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Corporate Governance in China: Risks and Opportunities
What do potential investors need to know about corporate governance when investing in Chinese firms? Experts share their insights at the Corporate Governance Forum at CUHK Business School
By Fang Ying, Senior Writer, China Business Knowledge @ CUHK
Despite the slowdown of China’s stock market in recent years, there are still plenty of opportunities for those looking to invest in the world’s second largest economy. To successfully invest in Chinese firms, the key is to fully assess the target firms and their state of corporate governance. This is the take-away message from a joint forum organized by China Business Knowledge @ CUHK, the Center for Institutions and Governance (CiG), and the School of Accountancy at CUHK Business School.
The Corporate Governance Forum, titled “What Do You Need to Know about Corporate Governance When Investing in Chinese Firms?”, was held earlier this year and was part of a two-day academic conference organized by CiG. More than 150 participants from the academia and the business community attended.
The forum was moderated by T.J. Wong, Choh-Ming Li Professor of Accountancy and Director of the CiG at CUHK Business School. The panelists included Albert Ng, Chairman, China and Managing Partner, Greater China, EY; Patrick Sun, Chairman of the Chamber of Hong Kong Listed Companies; Jie Lian, Partner of Primavera Capital Group; and Joseph Piotroski, Associate Professor of Accounting and Center for Global Business and the Economy Research Fellow, Stanford University.
Current State of China’s Corporate Governance
Albert Ng of EY started by sharing his opinion on corporate governance in Chinese-listed companies. He said, “Despite all the issues and concerns, the state of corporate governance in China has improved.”
According to Ng, there is a common perception among the general public that state-owned enterprises (SOEs) are better governed than privately owned enterprises (POEs) in China. However, he cited a study conducted by Nankai University, which shows that the level of corporate governance in POEs in China has been higher than that of state-owned enterprises SOEs since 2011. Nevertheless, it would be wrong to simply judge whether POEs are better-governed than SOEs or vice versa, according to Ng.
“Both POEs and SOEs have corporate governance challenges. It may be fair to say that different companies are faced with different corporate governance issues,” he explained. “It is not a matter of POE or SOE, but a matter of individual companies. As an investor, you should be aware of the fact that there are good and bad companies among both POEs and SOEs. Just try to get as much information as possible before you invest.”
At the same time, Ng pointed out that China has moved a big step forward in terms of the accounting statements prepared by its listed companies.
“When you look at the financial information of companies, they need to be comparable and prepared based on the same accounting standards as overseas companies,” said Ng. “Compared with the early days, nowadays the accounting statements of Chinese-listed firms are very much in line with IFRS (International Financial Reporting Standards). It probably is 98 percent similar…. This is a fundamental progress in corporate governance in China.”
In the video, Albert Ng of EY and CUHK Business School alumnus, shares with the audience the issues regarding corporate governance among China’s listed companies
Best Practices in SOEs
Patrick Sun, who is serving as an independent non-executive director (INED) for several listed companies in Hong Kong, two of which are SOEs, shared his observations on corporate governance in SOEs.
According to Sun, unlike in other markets, not only do SOEs in China have to maximize the shareholder value, they also need to advance the government’s policy targets. Through the State-Owned Assets Supervision and Administration Commission of the State Council (SASAC), the state, which is the major shareholder of China’s SOEs, can assert political influence in the management of SOEs.
However, when it comes to the role of INEDs in China’s listed SOEs, Sun said that it is rather similar to that in other markets. According to Sun, in Chinese-listed SOEs, it is legally required that more than a third of the board members are INEDs, with at least one accounting professional. Meanwhile, to qualify as an INED, one needs to attend a course and pass a certification exam. “No matter how senior the position you are holding, you have to take the exam,” Sun said, adding that in Chinese SOEs, INEDs can only serve two terms of three years each. He said this is a best practice that is not common in Hong Kong.
Another best practice among China’s SOEs is that they have a more stringent internal control system. “They even hire auditors to review their internal control procedure,” said Sun. “Actually, the level of corporate governance in SOEs is very high, and to some extent, it is even higher than some companies in Hong Kong.”
Avoiding the Risks of Scandals and Frauds
Following Sun’s presentation, Jie Lian, former Managing Director of Goldman Sachs Hong Kong, discussed the issue of fraud. Lian, who has rich experiences in the investment banking sector, pointed out that amid the slowdown of China’s macroeconomy, Chinese companies are currently facing an increasing exposure to various operational vulnerabilities. At the same time, he said, fraud has become a big issue for private equity investments in China.
Nepotism and guanxi are the two major factors that contribute to this issue, according to Lian. Why? First, as many of China’s companies are family-based, external members of the management team may find it hard to penetrate this family circle of trust and loyalty, making it challenging to monitor its decision-making process and enforce corporate decisions. Second, guanxi is a central theme in Chinese society, and relationships with the Chinese government exist in almost every aspect of business. For overseas companies, it is thus essential to understand whether their Chinese partners’ strong relationship with their government counterparts is an institutional alliance based on operational strength or based on bribery.
In light of this, Lian emphasized that corporate governance is of paramount importance to a company and can influence the performance of firms. “It is almost as important as a company’s primary business plan,” he said. When corporate governance is executed effectively, it can prevent corporate scandals, fraud and criminal liability of the company, while bad corporate governance hurts the interest of minority shareholders.
What are the best practices of corporate governance? “Make sure you have a diverse board composition; hiring “real” independent directors; and establishing professional committees controlled by independent professionals.” Lian said.
Investing in China
The last speaker, Joseph Piotroski, Associate Professor of Stanford University, shared his views on corporate governance in Chinese firms from an academic perspective.
Prof. Piotroski said that investing in China requires a more careful analysis of value-relevant information above and beyond the set of financial, economic and strategic factors considered in a “traditional analysis.” Because financial information about firms in China and other emerging economies is typically less reliable, investors need to exercise caution when interpreting financial reports. Additionally, the unique institutional environment of China means that shareholder value can be created or destroyed through numerous channels.
According to Prof. Piotroski, when considering an investment in a Chinese-listed firm, investors need to evaluate the company from the following five perspectives.
First, investors need to understand the ownership structure of the company and the prevailing incentives of the controlling shareholder. “You need to know who controls the firm. Is it the government, a family or an entrepreneur? In addition, you need to understand the incentives of the major shareholders,” said the professor.
Secondly, investors should analyze whether the company’s related party transactions add or destroy any value.
Thirdly, investors should assess the credibility of the company’s corporate governance practices to determine whether they are effective or window-dressing only. “Does the firm use a high-quality auditor and are the independent directors truly independent? Are there any conflicts of interest?” asked Prof. Piotroski.
Fourthly, investors should understand the company’s political connections and exposure to political factors. “This is an important issue in the China market,” he stressed. “Before you invest in Chinese firms, you should ask yourself if it’s a privately owned firm and to what extent the firm depends on the local government; and if it’s a state-owned firm, whether it is aiming to maximize profits.”
Lastly, he urged investors to understand the individual characteristics of different provincial and local institutions in China: “China is a collection of localities and each locality has a very different set of market institutions. For example, some provinces are deeper into reforms than others and some localities have more severe corruption problems. An investor needs to be aware of these differences.”
Prof. Piotroski concluded: “When you invest in Chinese-listed companies, you need to consider these issues. Nevertheless, China remains an exciting place to invest.”