Corporate Governance for Listed Companies
in China− Recent Moves to Improve
the Quality of Listed Companies −Takeshi Jingu

I.

Introduction

The quality of capital markets cannot be improved without raising the quality oflisted companies. Owing to the history of China's capital markets, the number of its
listed companies of high quality is limited; even government officials have stated1 thatabout 70% of the companies listed on China's domestic market do not meetinternational standards in terms of profits, returns and other indicators. In fact, withproblems such as companies falsifying their earnings statements and parent
companies misappropriating funds from their listed subsidiaries still a common
occurrence, investors view China's capital markets as nontransparent and full of risks.
The China Securities Regulatory Commission (CSRC) and other regulatory bodies
have responded by working to improve the quality of listed companies, a process thatbegan after the State Council's January 2004 release of its Several Opinions on
promoting the reform, opening up, and stable development of capital markets(referred to as the "Nine Opinions"). These efforts include implementation of the new
Company Law in January 2006, the writing of regulations governing M&A (which is
expected to take off after non-tradable share reforms), and the introduction of new
accounting standards in January 2007. Governmental authorities are using
administrative guidance in an attempt to solve issues that have built up thus far,including the misappropriation of corporate funds by large shareholders.

II. Governance structure of listed companies
A key question to ask is whether listed companies are well-managed, i.e., whether
they make efficient use of resources and generate profits, viewed both from the microperspective of the investor as well as from the macro perspective of resource
allocation across China's overall economy. Among listed companies in China,
1Remarks by Cheng Si-Wei, Vice-Chairman of the Standing Committee of the National
People’s Congress, People’s Republic of China, quoted in the 31 January 2007 edition of
the Financial Times.

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however, there are frequent examples of a parent company misappropriating funds
from its listed subsidiary or manipulating accounting data that is critical to assessing
the company's business.
To better consider why these problems occur we will take a look at institutional
design, which is closely related to a listed company's corporate governancecapabilities. As explained later, the fundamental institutional design of China's listed
corporations is built around a shareholders' general meeting, under which there is aboard of directors and a board of supervisors.
Although it is the rules governing joint stock limited companies (JSLC; also
referred to as "companies limited by shares") that are applied to listed companies,
under the Corporate Law the rules governing limited liability companies (LLC) are insome cases the same as for JSLC, so we discuss here both LLC and JSLC.2 Moredetailed rules for listed companies are set out in the Guidance for the Articles of
Listed Company, which was amended in 2006.

1. Shareholders' meetings and general shareholders' meetings
We start by looking at shareholders' meetings and general shareholders' meetings.
The shareholders' meetings of LLC comprise all of the shareholders and areconsidered the company's power structure (Article 37 of the Company Law3). The
LLC's shareholders' meeting has the power to decide the company's management
policy and investment plan, to elect and reappoint members of the board of
supervisors and the board of directors who do not work as employee representatives,to decide matters concerning the compensation of directors and supervisors, toexamine and approve reports issued by the board of directors, and to examine andapprove reports issued by supervisors or the board of supervisors (see Figure 1)(Article 38).
The composition and powers of a JSLC's general shareholders' meeting are similar(Articles 99 and 100), although it is also possible to use cumulative voting4 to electauditors and directors at the general shareholders' meeting, per the company's articles
of association or resolution of the general shareholders' meeting (Article 106).

2

3

4

An LLC differs from a JSLC in several respects, including minimal initial capital, which is
30,000 yuan for an LLC and 5 million yuan for a JSLC, and the number of founders, which
can be a single person for an LLC but must be between two and 200 persons for a JSLC.
The English translation of these articles is based on the Japanese translation publishedon 14 November 2005 by the law office of Mori, Hamada, and Matsumoto.
This system takes into account the needs of minority shareholders when there is anelection. It gives to each shareholder the same number of votes for each share as thenumber of directors being selected. Shareholders can either give all of their votes to asingle candidate or spread them out among multiple candidates.
Corporate Governance for Listed Companies in China− Recent Moves to Improve the Quality of Listed Companies − 37

Figure 1:The powers of the general shareholders' meeting
The general shareholders meeting is a company's highest authoritative body and exercises thefollowing powers
1)
2)

Deciding the company's management policy and investment plan
Electing and replacing members of the board of supervisors and the board of directors who
do not work as employee representatives, and deciding matters concerning thecompensation of directors and supervisors
3)
Examining and approving reports issued by the board of directors
4)
Examining and approving reports issued by the board of supervisors
5)
Examining and approving the company's proposed annual financial budgets and financial
results
6)
Examining and approving the company's plan for distributing profits and for recovering
losses7)Adopting resolutions regarding increases or decreases in the company's registered capital
8)
Adopting resolutions regarding the issuance of corporate bonds
9)
Adopting resolutions regarding the company's merger, division, dissolution, liquidation, orchanges in the company's format
10) Revising the company's articles of association
11)* Make resolutions regarding the appointment or dismissal of an accounting firm12)* Examining and approving matters pertaining to guarantees as prescribed in Article 41 of
the Guidance for the Articles of Listed Company
13)* Examining and approving the purchase and sale of important assets when the amount of
said purchase/sale during any one-year period exceeds 30% of the company's total
appraised assets in the most recent fiscal year14)* Examining and approving changes in the use of procured funds
15)* Examining and approving stock incentive plans16)* Examining and approving other matters which laws, administrative regulations,departmental rules, or the company's articles of association prescribe that the generalshareholders’ meeting must decide

Note:
Source:Based on the Company Law. Items marked with * are prescribed in the Guidance
for the Articles of Listed Company
Nomura Institute of Capital Markets Research, based on the Company Law andthe 2006 revision to the Guidance for the Articles of Listed Company. The English
translation is based on the Japanese translation of the Company Law published on
14 November 2005 by the law office of Mori, Hamada, and Matsumoto. (The same
holds for Figures 2 to 4).

2. Board of directors
An LLC must establish a board of directors, comprised of between three and 13
persons. This must include an employee representative for LLCs established with theinvestment of at least two state-owned enterprises (SOEs) or at least two other typesof state-owned investment entities. Other limited companies may also have an
employee representative on their board of directors (Article 45). The board of
directors is responsible to the shareholders' meeting (Article 47) and exercises
ownership rights when the shareholders' meeting is not in session.5 Its powers include
determining the company's operating and investment plans, establishing the5

Feng Wen-li, Governance Practices and System Establishment of China's Listed
Companies, Beijing: Economy and Management Publishing House, 2005 (in Chinese).

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Nomura Capital Market Review Vol.10 No.2

company's internal management structure, and hiring and replacing general managers
and deciding on matters related to their compensation (Article 47; see Figure 2).
JSLC also establish a board of directors, comprised of from five to 19 persons, andthe board of directors' powers are the same as in the case of an LLC (Article 109). The
board of directors is responsible to the general shareholder's meeting (Article 105 of
the Guidance for the Articles of Listed Company). The board of directors of a JSLC
must meet at least twice a year (Article 111 of the Company Law).

Figure 2: The powers of the board of directors
The board of directors is responsible to the general shareholder's meeting, and exercises thefollowing powers
1)
2)
3)
4)
5)
6)

Convening the general shareholders' meeting and reporting to same
Executing resolutions adopted by the general shareholders' meeting
Deciding the company's business plan and proposed investment plan
Formulating plans for the company's annual financial budgets and financial results
Formulating plans for distributing profits and for recovering losses
Formulating plans for increases or decreases in the company's registered capital and forthe issuance of corporate bonds7)* Formulating plans for important acquisitions and share buybacks by the company, themerger, division, or dissolution of the company, and changes to the company's form
8)* Deciding within the scope authorized by the general shareholders' meeting external
investments, the purchase or sale of assets, the pledging of assets, external guarantees,
entrusting money management, and related-party transactions
9)
Deciding on the establishment of internal governance bodies
10)* Appointing or dismissing managers and the board of directors' secretary; hiring or
dismissing the deputy general manager, CFO, and other senior management appointed by
the general manager; and deciding the compensation, punishments and rewards for same11) Determining the basic management organization
12)* Formulating proposed revisions to the company's articles of association
13)* Managing corporate disclosures
14)* Proposing to the general shareholders' meeting the hiring or replacement of an auditing
firm15)* Receiving the general manager's work report and examining the general manager's work16)* Other powers authorized by laws, administrative regulations, departmental rules, or thecompany's articles of association

Note:
Source:Based on the Company Law. Items marked with * are prescribed in the Guidance
for the Articles of Listed Company.
Nomura Institute of Capital Markets Research, based on the Company Law andthe 2006 revision to the Guidance for the Articles of Listed Company.

3. General managers
An LLC may have a general manager who shall be hired or dismissed by the boardof directors, as noted above. The general manager is responsible to the board of
directors, and has powers that include leading the management of the company's
production and business operations and implementing board of directors' resolutions(Article 50; see Figure 3). The board of directors determines the business policy, andCorporate Governance for Listed Companies in China− Recent Moves to Improve the Quality of Listed Companies − 39the general manager executes that policy.6 A JSLC may also have a general manager,
who has the same powers as above (Article 114). In addition, the board of directors of
a JSLC may appoint one of its members to concurrently serve as general manager.

Figure 3: The powers of the general manager
The general manager is responsible to the board of directors, and exercises the following powers
Leading management of the company's production and business operations, implementing
board of directors resolutions, and reporting on work to the board of directors
2)
Implementing the company's annual business plan and investment plan
3)
Formulating plans for the establishment of internal governance bodies
4)
Proposing the company's basic management organization
5)
Determining the company's detailed rules
6)
Proposing to the board of directors the appointment or dismissal of the deputy generalmanager and the CFO
7)Determining the appointment or dismissal of managers other than those who must havetheir appointment or dismissal determined by the board of directors
8)
Other powers as assigned by the board of directors
General managers must attend board of directors meetings
1)*

Note:
Source:Based on the Company Law. Items marked with * are prescribed in the Guidance
for the Articles of Listed Company.
Nomura Institute of Capital Markets Research, based on the Company Law andthe 2006 revision to the Guidance for the Articles of Listed Company.

4. Board of supervisors
An LLC must set up a board of supervisors (equivalent to the board of auditors inJapan), comprised of at least three persons. The board of supervisors must include
representatives of shareholders and employee representatives, with the lattercomprising a suitable percentage (at least 1/3) of the total number of board of
supervisors members. No director or senior manager (general manager, deputy generalmanager, CFO, board of directors secretary, or other officer as stipulated in thearticles of association) may concurrently serve on the board of supervisors (Article52). The composition of a JSLC's board of supervisors is similar (Article 118).
The powers of the board of supervisors include review of company's finances,supervision of directors and senior management, and submission of proposals to
dismiss directors and senior managers who violate the law (Article 54; see Figure 4).
Supervisors may attend board of directors meetings (Article 55), and the company
must bear the necessary costs incurred by the board of supervisors in executing its
powers (Article 55). The authority of a JSLC's board of supervisors is similar (Article
119).

6

Ibid

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Figure 4: The powers of the board of supervisors
The board of supervisors shall exercise the following powers
Examining, and submitting written opinions on the periodic company reports prepared by
the board of directors
2)
Examining the company's finances
3)
Supervising the performance of duties by directors and senior management, and making
proposals on the dismissal of directors and senior management who have violated laws,
administrative regulations, the company's articles of association, or resolutions of thegeneral shareholders' meeting
4)
Demanding that directors and senior management correct any conduct that harms thecompany's interests
5)
Proposing the convening of extraordinary meetings of shareholders, and convening andpresiding over the general shareholders' meeting when the board of directors does notconvene or preside over the general shareholders' meeting, as prescribed in the Company
Law
6)
Submitting proposals at general shareholders' meetings
7)
Bringing suit against directors and senior management based on Article 152 of theCompany Law , which provides rules concerning shareholder class action8)* May launch an investigation when irregularities in the company's management are found.
When necessary, may employ the services of accounting firms and law firms to cooperate
in the investigation, the expense of which shall be born by the company.
The articles of association may prescribe other powers of the board of supervisors
1)*

Note:
Source:Based on the Company Law. Items marked with * are prescribed in the Guidance
for the Articles of Listed Company.
Nomura Institute of Capital Markets Research, based on the Company Law andthe 2006 revision to the Guidance for the Articles of Listed Company.

5. Special provisions for listed companies
In addition to the above, the Company Law includes special provisions for listedcompanies. Listed companies must have independent (outside) directors (Article 123).
Another provision is that when the director of a listed company has a relationship witha company involved with a board of directors resolution, that director may not
exercise voting rights for said resolution (Article 125, abbreviated), and for relatedtransactions that director is limited in exercising voting rights.

6. Establishing a committee
Based on the Listed Company Rules, a listed company's board of directors may,with a general shareholders' meeting resolution, establish specialized committees tohandle business strategy, auditing, appointments, and compensation & appraisals. All
members of these specialized committees must be directors. Independent directors
must comprise the majority of committees handling audits, appointments, andcompensation & appraisals, and must be the heads of their respective committees. At
least one of the independent directors on the audit committee must be an accounting
specialist (Article 52 of the Listed Company Rules).

Corporate Governance for Listed Companies in China− Recent Moves to Improve the Quality of Listed Companies − 41

7. Special features of the institutional design of China's listed companies
As seen above, the institutional design of China's listed companies includes a boardof directors and a board of supervisors under the general shareholders' meeting, which
is similar in format to Japan's institutional design. Under the Listed Company Rules,
however, the board of directors may establish an auditing committee, which meansthat a listed company in China can have both a board of supervisors and an auditing
committee. In some cases, there is a division of duties between the two, such that theboard of supervisors provides checks on the overall business situation and on the
directors and senior management, while the auditing committee checks the accounting
information. In some cases, the thinking is that the auditing committee must be under
the control of the board of supervisors.7

III. Problems related to listed companies
Although the institutional design for the corporate governance of listed companies
has been put in place, problems still occur that betray the trust of investors, including
the misappropriation of funds associated with related-party transactions 8 and themanipulation of accounting.
We will look here at related-party transactions and the provision of guarantees
between related companies.9 Specifically, the interests of minority shareholders can beharmed when the listed company's funds are misappropriated or its profits
manipulated through the use of related-party transactions among listed subsidiaries,
the parent company, and sister companies.
There are a variety of ways that a parent company can misappropriate funds from alisted subsidiary. This is often done through the use of related-party transactions,although there are also more direct examples whereby the parent company arbitrarily
uses funds procured from a capital increase at a listed subsidiary. A specific exampleof the former is when a parent company misappropriates funds from the listedcompany over an extended period in the form of accounts receivable or prepaid
expenses, related to the purchase and sale of products or manufacturing inputs.
Another common example is when a listed company is forced to provide guarantees.
When the parent company receives bank financing, for example, and makes the listed
subsidiary provide guarantees, the listed company is under obligation to repay the
7
8

9

42

Based on interviews with CPAs and securities firms.
Transactions with related parties. Article 217 of the Company Law defines a related-party
relationship as follows. A relationship between any two companies in which one iscontrolled directly or indirectly by the other's controlling shareholder, person with effective
control, director, supervisor, or senior management, or any other relationship with thepotential to result in the shifting of profits between the two sides. Provided, however, that
this does not include relationships between companies in which the sole connection isthat the government owns a controlling stake in both.
For more on accounting manipulation, see Takeshi Jingu and Suiyo Ri, Chugoku no
Kigyou Kaikei, Kansa Seido (Corporate Accounting and Auditing in China) Capital Market
Quarterly, Winter 2007 issue (in Japanese).

Nomura Capital Market Review Vol.10 No.2

loan if the parent company is unable to do so. Another example is a paid-in capitalincrease, where the parent company puts nothing up, leaving most of the payment to
the minority shareholders, and then pays out a cash dividend, thereby bleeding thelisted company of funds. Profits can be manipulated by manipulating either the pricepaid between affiliates in an internal purchase/sale of products or materials, or the
price of assets.
To give an idea of the scale of the problem, the funds misappropriated by major
shareholders in 2003 was about 110 billion yuan.10 Illegal guarantees (those violating
Order #56 described below) on both the Shanghai and the Shenzhen Stock Exchanges
totaled 27.284 billion at 145 companies at the end of 2003, and 23.883 billion yuan at
148 companies at the end of 2004.11

IV. Why these problems occur
1. Large shareholder control and the lack of separation from state government
Much of the blame for the poor functioning of corporate governance at listedcompanies can be attributed to the process for listing state-owned enterprises. Manyof China's listed companies were originally state-owned enterprises that werereorganized as joint stock companies as part of the reform process. In the 1990s,
listing quotas were allocated to regional governments, which were able to meet these
quotas by creating seemingly strong joint stock corporations, transferring only thehigher quality assets into the company to be listed ("Baozhuang (wrapper) listings.")
In other words, the listing was not of the entire state-owned enterprise but only of apart of it, i.e., a partial listing. The original state-owned enterprise was turned into aholding company, under which is both the listed company and the corporations
comprising the unlisted parts (see Figure 5).12
The majority of China's listed companies were established through this sort ofrestructuring of state-owned enterprises, with the state and the state-owned enterprisethat was the parent company (the holding company in the example above) becoming
the major shareholder. As of end-March 2005, prior to the reform of non-tradable
shares, of the 1333 companies listed on both the Shanghai and Shenzhen Stock
Exchanges, 1074 (about 80%) were state-owned enterprises with some of their shares
owned by the state. The companies under state control, with the state owning at least a
30% stake, numbered 798 (60% of the total), with a simple average state ownership of
55%.13 The state or state-owned enterprise we refer to here often signifies that either a
10
11

12

13

Sohu Caijing, 23 July 2004. This was a statement from the listing division of the CSRC.
Shanghai Stock Exchange: China Corporate Governance Report (2006), Shanghai:
Fudan University Press, 2006 (in Chinese)
The decision as to whether the shares of the listed company are owned by thegovernment (state shares) or by a holding company as in the example above (SOEshares) depends on the asset breakdown of the state-owned enterprise prior to its
transformation into a listed company. Even in the case of state shares, the holding
company acts on the state's behalf and effectively becomes the shareholder.
Calculations based on data from Wind Information.
Corporate Governance for Listed Companies in China− Recent Moves to Improve the Quality of Listed Companies − 43regional government (State-Owned Assets Supervision and Administration
Commission (SASAC)) or a state-owned enterprise belonging to a regional
government owns the company (enterprise). The general shareholders' meeting andboard of directors are controlled by the major shareholders, and the chairman of theboard in some cases is also the general manager, which lowers the effectiveness of theboard of directors' supervision of management.
In fact, the chairman of the board and general manager are often appointed by theregional government as part of a system for promoting government officials.
Consequently, listed companies owned and controlled by the state failed to achieve
separation from the government, leaving the functions of the regional government andthe company commingled.
According to the Provisional Rules on the Supervision and Administration of StateOwned Assets (2003), the SASAC performs its duties primarily as an investor, without
taking over the government's function of managing the social and public aspects, andalso does not get directly involved in the company's production or other businessactivities. In other words, the SASAC's only role should be that of a shareholder, andit should not give any consideration to such issues as protecting jobs in the region. In
reality, however, when there is a conflict of objectives between the investor and thegovernment (such as regards the need to protect jobs), the government's objectives
wind up taking precedence. Particularly amid the vicious competition for economic
development between regional governments, which has been cited as one cause of therecent macroeconomic overheating, the listed companies of each region have played
an extremely important role in promoting economic development and encouraging
socioeconomic stability, from the perspective of each regional government.
This explains the use of manipulative accounting to help the listed company meetthe requirements for raising capital and the market manipulations aimed at boosting
the offering price. The funds thus obtained wind up being diverted to the parent
company and other companies under its umbrella through the use of related-party
transactions, and otherwise being misappropriated by the parent company. Meanwhile,
because the listed company serves as a vehicle for regional governments and stateowned enterprises to raise funds, in some cases the regional government injects profits
into the listed company in order to keep it from losing its listing.
This control by the major shareholders is also harmful in the case of private-sector
corporations, given their poor corporate governance capabilities.14

14

Shanghai Stock Exchange, op. cit.

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Nomura Capital Market Review Vol.10 No.2

Figure 5: Typical examples of state-owned enterprises that have beenreorganized and listed as stock companies
The original state-owned enterprise

Listed company(XYZ Co. Ltd.)
Prime assets

HoldingCompany(XYZ Group)

Other entities

2. Weak checking function
Under these conditions, neither the internal nor the external management checking
function worked very well. We have already noted the weakness of checks between
directors and management, but checks on the directors and management by the boardof supervisors have also been weak.
As noted earlier, there are two types of supervisors, those who are shareholder
representatives and those who are employee representatives. The majority of theformer are sent by major shareholders, while the latter have jobs working under thegeneral manager. In most listed companies, the chairman of the board of supervisors is
also the head of the labor union, and the head of the labor union is effectively
appointed by the in-house party chief (who is often concurrently the chairman of theboard of directors). Either way, this arrangement makes it difficult for the board of
supervisors to check on the conduct of the directors and management. Meanwhile, itappears that few listed companies have established an auditing committee.15
One could also argue that pressure on corporate management from the outside has
been weak. The market for the right to control companies has been slow to develop.
Prior to the reform of non-tradable shares, share prices did a poor job of indicating
enterprise value, as was evident from the discrepancy between the price of tradable
shares on the exchanges and the negotiated price for the transfer of non-tradable
shares. Because major shareholders were unable to sell their non-tradable
shareholdings on the exchanges, they were indifferent to the prices of tradable shares.
A negotiated transfer of non-tradable shares was also the primary method used for
M&A, thereby eliminating the pressure from hostile acquisitions.
Institutional investors have also had a fairly small presence and thus no impact on
corporate management. In addition, there were problems with the disclosure ofaccounting information, and because these companies' general manager and other
15

About 20% of all listed companies in 2003. Yang Yang, Jiang Ya Peng: Shangshi Gongsi
Kuaiji Jianguan Wenti Yanju (Research on Accounting and Auditing Problems in Listed
Companies), Dongbei University Press, 2005 (in Chinese).
Corporate Governance for Listed Companies in China− Recent Moves to Improve the Quality of Listed Companies − 45managers were effectively appointed by the responsible government divisions, anoutside market for hiring talent has been slow to develop.

V. Recent efforts toward improvement
1. Improvement on the legislative and regulatory fronts
There have thus been problems in the ability to place checks on management, bothinternally and externally, but there have been some recent moves toward improvementthat bear watching.
We look first at the progress made on the legislative and regulatory fronts. The new
Company Law was implemented in January 2006, and new accounting and auditing
standards have been applied to listed companies since January 2007. In the following
paragraphs we look more closely at the new Company Law.16
One key element of the new Company Law relevant to corporate governance is theincrease in powers given to the board of supervisors.17 The board of supervisors has
been given more powers, including the right to propose the dismissal of directors andsenior management, and it is also now able to make proposals to the generalshareholders meeting and bring lawsuits against directors and senior management(Articles 54 and 119). In addition, to solve the real problem of the chairman of theboard not convening a general shareholders' meeting, procedures for convening ageneral shareholders' meeting have been established, and the board of supervisors aswell as shareholders with at least a 10% stake are now able to convene and presideover the meeting (Articles 41 and 102). The board of supervisors can also now
question and propose board of directors' resolution items as well as investigate when
it discovers irregularities in how the company is being managed. It can hire an
accounting firm to help with the investigation, and can make the company pay thefees involved (Articles 55 and 119).
Second, the directors, supervisors, and senior management have been given newduties of diligence and loyalty, including an obligation to comply with laws and aprohibition on bribery and embezzlement (Article 148). The controlling shareholder,person with effective control, director, supervisor, and senior management cannot use
an affiliate relationship to harm the interests of the company, and directors with anaffiliate relationship are unable to exercise their voting rights on resolution items
relevant to that relationship (Articles 21 and 125). Transgressions such as themisappropriation of company funds or the offering of company assets as collateral
without the consent of the general shareholders' meeting or board of directors are also
prohibited, and any ill-gotten gains are returned to the company (Article 149).
16

17

For more on new accounting and auditing standards, see Takeshi Jingu and Suiyo Ri,
Chugoku no Kigyou Kaikei, Kansa Seido (Corporate Accounting and Auditing in China)
Capital Market Quarterly, Winter 2007 issue (in Japanese).
The description in this portion is based on Takeshi Jingu and Suiyo Ri, Chugoku no
Kigyou Kaikei, Kansa Seido (Corporate Accounting and Auditing in China) Capital Market
Quarterly, Winter 2007 issue (in Japanese).

46

Nomura Capital Market Review Vol.10 No.2

Third, there is now stronger protection of minority shareholders. It is also now
possible to use cumulative voting at the general shareholders meeting when electing
directors and supervisors (Article 106). Furthermore, the rights of shareholders toview financial statements have been strengthened (Article 34), and shareholder classaction can now be brought (Article 152). Companies are now obligated to present
truthful and complete accounting records to their accounting firm (Article 171).
Fourth, there are sections in the Company Law that refer specifically to listedcompanies. Chapter IV, Section 5 of the Company Law (Special Provisions on the
Organizational Structure of a Listed Company) requires listed companies to have
independent directors. This was added in response to the State Council's Nine
Opinions, and is specifically aimed at improving the corporate governance of listedcompanies. The Guidance for the Articles of Listed Company states that internal
directors (directors currently working as senior management or employee
representative directors) may not comprise more than half of a company's directors(Article 96 of said Guidance).
All of these points have become critical to future operations, but taking theexample of the system of independent directors implemented in 2001, although there
are examples of financial scandals at large corporations where the independent
directors were not made aware of information,18 in other companies the system has
been working, and we expect gradual improvements moving forward.

2. Reform of non-tradable shares
We look next at the impact from the reform of non-tradable shares. First, theprocess of reforming non-tradable shares resulted in a reduction in the percentage ofshares held by major shareholders, because the non-tradable shares were transferred tothe holders of tradable shares through a gratuitous conveyance (Figure 6). This
increased the voice of minority shareholders in numerical terms. The state has been
withdrawing from traditional industries and competitive industries and moving into
industries critical to national economic stability in terms of managing state-owned
assets, and we expect this reshuffling of ownership to continue.
Regarding the reform of non-tradable shares at individual corporations, it isimportant to note that at this point there has been no radical change in the generallevel of control exerted by major shareholders. This is because in some cases anotherform of paying compensation is being chosen when it appears that the gratuitousconveyance of non-tradable shares to minority shareholders may have an impact oncontrol of the company.19
Second, the interests of major shareholders, management, and minority
shareholders are starting to be aligned. The reform of non-tradable shares will
18
19

A financial scandal involving China Southern Airlines. Caijing Magazine, 2006, No. 10.
The non-tradable share reforms required holders of non-tradable shares to pay
compensation to tradable shareholders in return for the right to sell their shares on stock
exchanges. This compensation could be in form of cash or the gratuitous transfer of stock(non-tradable shares), among others.
Corporate Governance for Listed Companies in China− Recent Moves to Improve the Quality of Listed Companies − 47

gradually make it possible in the future to trade state-owned shares, SOE shares, andother non-tradable shares on a securities exchange. Until now, the price of tradable
shares and the negotiated price for the transfer of non-tradable shares has beendifferent, but we expect the market price quoted on exchanges to start reflecting
enterprise value and thus the performance of corporate management.
As non-tradable shares become tradable, shareholders will be able to sell theirshareholdings on the market, and this should quickly make them shed theirindifference to the market price. There is also now a tendency for the share price to bea factor in managers' performance evaluation. The Measures for the Administration of
Equity Incentive Plans of Listed Companies (implemented January 2006) also
attempts to provide directors, supervisors, and senior management with long-term
incentives. Under both the new Company Law and the 2006 revision to the Guidance
for the Articles of Listed Company, directors, supervisors, and senior management areallowed to sell up to 25% of their holdings in the company's stock each year during
their stint (they could only purchase stock previously).
Fourth, once share prices begin to reflect enterprise values, conditions should
become more conducive to M&A activity. Hostile takeovers will also become apossibility, providing a basis upon which capital markets can apply external pressure
on company management, even though this may not function immediately. In thisregard, China is working seriously toward establishing an environment conducive to
M&A, including its implementation in September 2006 of the Measures of
Administration of Acquisition of Listed Companies.

Figure 6: Large shareholders' ownership share of listed companies

< 35%

33%

≥ 35% < 50%

19%

≥ 50%

42%
52%

29%
25%

As of end-March 2005
Before non-tradable share reform

Note:

Source:48

As of end-February 2007
After non-tradable share reform

Shows the respective percentages of all listed companies in which the largest
shareholder owns 1) less than a 35% stake, 2) at least a 35% but less than a 50%
stake, and 3) a 50% stake or greater. There were 1,333 listed companies at endMarch 2005 and 1,430 at end-February 2007.
Nomura Institute of Capital Markets Research, based on data from Wind
Information

Nomura Capital Market Review Vol.10 No.2

3. Improvement through administrative measures
Measures implemented by regulators aimed at improving conditions include moves
taken in 2005-06 to solve the problem of parent companies misappropriating listedcompany funds. In response to the Nine Opinions announced in 2004, the CSRC
announced its Opinions on Improving the Quality of Listed Companies on 19 October
2005, with the specific aim of solving this problem. It required parent companies topay back all misappropriated funds to their subsidiaries before the end of 2006.
As a result, the over 45.6 billion yuan in funds that had been misappropriated from396 companies as of end-2005 dropped to 31.6 billion yuan from 147 companies by
end-June 2006, and then to 9.2 billion yuan from 17 companies by end-2006.20 The
parent companies use the various methods to repay their debt to listed subsidiaries,
including cash, offsets with their equity in subsidiaries or dividend payments fromsubsidiaries, and proceeds from the sale to third parties of their equity in subsidiaries.
The exchanges severely penalized those companies that had continued to conceal
their misappropriation of funds over an extended period until it ultimately became too
difficult to hide. Official decrees were handed down that publicly reprimanded thosecompany's senior management and officially deemed them unsuitable to serve as
senior management of a listed company. Negative inheritances that had accumulated
over time were cleared through strict measures such as these.
The problem with guarantees is dealt with by Order #56 of 2003, Notification ofSome Problems Related to the Exchange of Funds Between Listed Companies andRelated Parties, and to the Regularization of External Guarantees for Listed
Companies, which prohibits controlling shareholders or other related parties fromforcing a listed company to provide guarantees. More recently, there have beenreports of a reduction in illegal guarantees in 2006, just as with funds
misappropriation. The number of companies whose management was penalized forguarantee-related violations dropped from about 25 in 2005 to around 10 in 2006.21

4. Listing of all affiliates
Although administrative measures are able to solve past problems, they are unable
to fundamentally solve the problem of funds misappropriation. In this respect, theproblem of transactions between listed companies and their affiliates can be
definitively solved by ensuring that all, rather than just some, of a state-owned
enterprise's affiliates are listed.
There have long been examples of such entire listings, but their number has
increased since the reform of non-tradable shares because the CRSC has beenpromoting it.22 This group listing has been one focus of capital markets in 2007.

20
21
22

From various news sources.
Shanghai Securities News, dated 22 December 2006.
Integrating and listing only the major businesses is also considered an entire listing.
Corporate Governance for Listed Companies in China− Recent Moves to Improve the Quality of Listed Companies − 49

The authorities have taken a supportive of view of group listings since the reformof non-tradable shares. In its Guidance Opinions on the Split Share Structure Reformof Listed Companies of 23 August 2005, China's government supported (1) after
solving the non-tradable share problem, the listing of all affiliates of large firms withstrong earnings through third-party capital increases at the listed companies they
control. The government also promoted (2) the strengthening of listed companies andsupported restructuring through M&A, financed with the stock of listed companies
either in a direct purchase or an exchange of shares.
In opinion #14 of its Opinions on Improving the Quality of Listed Companies, it
supported the use of capital markets to make China's best companies even stronger.
This opinion specifically advocated the use of capital markets by state-owned
enterprises to consolidate the prime resources in listed companies and to insure that allaffiliates of the best large companies are listed.
Methods for achieving a group listing can be broadly categorized into two different
types: third-party capital increases and mergers through the exchange of shares. One
example of a third-party capital increase is the one announced in November 2006 by
Baotou Iron & Steel, a leading steel company based in Inner Mongolia. Baotou Iron &Steel conducted a 3 billion share third-party capital increase with its parent company,
the Baogang Group, to finance the purchase of the group's assets and companies,
primarily in the steel business (Figure 7). This has allowed Baotou Iron & Steel tobecome a company with refining and other upstream processes. Looking only at the
impact from the capital increase, the Baogang Group's stake in Baotou Iron & Steelincreased from roughly 47% to 72%.
An example of an exchange of shares was the group listing of Shanghai
International Port (Group) (SIPG), mainland China's largest port operator. SIPG
owned about a 70% stake in Shanghai Port Container (SPC), and it acquired the restof the company with a share exchange of 4.5 of its shares for every share of SPC(Figure 8). SIPG then listed its shares. Because the new company became listed, theusual IPO procedures were followed.
A group listing is also advantageous to the major shareholders because it makes it
possible to concentrate the prime assets. As could be surmised based on the examples
cited above, the parent company is able to increase its stake in the listed company (orin the case of SIPG, the shares owned by SIPG's major shareholders, including
Shanghai State Assets Supervision and Administration Commission, become listedcompany shares) and with the time approaching when nearly all shares will be
tradable, in the future it will be able to sell shares in the listed company to raise cash ifnecessary.
As of end-2006, roughly half of the companies that had been group listed were in
the steel industry. The steel sector's large number of companies with partial listingsand its heavy reliance on related-party transactions makes it a good candidate forgroup listings.

50

Nomura Capital Market Review Vol.10 No.2

Figure 7: Group listing of the Baogang Group
Prior to group listing

After group listing
Baotou Iron
& Steel46.72%

Baogang Group

Baotou Iron
& SteelBaogang Group

71.79%
Steel business(core business)(18 companies,
including its
No.1steel plant)

In October 2006, acquired 6.975
billion yuan of the group's steelbusiness assets, financed with athird-party capital increase (2.3yuan per share, 3.032 billion
shares).

Steel business(core business)(18 companies,
including its
No.1 steel plant)

Source:Miningbusiness

Rare earthbusiness

Nonferrous
business

Miningbusiness

Rare earthbusiness

Nonferrous
business

Nomura Institute of Capital Markets Research, based on various news reports

Figure 8: Group listing of Shanghai International Port (Group)
Prior to group listing
Shanghai
SASAC

After group listing
Shanghai
SASAC

Sell Shanghai Port Container(SPC) to obtain cash

50%

(Shanghai State
Owned Asset
Operations, China
Merchant Securities)

Exchange of shares with
SIPG at a 1:4.5 ratio

44.23%SIPG
Other
shareholders

SIPG

70.18%( September 2006,
listed on Shanghai
Stock Exchange )Exchange of shares with SIPG
at a 1:4.5 ratio

SPC

29.82%( Note )SIP shareholders that chose cash
SPC shareholders that did not choose cash

SPC
(July 2000, listed on Shanghai Stock Exchange
August 2005, non-tradable share reform)

Source:Shanghai State Owned Asset Operations is also a shareholder
of SIPG

Nomura Institute of Capital Markets Research, based on various news reports

Corporate Governance for Listed Companies in China− Recent Moves to Improve the Quality of Listed Companies − 51

5. External checking function
Focus has recently shifted to the growing presence of institutional investors,
including through the emergence of large-scale investment funds, and the role this has
played in placing outside pressure on listed companies to improve corporate
governance. Despite improved corporate disclosures and access to the prices paid for
related-party transactions, it is probably difficult for individual investors to accurately
value companies, given their lack of specialized knowledge. Analysts working for
institutional investors, meanwhile, have the ability to analyze such information, whichshould help insure that the information is reflected in the share price. Recently, a
growing number of capable foreign institutional investors have begun participating in
China's market through the Qualified Foreign Institutional Investor (QFII) program,and their presence should bring checks on corporate management up to international
standards.

VI. Conclusion
With the stage set by the State Council's Nine Opinions in 2004, and then theOpinions on Improving the Quality of Listed Companies of October 2005, specificsteps have been taken in China to improve the quality of listed companies, including,just over the past year, substantial reductions in the misappropriation of funds andefforts to promote group listings. The reform of non-tradable shares, which is coming
to a close, was an initial step toward changing a shareholder structure that had been
dominated by the state, and the implementation of the new Company Law and the new
Securities Law, along with revisions to related rules, has strengthened the check
function of corporate governance. One result of non-tradable share reform appears tobe that market share prices are starting to reflect the enterprise value of listedcompanies. This should make it easier to provide incentives to management throughM&A and the greater use of stock options.
In addition to efforts to raise the quality of individual companies already listed, it isclearly also raising the quality of the stock market overall to promote new listings ofquality companies. In 2006, listing standards and procedures were revised in responseto the new Company Law and new Securities Law. In addition, some large companies
strong enough to be listed on overseas markets were listed in the domestic market.
These rapid moves, aimed at improving the quality of both individual companies aswell as the overall market, bear watching. These moves are all in their initial stages, ofcourse, and the direction this takes moving forward is of key importance.

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