China corporate governance report: legal framework

• The proceeds of a public offer of shares from now on had to be used in accordance with the description of the funds’ purpose in the prospectus;
• Directors and senior offices of listed firms had to sign a confirmation that regular company reports were true, accurate and complete;
• three articles of the law provided for civil liability compensation when officers breached the law;
• several other articles gave greater clarity on the functions and powers of the CSRC.

The next major step came from CSRC again, which issued its Administrative Regulations on Listed Companies Information Disclosure in January 2007 (CSRC also issued regulations on directors, supervisors and senior managers’ shareholdings). Also in 2007 exchanges in Shanghai and Shenzhen enacted new regulations, partly to give effect to these changes in law. For example, that year the Shanghai exchange issued guidelines on information disclosure, covering disclosure rules for board secretaries, directors, supervisors, senior management and shareholders with holdings of 5% or more, among other things. Later that year it required directors, supervisors and senior management to report to the company any changes in their shareholdings within two working days, whereupon the company had two more days to notify the exchange itself. Similar provisions came through in Shenzhen in the same year, including one guideline warning about rumours and sensitive information.

In aggregate, this is quite a combination. When CLSA and the Asian Corporate Governance Association published their last CG Watch – a benchmark survey of corporate governance in Asia – in 2007, they wrote: “China has made a great leap forward by putting a framework in place to promote corporate governance.” And the changes are not just about legislation.

Equally important has been a process of shareholder reform. This was vital. For years, state-owned enterprises had two share classes: tradable and non-tradable stock. China acknowledged that the system was unsustainable and gradually set about converting all the stock to a tradable form, but the process was, as CLSA put it, “vast and complex”. It took years but was completed around 2007.

“The elimination of the current two-tiered structure will encourage more investor activism which will lead to better transparency,” said CLSA at the time. It added: “the consensus approach in determining the right compensation for non-tradable conversion has been a key step toward equitable treatment of minority shareholders.”

Kha Loon Lee is Asia Pacific head of the CFA Institute Centre for Financial Market Integrity, and has studied closely shareholder reform and related party transactions in China. “Shareholder reform is a very important initiative. It’s one of the best things they did,” he says. “There was a secondary black market for these non-tradable shares which are owned by the government. After this convergence, they still own the shares, but it’s more transparent.”

Qiao Liu, associate professor in finance at the University of Hong Kong, adds: “Currently in theory all shares are tradable. That is a big improvement on the corporate governance front.”

Also important was a new set of national accounting and auditing standards that came into effect in 2007, including 39 new accounting standards for business enterprises and 48 for certified public accountants, all released by the Ministry of Finance. Those standards, CLSA says, “bring China’s accounting and auditing regime largely in line with international standards.” It called the changes “momentous and should set the stage for a steady improvement in the quality and comparability of Chinese listed-company assets.”

So what next? On July 1, a new set of standards called the Basic Standard for Enterprise Internal Control, announced in June 2008, comes into effect. This standard impressed Hong Kong’s stock exchange which, responding in writing to questions from Euromoney, noted the “great efforts to align mainland law and regulation with international standards.” The standard outlines the regulatory requirements for Chinese enterprises to establish and assess effectiveness of their internal controls, and for accounting firms to audit the effectiveness of Chinese enterprises’ internal controls.

Zou at Allen & Overy notes: “This was deemed important because it was issued by the different regulators, including CSRC and the AIC [administration for industry in commerce – the major cities each have one of these] authorities. The emphasis of that regulation is that for listed companies, they will need to improve their internal corporate governance, including the concept that they will need to establish various committees – for example audit committees, nomination committees, compensation committees. These concepts are quite common in a western jurisdiction, but in China are relatively new. “