China corporate governance report: trends

In that environment, there are a lot of interconnected transactions. “Related-party transactions are inherent to companies in a centrally planned economy,” says Lee. “Where the state owns every business entity, all companies are by definition affiliated.”

In the early days of China listings, this could cause huge problems: parent companies taking back the good assets from a listed subsidiary after having taken the proceeds of an IPO. ST Monkey King Company, which makes electrical switches, shrank its assets from RMB3.4 billion at the end of 1999 to RMB70 million in February 2001; the city government where the company was headquartered later admitted to taking RMB524 million of those assets. It is hoped that those days are gone, but related party issues do cause tension between companies and shareholders today: in 2007 minority shareholders of CNOOC voted down a proposal to deposit billions of renminbi of its cash to CNOOC Finance, an unlisted affiliated company in Beijing. A similar reversal had happened to another sister company in the same group, China Oilfield Services, in 2004. (Fu Chengyu, CEO and chairman of CNOOC, talks about related party transactions in the interview on page xx; he argues that now CNOOC’s unlisted parent publishes financial reports under the same scrutiny and methodology as the listed groups, all information is now clear to investors.)

“If you look inside any annual reports you’re going to see connected or related transactions, sometimes as much as 90% of the business,” says Meyer. “The Chinese parent-subsidiary pattern remains in place and you sometimes feel you’re not getting the whole picture, when you want to know the relationship from the parent to the listed subsidiaries. That’s where the problems sometimes occur.”

Allen says there are other problems distinct to Chinese companies. “It’s been known for some time that the remuneration of executive directors and senior executives of big mainland companies in Hong Kong don’t get to keep all the money, and have to donate part back to the parent company,” he says. “Disclosure of compensation is not entirely accurate, and the regulator in Hong Kong is going to have to do something about that.” Another obvious shortfall that came to light last year was the way some red chips or H shares engage in derivatives trading – Citic Pacific being the most obvious example. A third worry is that on occasion board committee meetings are actually scripted. “We’re looking for evidence of less of that, since it slightly defeats the point of an independent board committee if you script everything.” Finally, Allen is looking closely at integrity of accounts in China, “to see what extent there’s a restatement of earnings or assets. If you remember, a couple of years back in booming markets, companies were investing a lot of money in the stock market.”

It would be churlish, though, not to recognise the effort that bigger Chinese companies in particular have made to raise standards, and the similarly impressive effort that the government has made to put regulation in place to raise the bar again. Interestingly, though, one has seen a level of market intervention by the state in recent years which, while generally aimed to be positive for the investor, is worth looking at closely.

“There are two series of changes,” says Meyer. “The first is what everyone’s familiar with. You go and list Petrochina overseas, and you put in place something that begins to resemble western corporate governance. You have independent directors, you have an annual report.

“On the other hand, the Chinese government has intervened and dramatically altered the landscape of compensation for CEOs. Salaries this year have been reduced in state owned and state influenced firms, and many have taken a 10% haircut. Is that a reversal of corporate governance? It’s clearly state initiated.”

Indeed, one can make an argument that while corporate governance – and particularly the legal framework around it –has clearly come on leaps and bounds in China, state intervention has actually increased in recent years. “Most of the focus on the markets has been the government trying to protect the market from falling too much,” says Allen. “Last year in the lead up to the Olympics there was quite a bit of intervention on behalf of the CSRC; asset managers weren’t allowed to move jobs. They were terrified of instability in the markets though none of the intervention effort seems to have made a huge difference.”