureaucrat’s appointment as CEO of a ally phase out its central planning function. In the 1990s, newly listed company. A first test of whether a politically the government allowed SOEs to be partially privatized by connected CEO and his or her affiliated government pursue issuing a minority allocation of shares to individual inves- objectives that run counter to corporate productivity was tors, who could trade their shares freely in newly developed therefore to determine if the appointment is associated with stock markets set up in Shenzhen and Shanghai in 1990 and poor long-term firm performance. If the government tends 1991, respectively. to extract rents from the firm, the appointment of a politi- But for ideological reasons, this partial privatization cally connected CEO would negatively affect post-IPO stock process, which was officially calledcorporatization, prohib- returns and operating performance, all else equal. ited the government from selling its controlling stake in the In a well-functioning capital market, the long-term firms. Therefore, unlike in most other countries where share negative effects of government intervention in the form issue privatizations are accomplished through secondary or of a politically connected CEO should be factored into a mixed primary-secondary offerings, the Chinese privatiza- company’s stock prices shortly after its stock is offered to the tions were primary offerings that did not involve subsequent public. Likewise, the anticipated negative effects of govern- secondary offerings.5 ment intervention should reduce the willingness of investors In association with the corporatization process in the to pay high prices for the new shares. To be sure, the govern- 1990s, the central government further decentralized its power ment could lower the offering price to boost demand for the by specifying the exact decision rights assigned to the SOE new shares, making the net effect of the politically connected level—rights that were related mainly to operating decisions CEO on initial returns unclear. But this scenario seems and the use of retained funds.6 But if the operating decision unlikely because the limited supplied IPO shares in China rights were largely granted to SOE managers, the government are almost always oversubscribed. Therefore, we would not
4. This paper is related to several other strands of literature. First, it considers the and Economics 47, 167-194, 2004; M. Faccio, “Politically connected firms,”American governance and performance consequences when a substantial ownership block is non- Economic Review 96, 369-386, 2006. transferable: Arrmen Alchian, “Some economics of property rights,” Il Politico 30, 816- 5. Most of our sample firms did not actively engage in secondary offerings, nor did 829, 1965. Reprinted in Arrmen Alchian, Economic Forces at Work. Liberty Press, In- some of the firms’ rights offering activities significantly dilute state ownership. We repeat dianapolis, IN, 1977 (Originally published in 1961 by the Rand Corporation); Michael our analysis on the sample, excluding 58 firms that made secondary offerings subse- C. Jensen, William H. Meckling, “Rights and production functions: an application to la- quent to their IPOs, and find that our results are generally unaffected by the exclusion. bor-managed firms and codetermination,” Journal of Business 52, 469-506, 1979; Subsequent to primary offerings, government-owned shares can occasionally be trans- J.M. Karpoff, E.M., Rice, “Organizational form, share transferability, and firm perfor- ferred in blocks among state-owned firms. However, free trading of these shares in the mance,” Journal of Financial Economics 24, 69-105, 1989. Second, it provides addi- secondary markets was strictly prohibited during our sample period. tional evidence on the effects of government ownership on post-privatization perfor- 6. Y. Qian, “Reforming corporate governance and finance in China,” In: M. Aoki, K., mance: S. Kole, J.H. Mulherin, “The government as a shareholder: a case from the Kim, (Eds.), Corporate Governance in Transitional Economies, World Bank, Washington, United States,” Journal of Law and Economics 40, 1-22, 1997; N. Boubakri, J. Cosset, D.C., 1995. O. Guedhami, “Liberalization, corporate governance and the performance of newly priva- 7. Alchian (1965), Jensen and Meckling (1979), and Karpoff and Rice (1989) pro- tized firms,”Journal of Corporate Finance 11, 767-790, 2005; N. Gupta, “Partial priva- vide analyses on the effects of non-transferable property rights on organizations and in- tization and firm performance,”Journal of Finance 60, 987-1015, 2005; and the afore- centives. When assets/shares are non-transferable, the firms cannot sell off its assets mentioned, Megginson, and Nash, 2005. Third, it extends the literature on government and/or controlling stakes to buyers who potentially can run the firms more productively. intervention and rent seeking. Our evidence that bureaucrats seek rents from firms com- The prohibition against trading the shares also renders two governance mechanisms, plements several recent studies that focus on political connections and rent seeking: A. incentive compensation contracts and corporate control, impractical. This problem is Agrawal and C.R. Knoeber, “Do some outsider directors play a political role?” Journal of exacerbated by the absence of a large secondary owner who benefits from additional firm Law and Economics 44, 179-199, 2001; C.J. Hadlock, D.S Lee, R. Parrino, R., “CEO productivity by serving as a high-power monitor (Shleifer and Vishny, 1986). careers in regulated environments: evidence from electric and gas utilities,” Journal of 8. Andrei Shleifer, Robert Vishny, “The Grabbing Hand: Government Pathologies and Law and Economics 45, 535-563, 2002; E. Helland, M.E., Sykuta, “Regulation and the Their Cures,” Harvard University Press, Cambridge, MA, 1998. evolution of corporate boards: monitoring, advising or window dressing?” Journal of Law
86 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Table 1 The sample
This table presents information on the sample of newly partially privatized firms in China that went public during 1993 to 2001. Columns 1 and 2 report the number of firms and the percentage of the total initial public offering (IPO) population. Columns 3 and 4 report numbers on the subsample of firms led by politically connected CEOs. Panel A reports the sample by year of IPO. Panel B reports the sample by industry sector.
Total sample Firms with politically connected CEOs Number % of the total IPO popu- Number % of the total sample lation by year/sector by year/sector Panel A: By year 1993 59 47.58 9 15.25 1994 64 58.18 16 25.00 1995 12 50.00 3 25.00 1996 132 65.02 46 34.85 1997 172 83.50 46 26.74 1998 88 83.02 32 36.36 1999 80 81.63 21 26.25 2000 117 85.40 29 24.79 2001 66 83.54 9 13.64 Panel B: By industry sector
Natural resources 48 78.69 19 39.58 Manufacturing 499 74.92 128 25.65 Services and trade 116 75.82 32 27.59 Public utilities 63 67.02 20 31.75 Finance & real estate 18 42.86 1 5.56 Conglomerate 46 64.79 11 23.91
Total 790 72.68 211 26.71 expect the marginally lower demand for the new shares due required by a firm is likely to be determined by the institu- to the government intervention to be a major concern in the tional environment to which the firm adapts.10 We began government’s IPO pricing decisions. with the expectation that the property regulations in China’s On the other hand, prior studies have shown that privatization scheme would lead to boards characterized by non-interventionist governments will underprice IPO shares strong bureaucratic influence, weak governance, and low to signal investors their intent to relinquish control of the professionalism. Specifically, we expected that firms with firm.9 Under this scenario, the CEO’s political ties (which, government-appointed, politically connected CEOs would again, are a proxy for government intervention) should be have more directors with political ties and fewer directors associated with smaller IPO underpricing (lower initial with business experience or professional backgrounds, mainly returns). Consistent with this signaling hypothesis, there because politically connected CEOs need allies on the board should also be a significant difference in the long-term post- to reinforce their policies and objectives. Non-political profes- IPO performance among privatized firms on the basis of the sionals, or directors representing investors’ interests, could CEO’s political ties, as predicted earlier. stand in the way of politicians’ objectives. Finally, we began with a hypothesis about the effect of politically connected CEOs on the boards of the newly Our Study: Data and Sample privatized firms. The structure of a board of directors We manually collected CEO and board data from the IPO reveals information about the quality of the firm’s manage- prospectuses of newly listed A-share companies on the Shang- ment and the extent of checks and balances on managerial hai Stock Exchange and the Shenzhen Stock Exchange from decisions. The degree of professionalism and monitoring 1993 to 2001.11 For each company, we obtained a profile of
9. See, e.g., Perotti (1995); Jones, Megginson, Nash, and Netter (1999). 10. B.E. Hermalin, M.S. Weisbach, “Boards of directors as an endogenously deter- mined institution: a survey of the economic evidence,” Economic Policy Review 9, 7-26, 2003.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 87 the CEO and each of the other directors from the company’s Post-IPO Performance prospectus. In addition to the CEO’s or director’s name, the We used several stock- and accounting-based measures to profile typically contains information on age, gender, educa- evaluate the post-IPO performance of the Chinese compa- tion, professional background, and employment history. nies in our sample. The stock performance measures were the From the profile, we traced the CEO’s or director’s political one-, two-, and three-year post-IPO cumulative abnormal connections by examining whether he or she was currently or market-adjusted stock returns (CARs), calculated on the basis formerly an officer of either the central government, a local of monthly stock returns starting from the first month after government, or the military. From the director’s profile and the IPO date. We used the equally weighted market index of the “Company History,” “Background of Founding Inves- both the Shanghai and Shenzhen stock exchanges for adjust- tors,” and/or “Background of Large Shareholders” sections ments in all our analyses, but our regression results remain of the company’s prospectus, we further identified each qualitatively similar with value-weighted indexes. director’s current or former business experience outside the We also used three measures of operating performance: business group to which the newly listed company belongs. sales growth, earnings growth, and the change in return on We obtained CEO and board data for 790 IPO firms sales (ROS). We calculated ROS as net income divided by during the 1993 to 2001 period, representing 73% of the total sales. We did not use return on book assets or return on book number of IPO firms in China over that period andcovering equity because Chinese share issue privatizations are primary 7,255 CEOs and directors.12 offerings that increase the asset base of the firms substantially Table 1 provides a summary description of our sample. As after the IPOs, creating a downward bias on performance can be seen in Panel A of Table 1, the IPO firms in our sample measures based on equity or assets. are unevenly distributed across the sample period, which Prior research on share issue privatization performance largely reflects the overall IPO pattern in China. The sample typically compares operating performance changes a few coverage improves over time, reflecting improved public years before and a few years after privatization.13 Consistent disclosure of company information, especially after 1997. with this research, we used the pre-IPO accounting figures Panel B breaks down the sample by industry sector. Of the of a firmas a benchmark to evaluate the firm’spost-IPO 790 firms, 48 firms are in the natural resources sector, 499 in performance. We computed the change in ROS by subtract- the manufacturing sector, 116 in the services and trade sector, ing the average ROS in the three years immediately prior to 63 in the public utilities sector, 18 in the finance and real the IPO from the average of the three years of annual ROS estate sector, and the remaining 46 are classified as conglom- after the IPO. The earnings (sales) growth measure was the erates operating in multiple sectors. The sample captures more percentage change in the average level of earnings (sales) over than 65% of all IPO firms in each of the sectors, with the the three years immediately prior to the IPO to the three exception of the finance and real estate sector (43%). years after the IPO.14 Table 1 also reports that almost 27% of the sample firms Fig. 1 shows that the average CAR of newly listed firms appointed politically connected CEOs who were current or in China not only failed to increase but actually fell by almost former government bureaucrats or military officers. This 17% during the three years after their IPOs. Fig. 2 plots the suggests that the government maintains direct influence on mean CARs of newly listed companies in China sorted by a significant portion of firms through its CEO appointments. whether or not their CEOs are politically connected. The There is no particular pattern in the percentage of politically mean CAR of the group of firms run by politically connected connected CEOs on a year-by-year basis, but there is a cross- CEOs exhibits a steep decline of 30% over the three years industry variation in the appointment of politically connected subsequent to the IPOs, while the mean CAR of the second CEOs. The highest percentage of politically connected CEOs group of firms exhibits a much smaller drop of 12% over the occurs in the natural resources sector (40%), followed by the same period. public utilities sector (32%), the services and trade sector Table 2 reports the mean and median values of the stock- (28%), the manufacturing sector (26%), conglomerates based and operating performance measures for the full sample (24%), and the finance and real estate sector (6%). and for subsamples sorted by whether or not the CEO is
11. During the sample period, A-shares were traded by domestic investors, versus tend to be heavily manipulated. In addition, if the CEO of a firm was politically con- other classes of shares, such as B- or H-shares that were traded by foreign investors. nected prior to its IPO, we would not expect a change in its operating return measures Starting in 2001, domestic investors were allowed to trade B-shares. after the firm went public. We would have to exclude such firms from the sample in our 12. In addition to the CEO/board data, we obtained IPO-year ownership data from the operating return analysis. However, we cannot discard these firms from the sample due Shenzhen Genius Information Technology Company database, stock return and financial to the lack of information on the political connections of the pre-IPO CEOs. This biases data from the China Stock Market and Accounting Research (CSMAR) database, and against finding a relation between political connections and accounting returns. China’s regional economic data from China Economic Information Network Data Co., Due to missing pre-IPO data, the number of observations in the change in ROS and Ltd. earnings growth statistics is 774, while it is 782 in the sales growth statistics. The pre- 13. See Megginson, Nash, and Randenborgh (1994); Boubakri and Cosset (1998); IPO sales and earnings data are missing for eight firms and the pre-IPO earnings data are D’Souza and Megginson (1999); Sun and Tong (2003). missing for another eight firms. We also “winsorize” the top and bottom 5% of each of 14. Note that we have omitted operating numbers in the IPO year because those data the accounting return variables to exclude the effect of outliers.
88 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Figure 1 Figure 2
Mean post-IPO cumulative market-adjusted compound stock Mean post-IPO cumulative market-adjusted compound stock returns (CARs) from one to 36 months after the initial trading returns (CARs) from one to 36 months after the initial trading month of 790 partially privatized firms in China that went month of 790 partially privatized firms in China that went public during 1993 to 2001. public during 1993 to 2001, sorted by whether their CEOs are current or former government bureaucrats.. 5%
5% 0%
0% 5%
5% 10%
CAR 10% 15% CAR 15% 20%
20% 25%
25% 30% 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 30% Months after IPO 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 Months after IPO
Table 2 Mean and median statistics of post-IPO performance measures
This table presents the mean and median values of stocks and accounting performance measures of Chinese firms that were partially privatized through IPOs during 1993 to 2001. The table also reports the statistics for two subsamples of firms sorted by whether or not their CEOs were politically connected. The stock performance measures are the cumula- tive market-adjusted stock returns (CARs) accumulated for 12, 24, and 36 months starting from one month after the IPO month. Monthly stock returns are used for calculating the CARs measures. Market returns are the equally weighted returns for all common stocks traded on the Shenzhen and Shanghai Stock Exchanges. In total, 790 firms are used for computing the CARs. The accounting return measures are the change in return on sales (ROS), sales growth, and earn- ings growth. The change in ROS is measured as the difference between the average annual ROS of the three years after the IPO and that of the three years before the IPO year. The sales (earnings) growth variables are the growth rates of sales (earnings) from the average annual sales (earnings) of the three years before the IPO year to that after the IPO year. Due to missing values, 774 observations are used for calculating the statistics of the change in ROS and earnings growth, while 782 observations are used for the sales growth measure. Test statistics for the differences in means and medians are provided. The symbols ***, **, and * denote significance at the 1%, 5%, and 10% level, respectively.
Mean Median Performance measure Total CEO is CEO is not Difference in Total CEO is CEO is not Difference sample politically politically mean sample politically politically in median connected connected connected connected CAR one year after IPO -1.89* -7.31 0.07 -7.38*** -7.64*** -14.08 -4.77 -9.31***
CAR two years after IPO -5.14*** -13.64 -2.04 -11.6*** -13.21*** -18.86 -11.03 -7.83*** CAR three years after IPO -16.57*** -29.62 -11.81 -17.81*** -20.62*** -30.13 -17.92 -12.21*** Change in ROS -4.23*** -5.34 -3.83 -1.51* -1.88*** -1.98 -1.80 -0.18 Growth in sales 105.7*** 85.9 113 -27.1*** 70.9*** 54.5 77.3 -22.8*** Growth in earnings 88.9*** 66.9 97.0 -30.1** 55.6*** 38.8 62.4 -23.6** politically connected. Consistent with Figs. 1 and 2, the mean of firms with politically connected CEOs were statistically and median CARs decreased significantly over time. In each significantly lower than those without politically connected of the three post-IPO years, the mean and median CARs CEOs, indicating that the market was able to distinguish
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 89 Table 3 Regression results of the effects of politically groups grew larger each year, suggesting that over the years connected CEOs on the post-IPO stock performance of the market gradually learns more about the negative effects newly partially privatized firms in China of government intervention. As for the operating measures of performance, the The dependent variable reported in this table is stock perfor- growth in post-IPO sales and earnings was quite substantial, mance, measured alternately as the cumulative market-adjusted averaging 106% for sales and 89% for earnings relative to stock returns (CARs) accumulated for 12, 24, and 36 months, the pre-IPO period. However, the mean (median) change in starting from one month after the IPO month. Monthly stock the three-year average ROS of the full sample was -4.23% returns are used for calculating the CARs measures. Market (-1.88%), which corroborates the post-IPO decline in stock returns are the equally weighted returns for all common stocks values.15 Moreover, our between-group comparison shows traded on the Shenzhen and Shanghai Stock Exchanges. The that firms led by politically connected CEOs experienced independent variables, measured upon the IPO year, include a more substantial drops in ROS and slower sales and earnings dummy variable equal to one if the CEO is politically connected growth than did their politically unconnected counterparts. (zero otherwise), the percentage ownership of the largest owner, the market-to-book equity ratio, the leverage ratio measured “Multivariate” Regression Analysis and Implications as total debt over sales, the natural log of total assets, and a We next performed a series of regression analyses designed dummy variable equal to one if the firm is in a heavily regulated to examine the effects of the CEO’s political connections on sector (natural resources, public utilities, or finance and real es- post-IPO firm performance. ableT 3 presents the results of tate). The regressions utilize the ordinary least squares method. our ordinary least squares (OLS) regressions using the one-, Absolute values of robust t-statistics are in parentheses. The two-, and three-year CARs as dependent variables. On the symbols ***, **, and * denote significance at the 1%, 5%, and right-hand side of the regressions, we include a dummy vari- 10% level, respectively. able equal to one if the CEO is politically connected. We also included a few control variables: the fraction of common CAR one year CAR two years CAR three after IPO after IPO years after IPO shares held by the largest shareholder (typically a govern- CEO is politically con- ment); the market-to-book equity ratio; the debt-to-sales ratio; -0.069 -0.099 -0.153 nected the log of total assets; and the regulated industry dummy vari- (2.87)*** (2.73)*** (3.40)*** able. The ownership variable controls for the possibility that Largest shareholder’s a politician’s rent-seeking incentives depend on the control- -0.000 -0.000 0.001 ownership % ling shareholder’s ownership stake in the firm. (0.14) (0.08) (1.07) Consistent with the “univariate” results reported in Table Market-to-book of 0.109 0.089 0.032 2, the multivariate regression results show that firms with equity politically connected CEOs experience a more statistically (10.05)*** (5.21)*** (1.59) significant stock performance decline after the IPO.16 The Leverage 0.012 0.002 -0.054 results show that firms with politically connected CEOs (0.73) (0.07) (1.72)* Log of total assets 0.049 -0.049 -0.133 underperformed those without politically connected CEOs by 7% one year after the IPO, 10% two years after the IPO, (2.86)*** (1.86)* (3.96)*** and 15% three years after the IPO. Regulated industry 0.095 0.132 0.196 Table 4 presents the results of OLS regressions that (2.90)*** (2.69)*** (3.41)*** analyze the effects of politically connected CEOs on post- Constant -1.330 0.760 2.633 IPO changes in operating performance.17 The regression (3.59)*** (1.35) (3.62)*** Observations 790 790 790 results show that firms with politically connected CEOs Adjusted R-square 0.18 0.11 0.09 experience deteriorating operating performance after their IPOs, regardless of whether performance is measured by sales growth, earnings growth, or the change in ROS. The between the two groups of firms within the first year after the difference in the accounting variable is around -1.6% for the IPO. Moreover, the difference in the CARs between the two change in ROS, -21% for sales growth and -24% for earnings
15. This decline in operating performance of the IPO firms in China is consistent with 17. The dependent variables are sales growth, earnings growth, and the change in data reported by Aharony, Lee, and Wong (2000) and Sun and Tong (2003). ROS. The independent variables are the dummy variable for a politically connected CEO, 16. We also calculate annual CARs and run the regressions on the pooled post-IPO the fraction of common shares held by the largest shareholder, the market-to-book eq- annual data adjusting for clustering effects (Peterson, 2005). The estimated coefficient uity ratio, the debt-to-sales ratio, the log of total assets, and a regulated industry dummy of the CEO’s political connections is -0.055 with a t-statistic of 2.84. The magnitudes of variable. The top and bottom 5% extreme values are winsorized for the dependent and the differences in CAR between these two subsamples are similar to the univariate re- independent variables in the model. sults even after controlling for firm-specific factors that could affect post-IPO stock return performance.
90 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Table 4 Regression results of the effects of politically con- growth. These results are consistent with the univariate results nected CEOs on the post-IPO accounting perfor- reported in Table 2.18 mance of newly partially privatized firms in China To examine if our results are driven by earnings reversals resulting from earnings manipulation during the year of the The dependent variable in this table is, alternately, change in IPO, we repeated the earnings growth regression reported ROS, sales growth, and earnings growth. The change in ROS in Table 4 using operating earnings, which are less subject variable is measured as the difference between the average to manipulation, rather than net earnings in the calculation annual ROS of the three years after the IPO and that of the of ROS and earnings growth. The coefficient of the CEO’s three years before the IPO. The sales (earnings) growth vari- political connections remains significantly negative, suggest- ables are the growth rates of sales (earnings) from the average ing that our results are unlikely to be driven by pre-IPO annual sales (earnings) of the three years before the IPO year accounting manipulations. to that of the three years after the IPO year. The independent In sum, the regression results in Tables 3 and 4 suggest variables, measured upon the IPO year, include a dummy that partially privatized firms in China generally have poorer variable equal to one if the CEO is politically connected (zero stock returns and accounting performance when their CEOs otherwise), the percentage ownership of the largest owner, are politically connected through their former or current the market-to-book equity ratio, the leverage ratio measured government or military positions. as total debt over sales, the natural log of total assets, and a dummy variable equal to one if the firm is in a heavily regu- Checking for Endogeneity Problems lated sector (natural resources, public utilities, or finance and We were concerned about potential endogeneity issues in the real estate). The regressions utilize the ordinary least squares relations between post-IPO performance and the CEO’s polit- method. Absolute values of robust t-statistics are in paren- ical connections. A firm’s performance and its CEO’s political theses. The symbols ***, **, and * denote significance at the status could both be affected by the firm’s local institutional 1%, 5%, and 10% level, respectively. conditions, creating a spurious relation between them. Specif- ically, regions with poor economic conditions or facing severe Change in ROS Growth in sales Growth in unemployment or fiscal problems could have poorly perform- earnings ing firms,creating stronger incentives on the part of local CEO is politically -0.016 -0.208 -0.238 connected governments to intervene by appointing bureaucrats to run (1.94)* (2.35)** (1.89)* the firms. Moreover, a firm performing poorly prior to its Largest shareholder's IPO might be likely to recruit a politically connected CEO to 0.000 -0.004 -0.001 ownership % facilitate its new share issuance, and then continue to perform (2.30)** (1.98)** (0.55) poorly after the IPO. Leverage -0.037 0.041 -0.209 To investigate this endogeneity concern, we re-ran the (6.87)*** (0.57) (2.51)** three-year CAR regressions (as in Table 3) on subsamples that Market-to-book of -0.000 0.306 0.297 were alternately stratified by firm and regional institutional equity factors to examine whether the predicted relations persist in (0.11) (7.41)*** (5.97)*** the subsample regressions.19 Log of total assets 0.001 0.123 -0.070 As reported in Table 5, the findings of our subsample (0.10) (1.96)* (0.79) regressions suggest that companies with politically connected Regulated industry 0.017 0.212 0.716 CEOs are associated with significantly negative post-IPO CARs (1.60) (1.62) (4.49)*** regardless of whether they are from regions with high or low Constant -0.052 -1.809 1.493 GDP per capita, healthy or poor fiscal conditions, or high or (0.42) (1.33) (0.79) Observations 774 782 774 low employment rates, or whether they have high or low ROS. Adjusted R-square 0.08 0.12 0.19 The sub-sample regression results thus corroborate the results in Table 3, providing support for the argument that the negative relations between firms’ political ties and their post-IPO stock return performance are robust to potential endogeneity.
18. We alternatively perform random and fixed-effect regressions based on firm-year negative and significant in the ROS and sales regressions, suggesting that politically panel data for the sample firms from three years before to three years after their IPOs, connected CEOs have a further negative effect on post-IPO accounting performance. excluding the IPO years. The dependent variables are accounting for performance levels These results are not reported in a table but are available upon request. (ROS, log sales level, and log net income level). In addition to our other independent 19. We partitioned the sample by the sample median value of 1) local (provincial) variables, we include a post-IPO dummy variable equal to one if an observation is from GDP per capita, 2) local fiscal deficit levels, 3) local unemployment rates, and 4) firm the post-IPO period and an interaction term for the CEO’s political connection dummy return on sales (ROS). The values of each of the regional and firm ROS variables corre- variable and the post-IPO dummy variable. We find that the estimated coefficients of the sponding to an IPO firm are calculated as three-year average values during the three post-IPO dummy variable are significantly negative, suggesting declined accounting per- years prior to the firm’s IPO. Endogeneity would be a concern if we did not find the rela- formance after the firms’ IPOs. Moreover, the coefficients of the interaction term are tion between the CAR and the CEO’s political ties in both of the subsamples.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 91 Table 5 Regression results of the effects of politically connected CEOs on the post-IPO stock performance of newly partially privatized firms in China using stratified subsamples
This table reports the results of stock performance regressions on subsamples alternately stratified by firm and regional institutional factors. The sample is partitioned alternately by the sample median value of local (provincial) GDP per capita, local fiscal deficit, local unemployment rate, and firm return on sales (ROS). The values of each of the regional and firm ROS variables corresponding to an IPO firm are calculated as the three-year average values for the three years prior to the firm’s IPO. The dependent variable is stock performance, measured as the three-year cumulative market-adjusted stock return (CAR). The stock returns are accumulated for 36 months, starting from one month after the IPO month. Monthly stock returns are used for calculating the CARs. Market returns are the equally weighted returns for all common stocks traded on the Shenzhen and Shanghai Stock Exchanges. The independent variables, measured upon the IPO year, include a dummy variable equal to one if the CEO is politically connected (zero otherwise), the percentage ownership of the largest owner, the market-to-book equity ratio, the leverage ratio measured as total debt over sales, the natural log of total assets, and a dummy variable equal to one if the firm is in a heavily regulated sector (natural resources, public utilities, or finance and real estate). The regressions utilize the ordinary least squares method. Absolute values of robust t-statistics are in parentheses. The symbols ***, **, and * denote significance at the 1%, 5%, and 10% level, respectively.
GDP per capita Fiscal deficit Unemployment rate ROS Low High Low High Low High Low High
CEO is politically connected -0.149 -0.223 -0.155 -0.127 -0.152 -0.147 -0.132 -0.185 (2.30)** (3.60)*** (2.35)** (2.06)** (2.15)** (2.55)** (2.17)** (2.72)*** Largest shareholder’s ownership % 0.001 0.002 0.002 0.000 -0.001 0.003 -0.001 0.002 (0.66) (1.24) (1.23) (0.18) (0.58) (2.13)** (0.46) (1.67)* Market-to-book of equity 0.005 0.068 -0.001 0.089 0.025 0.048 0.003 0.069 (0.16) (2.59)*** (0.04) (2.82)*** (0.81) (1.68)* (0.10) (2.19)** Leverage -0.091 -0.037 -0.094 0.027 -0.083 -0.030 -0.153 -0.003 (1.69)* (0.96) (2.29)** (0.57) (1.77)* (0.72) (3.03)*** (0.07) Log of total assets -0.218 -0.062 -0.194 -0.030 -0.139 -0.127 -0.217 -0.069 (4.40)*** (1.47) (4.27)*** (0.58) (2.93)*** (2.58)** (4.94)*** (1.26) Regulated industry 0.227 0.157 0.407 -0.036 0.148 0.208 0.305 0.144 (2.69)*** (1.94)* (4.44)*** (0.52) (1.60) (2.88)*** (2.51)** (2.11)** Constant 4.530 1.000 3.729 0.354 2.953 2.310 4.655 1.044 (4.28)*** (1.09) (3.85)*** (0.31) (2.86)*** (2.19)** (4.84)*** (0.89) Observations 389 396 390 395 392 393 391 391 Adjusted R-square 0.12 0.15 0.10 0.09 0.08 0.10 0.12 0.08
When Do the Valuation Effects of Political by almost 4% within the first 60 days after IPO, exclud- Connections Show Up? ing the initial day of trading. When we divide the sample We also investigated how soon after the first public trading based on the CEO’s political ties, as shown in Fig. 4, the day the stock market begins to capture the effects of the polit- politically connected firms start to underperform their politi- ical connections of a firm’s CEO by examining the daily stock cally unconnected counterparts around 13 to 14 days after return patterns in the first 60 days of trading, starting from the IPO. The difference in the mean CAR between the two the second day after the IPO. We then focused on the initial groups of firms widens over time to about 4.4% by the60th (first-day) stock return pattern of the IPO firms. day. 20 Consistent with Fig. 4, the regression results suggest Fig. 3 plots the mean daily CAR of the sample firms that the negative impact of the CEO’s political connections from the first day tothe 60th day subsequent to the initial grows over time, from 0.6% in the first 20 days to 4% by trading day. As shown in the figure, the mean CAR drops the 60th day. These results indicate that the firms led by
20. To test whether the short-term CAR difference between the two groups is signifi- tive but insignificant in the 20-day CAR regression, but it is negative and significant in cant and robust to other influencing factors, we run the same regressions reported in the 40-day CAR regression (10% significance level) and in the 60-day CAR regression Table 3, but alternately using CARs 20 days, 40 days, and 60 days after the initial trad- (5% significance level). ing day as dependent variables. The coefficient on the CEO’s connection dummy is nega-
92 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Figure 3 Figure 4
Mean post-IPO cumulative market-adjusted compound stock Mean post-IPO cumulative market-adjusted compound stock returns (CARs) from one to 60 days after the initial trading day returns (CARs) from one to 60 days after the initial trading day of 790 partially privatized firms in China that went public dur- of 790 partially privatized firms in China that went public dur- ing 1993 to 2001. ing 1993 to 2001, sorted by whether their CEOs are current or former government bureaucrats. 0%
-1% 0%
-1% -2%
-3% -2%
-4% -3% CAR
-4% CAR
-5%
-5% -6%
-7% -6%
-7% 1 11 21 31 41 51 60
Days after IPO 1 11 21 31 41 51 Days after IPO
politically connected CEOs significantly underperform their and low firm productivity. politically unconnected counterparts beginning shortly after As we expected, several control factors appear to have their IPOs. influenced an IPO’s initial returns. When the time lapse We next included additional control variables, based between the offering and listing day was longer, and when on prior studies of Chinese IPOs.21 Information asymme- the issue size was smaller, the initial returns were higher. The try among the issuer, the underwriter, and investors could estimated coefficienton the largest shareholder’s ownership lead to underpricing of IPO shares.22 We included issue size percentage was significantly negative, suggesting that IPO (the natural logarithm of the number of shares issued) to stock investors discount the value of new issues when the state capture the effects of information asymmetry. Initial returns retains a large non-tradable ownership block. Nonetheless, are expected to be higher from a smaller share issue. As an the coefficient of the CEO’s political connection dummy additional control of information asymmetry, we included the variable remained negative and significant at the10% level. natural logarithm of the number of days between the offering The marginally lower initial return, or smaller underpricing, date and the listing date, because information asymmetry associated with a politically connected CEO is consistent with tends to be more severe when a longer time elapses between the signaling argument that non-interventionist governments the offering date and the listing date. China’s IPOs are often underprice IPO shares to signal their credible intention of characterized by such time lags. relinquishing control of the firms. Finally, we included the largest shareholder’s owner- ship percentage to control for the effects of non-tradable Effects on Board Composition shares and state control. The ex ante relation between the Finally, we examined the board structures of IPO firms in ownership variable and the initial return is ambiguous. One China, and how the government’s rent extraction incentive potential effect of the high concentration of ownership in might affect the degree of professionalism and the monitor- government hands is that there are too few tradable shares to ing function of the boards. We constructed several variables satisfy market demand, hence causing high initial returns. to capture the governance and the degree of professionalism Another effect could be that investors discount the stock (and of the sample firms’ boards of directors. The mean statistics of hence there are low initial returns) because they anticipate the the full sample reveal that a typical corporate board in China association between a high concentration of state ownership has about nine directors (excluding the CEO), 24% of whom
21. (Su and Fleisher, 1999; Chan, Wang, and Wei, 2004; Chen, Firth, and Kim, 22. (see, e.g., Baron, 1982; Rock, 1986). 2004).
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 93 Table 6 Regression results of the effects of different types are current or former government bureaucrats and 33% of of political connections of the CEO on the post-IPO stock whom are senior managers of the company. performance of newly partially privatized firms in China Forty-three percent of the board members are professional managers. Their backgrounds are in unaffiliated businesses— The dependent variable in this table is stock performance, mea- in accounting, law, or finance—or in academic institutions. sured alternately as the cumulative market-adjusted stock return Only 24% of the directors had current or previous experience (CAR) cumulated for 12, 24, and 36 months starting from one in unaffiliated companies. This percentage is rather small month after the IPO month. Monthly stock returns are used for relative to boards of U.S. firms, which are typically dominated calculating the CARs measures. Market returns are the equally by outside directors with professional qualifications.23 Accoun- weighted returns for all common stocks traded on the Shenzhen tants, lawyers, or directors with prior experience in financial and Shanghai Stock Exchanges. The independent variables, institutions or securities intermediaries constitute only 6% of measured upon the IPO year, include three dummy variables for the board. By contrast, there is a surprisingly large percent- political connection that equal one if, alternately, 1) the CEO is age (mean 14%) of directors with academic backgrounds. The connected with a local government governing the firm’s region, board is young (mean age of 47) and the average education 2) the CEO is connected with the central government, and 3) level of the directors is low (between junior college and college). the CEO is connected with a local government outside the firm’s Compared with boards of U.S. firms, there is a higher percent- geographic region, respectively. Other variables are the percent- age (6%) of female directors.24 There was almost no director age ownership of the largest owner, the market-to-book equity representing minority shareholders during our sample period, ratio, the leverage ratio measured as total debt over sales, the be they institutional or individual investors. natural log of total assets, and a dummy variable equal to one if Our study showed that when a CEO is politically the firm is in a heavily regulated sector (natural resources, pub- connected, it is highly likely that his or her political allies are lic utilities, or finance and real estate). The regressions utilize also on the board. Moreover, CEOs’ political connections are the ordinary least squares method. Absolute values of robust t- associated with low professionalism on boards: the difference statistics are in parentheses. The symbols ***, **, and * denote in both the mean and median percentage of professionals was significance at the 1%, 5%, and 10% level, respectively. significantly smaller for the group of firms led by politically connected CEOs. When a CEO is politically connected, his CAR one year CAR two years CAR three after IPO after IPO years after IPO or her firm had fewer directors with business experience from CEO is connected with a local -0.051 -0.090 -0.135 unaffiliated firms, fewer academicians and women serving as government of the same region directors, and older directors on average. The firm also had (1.84)* (2.16)** (2.51)** fewer directors with experience in accounting, finance, or law, CEO is connected with the -0.112 -0.241 -0.285 but the difference is statistically insignificant. The directors’ central government education levels were also higher for firms with politically (1.65)* (2.35)** (2.16)** connected CEOs, but the differences are not statistically CEO is connected with a local -0.084 -0.056 -0.136 government of a different region significant. (1.97)** (0.87) (1.64) Largest shareholder’s owner- -0.000 -0.000 0.001 Conclusion ship % Our study provides suggestive evidence of the negative effects (0.14) (0.19) (1.06) of politically connected CEOs on the corporate performance Market-to-book of equity 0.108 0.088 0.031 and governance of publicly listed companies in China. Newly (11.34)*** (6.07)*** (1.67)* listed Chinese companies with politically connected CEOs Leverage 0.012 0.002 -0.054 are more likely to have boards that are populated by current (0.74) (0.09) (1.73)* or former government bureaucrats, and that generally exhibit Log of total assets 0.049 -0.048 -0.134 (2.91)*** (1.91)* (4.13)*** low degrees of professionalism, as indicated by fewer directors Regulated industry 0.097 0.138 0.202 with relevant professional backgrounds. At the same time, the (3.16)*** (2.96)*** (3.39)*** operating and stock-return performance of the firms run by Constant -1.315 0.753 2.641 politically connected CEOs has failed to match that of their (3.68)*** (1.39) (3.80)*** politically unconnected counterparts. Observations 790 790 790 In sum, our study provides more support for the Adjusted R-square 0.18 0.11 0.09 argument that bureaucrats and politicians extract resources
23. See, for example, Hermalin and Weisbach (1988) and Yermack (1996). directors possessing business experience from unaffiliated firms (19%) and directors 24. Farrell and Hersch (2001) document that the percentage of women on the board with legal, accounting, or finance expertise (24%). These gender statistics suggest that of Fortune 1000 firms was less than 2% from 1990 to 1999. As reported in Appendix women are more likely appointed to boards for their specialized expertise than for their 2, female directors are negatively correlated with the presence of politically connected managerial or political roles. Similarly, Agrawal and Knoeber (2001) find that female CEOs (-10%) and politically connected directors (-12%), while positively correlated with directors do not play a political role in the U.S.
94 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 from listed SOEs under their control to fulfillobjectives that limited property rights. Such countries can learn from the are not consistent with firm value maximization. Expressed experience of China’s partial privatization that a government’s in more general terms, the main finding of our study is that reluctance to relinquish even just a subset of its property rights the constraints on property rights faced by Chinese SOEs— with regard to its enterprises can have significantly negative namely the non-transferability of state ownership and the consequences on corporate governance and firm performance. right of the government to appoint CEOs—appear to have significantly negative effects on firm performance as well Joseph Fan is the Professor of the Department of Finance and School of as board professionalism and governance. Removing these Accountancy and Co-Director of The Institute of Economics and Finance constraints will likely have to be a critical part of any future at The Chinese University of Hong Kong (CUHK). He received his Ph.D. reforms that aim to improve the productivity of listed Chinese in Finance from the Katz Graduate School of Business at the University companies. of Pittsburgh. Before joining CUHK, he taught at the University of Hong But does this rule out the possibility that stock markets Kong and Hong Kong University of Science and Technology. could play an effective role in monitoring corporate manage- ment even if the government remains the controlling owner T. J. Wong is the Choh-Ming Li Professor of Accountancy and the Direc- of privatized firms? The evidence in support of this possi- tor of the Center for Institutions and Governance at the Chinese University bility is mixed.25 Unlike India and the U.S., China did not of Hong Kong (CUHK). He also served as Dean of the CUHK Business have a well-established stock market that pre-dates its partial School from 2008 to 2013. Before joining CUHK, Professor Wong taught privatization. And the agency conflicts between bureaucrats/ at the University of Maryland-College Park and the Hong Kong University politicians and minority shareholders that are the main focus of Science and Technology. He received his MBA and PhD from UCLA. of our study would appear to be a major (if not the most important) contributor to the general post-IPO underper- Tianyu Zhang is the Associate Professor of Accountancy and the formance of China’s SOEs. Associate Director of the Center for Institutions and Governance at the Perhaps most important, we believe that our findings Chinese University of Hong Kong (CUHK). He received his PhD from Hong about China’s companies could be instructive for emerging Kong University of Science and Technology. economies around the world that have weak legal systems and
25. Prior literature provides mixed evidence. Based on a developing country sample, with substantial ownership under federal government custody during and after World Boubakri, Cosset, and Guedhami (2005) report that post-privatization firm performance War II. Consistent with the market monitoring view, they report that the performance of is positively related to the degree to which the government relinquishes control. However, the government-controlled firms is not significantly different from private-sector firms in a parallel study of developed countries by D’Souza, Megginson, and Nash (2005) finds the same industry. Gupta (2005) finds that partial privatization in India is associated that state ownership is associated with reduced employment and increased capital with improvement in firm profitability. spending after privatization. Kole and Mulherin (1997) examine a sample of U.S. firms
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 95 The Composition and Effectiveness of Audit Committees in the Presence of Large Controlling Shareholders* by Re-Jin Guo, University of Illinois at Chicago and Yin-Hua Yeh, National Chiao Tung University
he Asian financial crisis of 1998 put the region’s Corporate governance practices are inevitably affected corporate governance to a serious test.1 Several by ownership structure. Many East Asian firms are T economists have suggested that weak corporate controlled by large shareholders with concentrated owner- governance in those emerging markets not only ship. Economists have generally found that the monitoring made them more susceptible to sudden economic shocks, but and concentration of interests provided by such sharehold- also exacerbated the crisis. As a consequence, considerable ers (sometimes referred to as “blockholders”) are good for emphasis has been placed on strengthening the oversight role corporate governance. But in many cases, the effective of the board of directors in Asian countries. control of companies comes not from investment in a major- In particular, the establishment of an independent audit ity of shares but rather through complicated arrangements, committee on the board has been high on the agenda,2 with such as pyramidal and cross shareholdings, where actual the goal of reducing information asymmetry and manag- ownership and legal title to a company’s cash flow (say, ing potential conflicts between controlling shareholders and through dividends) is comparatively low.5 It is especially outside, minority investors. The primary duty of a company’s important in such latter cases to examine the effectiveness audit committee is to oversee its financial reporting process. It of audit committees in monitoring management. meets regularly with the outside auditors and internal finan- We also provide evidence that audit committees are an cial managers of the firm to review the financial statements, indispensable and value-increasing corporate practice, though audit process, and internal accounting controls of the firm. potentially of greater economic significance when large share- After the 1998 crisis, most regulatory agencies in East holders are present and information is less credible to outside Asian countries required publicly listed companies to institute investors. In such markets, the monitoring role played by an audit committees. This paper summarizes the findings of our independent and professional audit committee could help recent study of audit committees that have been established in limit such information problems. East Asian public companies since the crisis, of the indepen- In the first part of our analysis, we tested two comple- dence and professional qualifications of their committee mentary hypotheses about how controlling shareholders members,3 and of the effects of such committees, if any, on might influence the composition of the audit committee. firm value. More specifically, using the companies with the The first we call the “interest alignment hypothesis”— largest market valuations at the end of 2000 in Hong Kong, the idea that a controlling shareholder with a majority of Singapore, and Malaysia, we tested the effects of ownership shares (cash flow rights) would have a strong incentive to structure on the composition of audit committees, and any maximize the firm’s value. Such a shareholder would choose corresponding effects on firm valuation.4 an audit committee to monitor management effectively and
*The authors wish to thank Don Chew and John L. McCormack for revising this paper. DeFond, Rebecca Hann, and Xuesong Hu. 2005, “Does the Market Value Financial Ex- Corresponding author Yin-Hua Yeh, Graduate Institute of Finance, National Chiao Tung pertise on Audit Committees of Boards of Directors,” Journal of Accounting Research University, 1001 Ta-Hsueh Rd., Hsinchu City, Taiwan 30010, Email: [email protected] 43, 153-193. 1. Nobel laureate Joseph Stiglitz and economists Campbell Harvey and Andrew Rop- 4. To the best of our knowledge, this is the first study to examine the composition and er cite weak corporate governance as one of the major causes of East Asian Financial effectiveness of audit committees under concentrated ownership. Other researchers have Crisis. See “The Role of International Financial Institutions in the Current Global Econo- analyzed the determinants of audit committees composition in widely held companies. my,” Address to the Chicago Council on Foreign Relations, February 27; and Campbell Our paper investigates how controlling shareholders in East Asia influences audit com- Harvey and Andrew Roper, 1999, “The Crisis on Emerging Financial Markets,” Brook- mittee composition. ings Institution Press, Washington DC, pp 29-115. MIT professor Simon Johnson showed 5. See Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, 1999, “Cor- that the effectiveness of minority shareholder protection explains the exchange rate de- porate Ownership Around the World,” Journal of Finance 54, 471-517; Rafael La Porta, preciation and stock market decline during the crisis better than various macroeconomic Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, 2002, “Investor Pro- measures. See Simon Johnson, Peter Boone, Alisdair Breach, and Eric Friedman, 2000, tection and Corporate Valuation,” Journal of Finance 57, 1147-1171; Stijn Claessens, “Corporate Governance in the Asian Financial Crisis,” Journal of Financial Economics Simeon Djankov, and Larry H. P. Lang, 2000, “The Separation of Ownership and Control 58, 141-186. in East Asian Corporation,” Journal of Financial Economics 58, 81-112; Stijn Claes- 2. Recent experience in the U.S. market has partly contributed to the emphasis on the sens, Simeon Djankov, Joseph Fan, and Larry H. P. Lang, 2002, “Disentangling the In- establishment and independence of audit committees in the Asian markets. centive and Entrenchment Effects of Large Shareholdings,” Journal of Finance 57, 3. We define a professional as a person with experience as a public accountant, audi- 2741-2742; and Mara Faccio, and Larry H. P. Lang, 2002, “The Separation of Owner- tor, principal or chief financial officer, controller, or principal chief accounting officer. This ship and Control: an Analysis of Ultimate Ownership in Western European Corporations,” follows widely used procedures to classify independent directors. For example, Mark Journal of Financial Economics 65, 365-395.
96 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 so minimize the information asymmetry between manage- audit committee under concentrated ownership is associated ment and outside investors. with incrementally higher firm valuation (as measured by a The second hypothesis is the “entrenchment hypothe- firm’s market-to-book ratio)7 in the three East Asian markets. sis”—the possibility that some controlling shareholders could And we do in fact find higher market-to-book ratios become entrenched and expropriate the wealth of minority among East Asian firms with higher percentages of indepen- shareholders for themselves, thereby reducing the value of the dent and professional members. Furthermore, in those firm. The risk of entrenchment is significant when large share- markets, investors may have initially underreacted to the holders exert control despite having disproportionately small potential benefits of effective audit committees, since we share ownership (cash-flow rights). When large shareholders find increasing market-to-book ratios over the three years have control in excess of their cash flow rights, they are more following establishment of committees with independent likely to seek personal benefits at the expense of minority and professional members. As we interpret our findings, the shareholders. And in cases where controlling shareholders selection of independent and professional audit committee have a strong incentive to expropriate minority sharehold- members appears to provide the market with a credible signal ers through unlawful transactions, they would be strongly of the commitment by controlling shareholders to increase inclined to select affiliated individuals, or people with no shareholder wealth. What’s more, a company’s choice of audit financial expertise, as audit committee members. committee members, based on their expertise rather than Our study accordingly begins with the assumption that, affiliation, serves to limit potential expropriation (by large all else equal, larger disparities between share voting rights controlling shareholders) and increase firm valuation. and cash rights (or what we refer to as “voting-cash devia- tions”) provide controlling shareholders with both the motive Our Study and the means to exploit the wealth of minority shareholders. Many studies have provided evidence suggesting that capi- In such cases, a weak and dependent audit committee is likely tal markets favor independent and professional members of to be appointed for the benefit of entrenched shareholders. boards of directors. Independent boards are associated with The first part of our analysis provides strong evidence lower costs of debt financing, suggesting that independent for our two complementary predictions. For companies with directors serve a certification role for firms.8 Stock markets large controlling shareholders with proportionately large cash react positively to the appointment of an accounting finan- flow rights, we find (1) a higher likelihood that a majority of cial expert to the audit committee.9 What’s more, one study audit committee members are independent and professional; reports that Taiwanese firms receive higher market valua- and (2) a significantly higher percentage of independent and tions when controlling families hold less than 50% of a firm’s professional members. By contrast, when controlling share- board seats, and that the higher valuations in such cases are holders are entrenched, it is much less likely that a majority of strongly associated with more independent boards and moni- audit committee members are independent and professional. toring.10 All of these findings are consistent with the idea that In the second part of our analysis, we relate the composi- a company’s choice of effective audit committee members can tion of a firm’s audit committee to its year-end market-to-book increase the value of the firm. ratio, a measure viewed by many as an indicator of value In our study of East Asian audit committees, we used a added (or destroyed) by management. Although many set of 450 companies, consisting of the 150 largest (by market researchers have found positive relationships between the valuation at year-end 2000), listed firms in each of Hong independence and professionalism of members and the effec- Kong, Singapore, and Malaysia. These companies represented tiveness of the audit committee in U.S. companies,6 it remains 79.89%, 71%, and 81.1% of total market capitalization in unclear whether this effect extends to East Asian firms with each of the three countries, respectively. We took our sample ownership structures that are distinctly different from the from the year 2000 mainly because all three countries dispersed ownership structures of most U.S. firms. We test strengthened their standards on audit committees in the late for this possibility by examining whether such an effective 1990s. We manually gathered information about ownership
6. See Klein, A. 2002, “Audit committee, board of director characteristics, and earn- Accounting Earnings: The Role of the Audit Committee,” Pacific-Basin Finance Journal ings management,” Journal of Accounting and Economics 33, 375-400; Davidson III, 23, 1-24. W. N., B. X. Xie, and W. Xu, 2004, “Market Reaction to Voluntary Announcements of 7. We also address the potential issue of endogeneity by examining the correlation Audit Committee Appointments: The Effect of Financial Expertise,” Journal of Account- between the market-to-book ratio and the audit committee composition in our primary ing and Public Policy 23, 279-293; DeFond, M., R. Hann, and X. Hu. 2005, “Does the analysis. market value financial expertise on audit committees of boards of directors,” Journal of 8. Robert Anderson, Sattar Mansi, and DavidReeb, 2004, “Board Characteristics, Accounting Research 43, 153-193; Chen, K. Y. and J. Zhou, 2007, “Audit Committee, Accounting Report Integrity, and the Cost of Debt,” Journal of Accounting and Econom- Board Characteristics, and Auditor Switch Decisions by Andersen’s Client,” Contempo- ics 37, 315-342. rary Accounting Research 24, 1085-1117; Krishnan, G. V., and G. Visvanathan, 2009, 9. Mark DeFond, Rebecca Hann, and Xuesong Hu. 2005, “Does the Market Value “Do Auditors Price Audit Committee’s Expertise? The Case of Accounting v.s. Non-Ac- Financial Expertise on Audit Committees of Boards of Directors,” Journal of Accounting counting Financial Experts,” Journal of Accounting, Auditing and Finance, Vol. 24, 115- Research 43, 153-193. 144; Krishnan, J., Y. Wen, and W. Zhao, 2011, “Legal Expertise on Corporate Audit 10 Yin-Hua Yeh, Tsin-Siou Lee and Tracie Woidtke, 2001 March, “Family Control and Committees and Financial Reporting Quality,” The Accounting Review 86, 2099-2130; Corporate Governance: Evidence from Taiwan,” International Review of Finance 2, 21- Woidtke T. and Y. H. Yeh, 2013 June “Corporate Governance and the Informativeness of 48.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 97 Table 1 Ultimate Control Type and Audit Committee Independence by Country
The sample consists of the largest 150 listed firms each from Hong Kong, Singapore, and Malaysia. Panel A identifies the largest shareholder in each firm by type. Panel B presents the establishment of audit committees. Panel C presents the frequency of firms according to the proportion of independent directors appointed to the audit committee.
Panel A: Ultimate Control Owner by Type Type Hong Kong Singapore Malaysia All N Fraction (%) N Fraction (%) N Fraction (%) N Fraction (%) Family 113 75.33 115 76.67 96 64.00 324 72.00 Government 24 16.00 29 19.33 21 14.00 74 16.44 Others 13 8.67 6 4 33 22.00 52 11.56 Total 150 100 150 100 150 100 450 100 Panel B: Establishment of Audit Committee
Audit Committee Hong Kong Singapore Malaysia All N Fraction (%) N Fraction (%) N Fraction (%) N Fraction (%) Yes 104 69.33 148 98.67 150 100 402 89.33 No(1) 46 30.67 2 1.33 0 0 48 10.67 Total 150 100 150 100 150 100 450 100 Panel C: Percentage of Independent Directors on the Audit Committee
Percentage of Hong Kong Singapore Malaysia All independent audit N Fraction (%) N Fraction (%) N Fraction (%) N Fraction (%) committee members 0%(2) 46 30.67 2 1.33 0 0.00 48 10.67 0~1/3 2 1.33 1 0.67 9 6.00 12 2.67 1/3~2/3 28 18.67 86 57.33 103 68.67 217 48.22 2/3~1 4 2.67 17 11.33 28 18.67 49 10.89 100% 70 46.67 44 29.33 10 6.67 124 27.56 Total 150 100 150 100 150 100 450 100
(1) Eight Hong Kong and two Singapore companies disclose that they have set up the audit committee, but give no further details of composition and independence. Those ten firms are classified as having no audit committee. (2) The percentages of independent audit committee members are zero for firms with no established audit committee. structure and corporate board characteristics as well as audit Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny. In committees from the 2000 annual reports for each firm in addition, these three countries were also ranked by Credit our sample. What’s more, our sample of listed East Asian Lyonnais Securities in 2004 among the top ten Asian emerg- companies included both companies where large shareholders ing markets, based on the following five dimensions: (1) rules, have proportional rights to cash flow and companies where regulations, and enforcement; (2) political/regulatory inter- “deviations” of the voting and cash flow rights allowed us ference; (3) International Generally Accepted Accounting to evaluate our competing hypotheses about the choice and Principles; (4) institutional mechanisms; and (5) corporate governance role of audit committee members. governance culture. We selected Hong Kong, Singapore, and Malaysia These three countries also have had similar strategies because of their similar ownership structures and corporate for improving audit committee quality and corporate gover- governance environments. As of the year 2000, all of these nance in general. In 1992, the Stock Exchange of Hong countries had put in place either four or five of the six key Kong amended its rules to require independent directors shareholder protection measures11 described in the much cited and encouraged greater disclosure, accountability, and the 2002 Journal of Finance article by Rafael La Porta, Florencio use of audit committees.12 Each company listed on SEHK
11. The average measure is four for firms in the common law countries, and five for 12. In Hong Kong, the market regulators are the Securities and Futures Commission firms in the U.S. See Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and and the Stock Exchange of Hong Kong. The Securities and Futures Commission enjoys Robert W. Vishny, 2002, “Investor Protection and Corporate Valuation,” Journal of Fi- powers of investigation and enforcement that the exchange lacks (the highest penalty nance 57, 1147-1171. that the exchange can impose is suspension or de-listing). The main drivers of corporate governance reform in Hong Kong have been the Stock Exchange of Hong Kong, the Se- curities and Future Commission, professional bodies and a few maverick shareholder activists.
98 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 is required to have at least two independent, non-executive the findings of our analysis of the 402 firms in our sample directors on its boards and, since January 1999, every listed that have audit committees. In our sample, 35.7% of audit company has been expected to set up an audit committee. committee directors are categorized as “independent” and In Singapore, audit committees became mandatory for “professional.” Finally, we construct an audit committee publicly listed companies in 1989. The audit committee must profession indicator, with value of one when 50% or more have at least three board members and a majority must be of the directors on a firm’s audit committee are professional independent non-executive directors. The Singapore Stock directors as defined above. Exchange strengthened audit committees by mandating These designations appear to matter to investors because certain best practices in the late 1990s. researchers have found significantly positive three-day In Malaysia, the Securities Commission and Stock cumulative abnormal returns in response to the appointment Exchange began in 1994 to require listed companies to of accounting financial experts to the audit committee, but establish audit committees of at least three members and not to the appointment of non-accounting financial experts with a majority of independent non-executive directors. The or directors without financial expertise.14 But the positive regulatory authorities also established committees and codes reaction occurs only when the newly appointed outside direc- of corporate governance in the late 1990s. tors are independent (as opposed to affiliated), and when the appointing firms have relatively strong corporate governance The Findings of our Study prior to appointing the new directors. First of all, concentrated ownership and family control were We identify the ultimate controlling shareholder and the rule among East Asian companies in 2000. As reported their associated voting and cash flow rights. The shareholder in Panel A of Table 1, family-controlled firms accounted with the dominant voting rights is designated as the control- for 72% of our entire sample, with percentages of 75.33%, ling shareholder. We consider shares held both directly and 76.67%, and 64% for companies in Hong Kong, Singapore, indirectly when calculating both the voting and cash flow and Malaysia, respectively. Government-controlled firms rights of a firm’s ultimate controlling shareholder. Directly accounted for 16.44% of the entire sample, with percent- held shares are those rights registered in the name of the ages of 16%, 19.33%, and 14% in Hong Kong, Singapore, controlling shareholder, while indirectly held shares are those and Malaysia. held by individuals and businesses affiliated with the control- Panel B of Table 1 shows that the vast majority of firms ling shareholder. Direct voting rights are then calculated as have established audit committees.13 More specifically, our the sum of the fraction of shares registered to the ultimate findings show that 89.3% had clearly established an audit controller; the indirect voting rights are calculated as the committee, while 8.4% of firms reported having no audit “weakest link” in the chain of shares (lowest percentage of all) committees and 2.2% of firms provided no disclosure on held by firms that the ultimate owner controls. The ultimate audit committee composition. controller(s) could be a family, an individual, the State, a Panel C of Table 1 presents the percentage of indepen- widely held financial institution, or a widely held corporation. dent directors serving on the audit committees of our sample Accordingly, we also constructed ownership variables to firms, with a percentage of zero independent directors for account for different ownership types. In cases with multiple those 48 firms categorized as “with no audit committee.” control chains, we took voting rights to be the sum of the Hong Kong has the highest percentage (31%) of companies voting rights along the chain with the weakest link of all without independent directors on audit committees, but at the holding layers. Our variable “voting rights” was used as the same time the highest percentage (47%) of companies a measure of the controlling shareholder’s ability to affect with audit committees that consist solely of independent the decisions of a firm, such as through the election of direc- directors. Twenty-nine percent of the companies in Singapore tors to the board and the appointment of supervisors. The have completely independent audit committees, but only 7% indirect voting rights of a major shareholder can be channeled of companies in Malaysia have completely independent audit through a pyramidal structure or cross shareholding. When committees. The majority of companies in Singapore and a major shareholder invests in a listed company A, which in Malaysia have audit committees that are made up of 66.6% turn invests in another listed company B, we assume that the independent directors. controlling shareholder obtains indirect control over company Table 2 presents a summary of the variables constructed B through a pyramidal structure. There may be multiple for our analysis, while Table 3 presents the summary statis- layers of chains through which a shareholder exerts control. tic of those variables. In tables 3 through 6, we summarize Cross shareholding is a structure in which various
13. All companies listed in both Singapore and Malaysia are required to have an audit 14. Mark DeFond, Rebecca Hann, and Xuesong Hu. 2005, “Does the Market Value committee consisting of a majority of independent members and an independent chair- Financial Expertise on Audit Committees of Boards of Directors,” Journal of Accounting man. In Hong Kong, the Code of Best Practices recommends listed firms to establish Research 43, 153-193. audit committees, or disclose reasons on why firms opt not to establish such committees.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 99 Table 2 Variable Definition
This Table presents a summary of the variables constructed for our analysis. All variables are recorded
at the year end of 2000, except the variable of ROA1999.
Variable name Definition Ownership of Large Shareholder: Family control dummy Dummy variable with a value of one when the ultimate control type is “family” and zero other- wise. Control (%) Proportion of votes controlled by the largest shareholder group. Ownership (%) Proportion of cash flow rights owned by the largest shareholder group. Excess Control (%) The divergence between control rights and cash flow rights of the largest shareholder group. Divergence dummy Dummy variable with a value of one when the variable of Excess Control is positive and zero otherwise. High cash flow dummy Dummy variable with a value of one for firms with above-median cash flow rights, and a value of zero otherwise. Board Characteristics: Percentage of independent board members (%) Percentage of independent directors in the corporate board. Number of board members Total number of directors. Percentage of independent audit committee Percentage of independent directors in the audit committee. members (%) Number of audit committee members Total number of members in the audit committee. Audit committee independence dummy Dummy variable with a value of one for an audit committee consisting solely of independent directors, and zero otherwise. Percentage of professional audit committee Percentage of independent directors with financial expertise in audit committee. members (%) Audit committee profession dummy Dummy variable with a value of one for audit committee with above-50% professional indepen- dent directors, and zero otherwise. Chairman and CEO dummy Dummy variable with a value of one for a CEO affiliated with the largest shareholder serving also as the chairman of the board, and zero otherwise. Firm Performance and Financial Ratios:
ROA1999 Return on asset in the year of 1999 Total assets Book value of total assets (in US$ millions) Leverage Ratio of book value of debt scaled by the book value of total assets. R&D Ratio of R&D expenditures scaled by sales. Adjusted Market-to-book ratio of averaged data of Difference in ratio of market value of equity scaled by book value of asset between a sample firm 2001 to 2003 and average value of firms in the same industry. affiliated business entities are controlled by the same major priation, but only bears a fraction of the cost. In our sample, shareholder through the affiliated entities’ practice of holding the controlling shareholders owned an average of 32% of cash shares in one another. There are some cases of cross sharehold- flow rights while possessing 46% of the voting rights. And ing in which the controlling shareholder uses the company’s 68% of our sample firms had a divergence between cash and resources to institute a nominal company that owns shares control rights of the largest shareholders, with an average of of the listed company. With both a pyramidal structure and 14% control rights in excess of cash flow rights. cross shareholding, the voting rights of a controlling family We constructed several measures of a firm’s general are aggregated from their collective direct and indirect voting governance structure. For example, the number of direc- rights over the firm. tors can affect board performance. NYU professor David In measuring the degree of “excess” control (or divergence Yermack finds higher Tobin’s Q for companies with small from the one share-one vote ownership structure) as a proxy boards and suggests that large boards are ineffective due to for the controlling shareholder’s incremental motive to extract poor communication and decision-making.15 Presumably, private benefits from the firm, we calculated the difference small boards could be more effective in instituting action to between the controlling shareholder’s voting and cash flow improve corporate governance practices (in our sample, there rights. Under such an ownership structure, the controlling was an average of 8.84 directors on each board). shareholder could receive the entire benefit of wealth expro- The composition of boards may also reveal the influence
15. See David Yermack, 1996, “Higher Market Valuation for Firms with a Small Board of Directors,” Journal of Financial Economics 40, 185-211.
100 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Table 3 Descriptive statistics
From table 3 to 9, we analyze the 402 sample firms where have audit committees in the three countries. See Table 2 for the definition of variables.
Variables Mean Standard Q1 Median Q3 Deviation Control (%) 46.13 17.05 32.66 45.84 59.3 Ownership (%) 32.11 18.09 18.91 30.25 43.07 Excess Control (%) 14.02 13.68 0 12.55 24.495 Divergence dummy 0.681 0.467 0 1 1 Percentage of independent board members (%) 37.77 16.32 25 33.33 50 Number of board members 8.84 2.82 7 9 10 Percentage of independent audit committee members (%) 73.82 21.87 66.67 66.67 100 Number of audit committee members 3.11 0.93 3 3 3 Audit committee independence dummy 0.3 0.46 0 0 1 Percentage of professional audit committee members (%) 35.67 32.29 0 33 67 Chairman and CEO dummy 0.53 0.5 0 1 1 Total assets (US$ millions) 2,448.3 7,496.1 182.5 465.1 1273 Leverage (%) 50.9 33.02 28.49 46.65 70.71 R&D (%) 0.58 1.68 0.04 0.13 0.36
ROA1999 (%) 5.37 10.74 1.4 4.41 9.14 Market-to-book ratio 1.31 3.461 0.297 0.556 1.063
Table 4 Correlation of Audit Committee Independence and Professionalism with Other Variables of Interest
Variables are as defined in Table 2. Pearson correlation coefficients are presented with the z-statistics in the parenthe- ses. One, two, and three asterisks indicate the two-tailed significance at the 10, 5, and 1 percent levels, respectively.
Percentage of independent audit Percentage of professional Variable committee members audit committee members -0.082 -0.045 Family control dummy (0.097)* (0.360) 0.146 0.069 Ownership (%) (0.003)*** (0.187) -0.082 -0.165 Excess Control (%) (0.098)* (0.002)*** 0.063 0.071 Percentage of independent board members (%) (0.199) (0.154) 0.035 - Number of board members (0.474) -0.039 0.085 Number of audit committee members (0.433) (0.098)* 0.066 -0.101 Chairman and CEO dummy (0.182) (0.037)** -0.025 0.039 Total assets (0.062) (0.43) -0.052 -0.029 Leverage (0.29) (0.552) 0.096 0.084 R&D (0.054)* (0.092)* 0.098 0.108 Adjusted Market-to-book ratio (0.046)** (0.010)**
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 101 Table 5 Probit Analysis on Determinants of Firm’s Adoption of Independent and Professional Audit Committee
Audit committee independence dummy is one for an audit committee consisting solely of independent directors, and zero otherwise. Audit committee profession dummy is one for audit committee with above-50% professional indepen- dent directors, and zero otherwise. We also include country dummies as well as industry dummies (not reported) in each regression analysis. Other variables are as defined in Table 2. One, two, and three asterisks indicate the two- tailed significance at the 10, 5, and 1 percent levels, respectively.
Variables Audit committee independence dummy Audit committee profession dummy Intercept -2.95 2.226 (5.138)*** (3.246)* Family control dummy -0.94 0.176 (0.095) (0.387) Ownership 0.018 0.016 (5.12)** (2.848)* Excess control -0.015 -0.022 (2.899)* (5.115)** Percentage of independent board members (%) -0.917 0.419 (1.148) (0.308) Number of board members 0.046 -0.031 (0.741) (0.385) Chairman and CEO dummy 0.513 -0.539 (3.897)** (5.518)** Ln (total assets) 0.123 -0.095 (1.655) (1.12) Leverage -0.761 0.251 (2.44) (0.342) R&D 0.116 -0.182 (1.412) (2.024)
ROA1999 0.004 -0.006 (0.106) (0.266)
Market-to-book ratio1999 0.133 -0.113 (2.012) (1.465) -2 Log Likelihood 416.72 432.14 of the controlling shareholder over the firm. Perhaps most performance: “Total Asset” is the book value of total assets (in important is the proportion of directors who are affiliated $US millions). ROA1999 is return on assets in 1999. Leverage is with the controlling shareholder. The greater the proportion the ratio of book value of debt over book value of total assets, of affiliated board members, the easier it is for an entrenched while R&D is the ratio of R&D expenditures over sales. controlling shareholder to pursue non-profit-maximizing We find a significant positive correlation between the objectives in return for personal gains. percentage of independent audit committee members and We identified the board members associated with the both concentrated share ownership and R&D expenditures. controlling shareholder, including family members and We find a significant negative correlation between the percent- the representatives of controlled institutions. Unaffiliated age of independent audit committee members and entrenched board members were classified as independent directors. In control by large shareholders and the presence of a controlling our sample, an average of 38% of directors were classified family. Firms with higher percentage of independent audit as “independent.” Since many scholars and regulators have committee members are associated with higher adjusted advocated separation of the roles CEO and board Chair, we market-to-book ratios. Table 4 shows the results of correla- also constructed an indicator variable that has a value of 1.0 tion analysis between the audit committee independence and when an individual affiliated with the largest shareholder professionalism with ownership variables, board characteris- group serves both as the board chairman and the CEO of tics, and financial variables, including firm performance. the firm, and zero otherwise. In our sample, 53% of the Similarly, the correlation between percentage of profes- companies had an individual affiliated with the controlling sional audit committee members and excess control by larger shareholder who served the dual role of CEO and chairman. shareholders is strongly negative. There are also likely to be We constructed several measures of firm’s financial fewer professional audit directors when the CEO also serves
102 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 Table 6 Cross-sectional Regression Analysis of Adjusted Market-to-Book Ratios
The dependent variable is the adjusted Market-to-Book Ratios of averaged data of 2001 to 2003, difference in ratio of market value of equity scaled by book value of asset between a sample firm and the average value of firms in the same industry. We also include country dummies. Other variables are as defined in Table 2. Coefficient estimates are presented with t-statistics in parentheses. One, two, and three asterisks indicate the two-tailed significance at the 10, 5, and 1 percent levels, respectively.
Variables Adjusted market-to-book ratio Intercept -10.01 -10.11 -8.53 (-2.14)** (-2.13)** (-1.97)* Family control dummy 1.337 1.334 1.234 (2.43)** (2.42)** (2.25)** Percentage of independent audit committee 0.893 0.913 members (%) (1.08) (1.15) Percentage of independent audit committee mem- 1.173 bers * audit committee profession dummy (2.27)** Percentage of professional audit committee 0.514 members (%) (1.02) Percentage of professional audit committee mem- 1.292 bers * audit committee independence dummy (1.99)** Number of board members -0.045 -0.044 -0.049 (-0.45) (-0.44) (-0.49) Chairman and CEO dummy 0.801 0.813 0.845 (1.65)* (1.67)* (1.73)* Ln (total assets) 0.698 0.702 0.692 (3.89)*** (3.90)*** (3.84)*** Leverage 2.621 2.621 2.629 (3.04)*** (3.04)*** (3.02)*** R&D -0.183 -0.179 -0.101 (-1.14) (-1.10) (-1.01) Adjusted R2 (%) 13.24 14.26 13.78 as chairman. Firms with higher percentages of professional large shareholders are associated with higher likelihood of audit committee members are likely to have higher adjusted an audit committee with a majority of independent directors market-to-book ratios and higher R&D intensity. with financial expertise. It is noted that firm’s market-to-book For our first set of hypotheses (the interest alignment and ratio in the prior year (1999) is significant in predicting the the entrenchment hypotheses), we examine whether owner- likelihood of neither an entirely independent audit commit- ship variables have effects on whether a firm adopts an audit tee, nor an audit committee with majority of independent committee consisting entirely of independent directors, or and professional members. an audit committee with a majority of independent directors Finally, we investigated the correlation between the with financial expertise in probit analyses. Table 5 shows that existence of an effective audit committee and firm valuation. large shareholder’s ownership of cash flow rights is positively Table 6 presents regression results on how the various measures associated with the likelihood of firm’s adopting an audit of audit committee effectiveness affect industry-adjusted committee consisting entirely of independent members. For market-to-book ratios. The industry-adjusted16 measures are firms with excess control by large shareholders, firm’s likeli- defined as the difference between the raw measures of the hood of establishing an audit committee consisting entirely underlying firm and the corresponding industry averages. of independent members is (marginally) significantly lower. We find higher valuation among companies with higher We report similar findings for our probit analysis on audit percentages of independent directors in audit committees that committees with a majority of independent directors with consist of more than half of independent directors with finan- financial expertise, in that higher ownership of cash flow cial expertise. We also find higher valuation among firms with rights by large shareholders, and less excess control rights of higher percentages of members with financial expertise in audit
16. The industry in which each firm operates is based on two-digit Standard Indus- trial Classification (SIC) code.
Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 103 committees that consist only of independent directors. fewer obstacles to their tendency to exploit the wealth of Our study of audit committees in 450 East Asian minority shareholders. companies finds a strong positive correlation between the Altogether, our results are consistent with the arguments “cash flow” ownership (as opposed to just voting rights) that ownership structure affects audit committee composi- of large shareholders and the percentage of independent tion, and that independent and professional audit committees audit committee members. Also, there is a strong positive can help increase firm value. correlation between the “cash flow” ownership of large shareholders and the percentage of professional audit Yin-Hua yeh is a Professor of Finance at National Chiao Tung Univer- committee members. This finding is consistent with the sity. His research interests include corporate governance, mergers and hypothesis that large cash flow ownership provides large acquisitions, cross-straits finance, and the management of financial insti- shareholders with strong incentives for more effective tutions. governance. Conversely, the lower percentages of independent or professional audit directors at companies Re-Jin J. Guo is an Associate Professor of Finance at the University of with large disparities between cash ownership and voting Illinois at Chicago. Her research interests include corporate governance, rights is consistent with our suspicion that entrenched large IPOs, cost of capital, and the market valuation of corporate innovation. shareholders prefer inferior governance structures that pose
104 Journal of Applied Corporate Finance • Volume 26 Number 3 Summer 2014 ADVISORY BOARD EDITORIAL
Yakov Amihud Robert Eccles David Larcker Charles Smithson Editor-in-Chief New York University Harvard Business School Stanford University Rutter Associates Donald H. Chew, Jr.
Mary Barth Carl Ferenbach Martin Leibowitz Joel M. Stern Associate Editor Stanford University Berkshire Partners Morgan Stanley Stern Value Management John L. McCormack
Amar Bhidé Kenneth French Donald Lessard G. Bennett Stewart Design and Production Tufts University Dartmouth College Massachusetts Institute of EVA Dimensions Mary McBride Technology Michael Bradley Martin Fridson René Stulz Duke University Lehmann, Livian, Fridson Robert Merton The Ohio State University Advisors LLC Massachusetts Institute of Richard Brealey Technology Alex Triantis London Business School Stuart L. Gillan University of Maryland University of Georgia Stewart Myers Michael Brennan Massachusetts Institute of Laura D’Andrea Tyson University of California, Richard Greco Technology University of California, Los Angeles Filangieri Capital Partners Berkeley Richard Ruback Robert Bruner Trevor Harris Harvard Business School Ross Watts University of Virginia Columbia University Massachusetts Institute G. William Schwert of Technology Christopher Culp Glenn Hubbard University of Rochester University of Chicago Columbia University Jerold Zimmerman Alan Shapiro University of Rochester Howard Davies Michael Jensen University of Southern Institut d’Études Politiques Harvard University California de Paris Steven Kaplan Clifford Smith, Jr. University of Chicago University of Rochester
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