Without sound corporate governance, the future of the Shanghai market will not be guaranteed
In November 2011, the IMF published their first Financial System Stability Assessment report on the Chinese financial system. Although the report was primarily concerned in reporting on China’s banking system it made recommendations on the legal and governance system in the securities sector. The IMF noted that the Chinese Securities Regulatory Commission (CSRC) has taken “an active and strategic approach to regulate securities markets, the legal and regulatory system needs improvement.” The IMF specifically recommended that the CSRC should increase their efforts “to detect and deter unfair trading practices”, notably insider trading and market manipulation. These recommendations resonated with the findings of a group of CEIBS MBA students who formed a Corporate Governance Think Tank in February 2011 to discuss the particular challenges faced by Chinese investors. They were particularly keen to advance the case for better protection for small investors against the power of dominant shareholders.
Concerns expressed by the Think Tank were the lack of knowledge about corporate governance regulations by board members of Chinese listed companies and the consequential detriment to small-scale investors. They also pointed out that the gains possible by fraudulent accounting and insider trading were greater than the threat of being caught by the CSRC. In their report, the IMF recommended that the CSRC redouble its efforts at “investigating suspicious trading around events likely to involve it, like initial public offerings (IPOs) and merger announcements, and lowering the thresholds for investigating or making enquiries.” Both the CSRC and the media have responded positively to the IMF report.
The rapid development of the socialist market economy in China and the emergence of the two stock exchanges in Shanghai and Shenzhen have been accompanied by the significant regulatory and enforcement challenges most notably witnessed in cases of insider trading. Small investors in China, reflected in the membership of the CEIBS Corporate Governance Think Tank, believe that insider trading on the Shanghai stock exchange is prevalent. Market-making by fund managers has included unlawful affiliate transactions between funds and their corporate board directors and also their distributors. Personal trades made by a fund manager who trades for personal profits through advanced knowledge has become known as “rat-trading” which is widely regarded as common practice. However, the enforcement regime in China is being strengthened and under an amendment to the Criminal Law enacted in February 2009, the CSRC successfully prosecuted a Shenzhen fund manager in 2011 for making a 270,000-yuan profit through secretly trading the Jiufu Listed Open-Ended Fund. The fund manager was sentenced to one year in jail and fined 310,000 yuan.
Despite renewed efforts at tracking down rat-trading by fund managers, corporate governance and financial accounting practices in China have, in the view of the Think Tank, suffered from lax monitoring and non-existent enforcement leading to a decline in investor confidence by Chinese domestic investors and also by foreign investors in Chinese companies listed on foreign exchanges. According to the CEIBS Think Tank, many smaller investors are disadvantaged both in direct trading as well as through fund investments due to a lack of transparency in reporting and governance, a point noted by the IMF and reported in the China Daily . They particularly point out the lack of truly independent directors in listed companies to represent their interests at board level and to scrutinise potential insider trading transactions. The Company Law in China sets out international best practice standards for board appointments to listed companies with the following vital safeguards for investors.
• A two-tier board: executive board and a supervisory board.
• Directors’ appointments should not exceed three years subject to reappointment procedures for any extension to the term of office.
• Executive boards should have at least two independent directors and should anyway comprise a minimum of one-third of the overall board.
• At least one independent director should be a professional accountant.
The law defines independent directors as those “who hold no posts in the company other than the position of director, and who maintain no relations with the listed company and its major shareholder that might prevent them from making objective judgment independently.” However, it is widely believed that these standards of governance are not followed in actual practice by boards. The power of nominated independent directors is questioned and China is still coping with a first generation of board directors who may lack the training and experience required for their role. Without truly independent directors on the board, strategic and financial decisions can be made in the interests of the management which may result in financial disadvantage to investors. It is not uncommon for Chinese investor websites such as chinalawedu.com to call for improvements in the corporate governance law and stronger enforcement measures by the CSRC.
CEIBS MBA student, Ted Yang, formerly a CPA auditor at KPMG’s Shanghai office, makes the link between corporate governance weaknesses, investor confidence and the lack of best practice accounting standards in Chinese listed companies. According to Mr Yang, although only a small number of companies have been prosecuted for fraudulent financial statements, he believes that the practice by listed companies of reallocating expenses and revenues between different accounting periods to avoid showing consecutive losses is prevalent. This is particularly the case by companies under special treatment by the Shanghai and Shenzhen Stock Exchanges who are working to retain their listing. In 2006, the Ministry of Finance issued a new set of accounting principles called Accounting Standards for Business Enterprises (“new PRC GAAP”) which have substantially converged with the International Financial Reporting Standards (IFRS). Every company listed on the Shanghai and Shenzhen stock exchanges were required to apply the new PRC GAAP. However, Mr Yang believes that there is a higher risk of accounting estimation failure in China than in Europe because of a lack of understanding of the PRC GAAP requirements such as the fair value approach and even a lack of care by accounting information users.
Accounting estimation, especially fair value accounting, requires active markets for reference, such as an active OTC market for non-listed companies. In China, other than the stock market, few other active markets exist that can provide a reliable reference for fair value accounting. Furthermore, many current corporate accountants have not yet adapted their accounting methods to a principle-based accounting regulation regime which could result in the accounting information being subject to a high risk of misstatement. Until 2010, foreign investors had appeared to be oblivious of the accounting standards risks in what the Financial Times has referred to as the “gold rush mentality” associated with the rapid rise of Chinese securities listed on international bourses over the past decade. The most common form of gaining foreign listing (usually on US exchanges such as Nasdaq) has involved about 370 Chinese companies to date acquiring shell companies that were already publicly traded. These deals became known as “reverse mergers” and avoided the scrutiny of the IPO process.
Respected US and Hong Kong auditors, combined with the perceived security of a company regulated by the US Securities and Exchange Commission (SEC), attracted investors looking for new investment opportunities in entrepreneurial Chinese companies. China MediaExpress (CCME), has been the classic case of what was seen to be an entrepreneurial company promising very high returns to investors. CCME began trading on the U.S. NASDAQ exchange following a 2009 takeover of TM Entertainment & Media Inc., a shell or “blank check company” with no operations of its own. In March 2011, Deloitte resigned saying that they were “no longer able to rely on the representations of management” and indicated that the company’s historical results may not be reliable. Analysts were more caustic in their criticisms pointing out that if their revenue result were true, CCME’s ROI would be one of the highest in the world, and “a complete outlier in the Chinese advertising market, generating even more profit than giant Focus Media, and outpacing all of their competition by a landslide, despite their smaller footprint” (China Hearsay website ).
CCME was one amongst a number of Chinese companies traded in the U.S. that disclosed auditor resignations or accounting irregularities in 2011 that have led to the suspension or delisting of their shares. Similar issues have emerged elsewhere. In 2011, the Ontario Securities Commission investigated Toronto-listed timber company Sino-Forest and footwear maker Zungui Haixi following auditor resignations resulting from “accounting irregularities”. Three Chinese companies were suspended from the Singapore stock exchange in 2011 also for “accounting irregularities” placing “14,000 minority shareholders in a fix” according to the Securities Investors Association Singapore.
According to a report by the Financial Times in 17 June 2011 entitled: “Express route to Chinese riches goes into reverse”, the tumbling of Chinese securities on international stock markets are the result of alleged problems being uncovered such as: “forged bank statements, fictional assets and customers and undisclosed transactions.” The article points to the formidable obstacles faced by international lawyers, regulators and auditors in getting clear-cut information on Chinese companies and analysts expect that companies operating by scams may “simply see their stock process spiral toward zero.” The China Daily has also followed the demise of Chinese foreign-listed securities and reported on 11 June 2011 that the Interactive Brokers Group in New York had “banned clients from borrowing money to buy any of 160 Chinese securities because of accounting scandals.”
Incentives towards mature corporate governance standards in China
We are in an era of global stock volatility and investor uncertainty. Eurozone and US$ markets are subject to unique currency pressures which may result in collapses in euro and US$ securities markets. The proposed yuan offshore trading centre in London is the beginning of the road towards the gradual realisation of the renminbi’s convertibility described in the 12th Five Year Plan. The opportunity for China to provide a stable currency platform on which to develop the cross-listing of Chinese firms will incentivise leading Chinese companies and fund managers to address corporate governance and PRC GAAP compliance issues. CEIBS MBA student, Frank Pan, formerly a financial adviser with North American investment dealers, Raymond James, has observed that many firms still opt for an overseas listing due to short time-to-market and corporate strategy reasons.
Obtaining a listing on the Chinese stock exchanges is an arduous and lengthy process, whilst listing on the NYSE or NASDAQ can be very attractive for the investment potential. Mr Pan points out that the tangible benefits available through cross-listing are an incentive for Chinese companies to comply with best practice corporate governance standards and undergo an overhaul of management structures and financial reporting standards. The result of improvements made in governance standards by cross-listed Chinese companies is likely to have a knock-on effect on Chinese domestically-listed companies as companies may be forced to compete on the quality of corporate governance and reporting standards especially in attracting long-term institutional investors.
A further incentive to drive higher quality governance and accounting standards by Chinese listed companies is the goal of the Shanghai government to develop Shanghai into an international financial centre by 2020. One of the IMF’s recommendations is for a greater emphasis to be made to educate company officers, officers of securities and futures companies and CEIBS is playing its part in launching its Finance MBA program at Shanghai’s Lujiazui International Finance Research Centre. CEIBS Executive President, Zhu Xiaoming, expresses optimism that Shanghai will achieve the vision of an international finance centre:
“A well-functioning stock market is key to Shanghai’s aspiration to build itself into an international financial centre. In fact, a well-run stock market is almost one of the preconditions for Shanghai to attract global investors. Without sound corporate governance, the future of the market will not be guaranteed. Effective corporate governance depends on many factors, among which regulation is one of the most important. I hope that within the next decade, regulators will focus more on the quality of listed companies than on quantity.”
Mike Thompson is Professor of Management Practice, CEIBS Director of the Centre for Leadership and Responsibility (ECCLAR)