Adaptation and Convergence in Corporate

8/8/2019 Adaptation and Convergence in Corporate

1/56

ADAPTATION AND CONVERGENCE IN CORPORATE GOVERNANCE: THE

CASE OF CHINESE LISTED COMPANIES

Iain MacNeil

INTRODUCTION

Prior to 1978, private enterprise had been effectively eliminated in China as a result

of central (state) planning of the economy. Recent years have, however, seen a

transformation. The economic reform process, which began in 1978, has led to

fundamental changes in enterprise organisation, a re-definition of the role of the state

and recognition of a role for private capital and private enterprise. The main elements

of that process have been the introduction of company and securities law, conversion

of state-owned entities into companies and listing of these companies on the Stock

Exchanges. From this process, there has emerged a group of public listed

companies, which represent a substantial part of Chinas economy. A more recent

development has been the introduction of Corporate Governance Guidelines for

listed companies.

The creation of the legal and institutional framework which supports listed companies

in China raises a number of interesting issues. First, as company and securities law

had to be created ab initio so as to allow for the participation of private capital in the

economy, China provides a real example of the choices available in the design of a

corporate governance framework. A number of basic issues had to be addressed.

One was definition of the rights of shareholders and other stakeholders. Another was

the structure of the legal rules and in particular the balance between mandatory and

default rules. The rights of minority shareholders were also an important

consideration if private capital was to participate in the newly formed stock

exchanges. Second, the Chinese experience in establishing a regulatory regime forlisted companies provides some indication of the extent to which convergence

towards international norms is a significant force in corporate governance. This is of

particular interest in China, in view of the stated objective of the company and

securities law of promoting a socialist market economy. In particular, the experience

in China may provide some guidance as to elements of the corporate governance

The Law School, University of Aberdeen. Research for this article was undertaken during a term of sabbatical leave spent in Hong Kong and China. I am grateful to the Leverhulme Trust for financial

support; to the Hong Kong Baptist University for the provision of research facilities; to Alex Lau of HKBU for translating Chinese legal materials; and to the many LLM alumni of Aberdeen Universitywho provided valuable assistance, particularly Zhou Xinguo, my research assistant.

NewCGin PRC - 25/04/02 1


2/56

framework effectively mandated by global capital markets and the residual power left

to individual countries to pursue their own objectives. Third, the Chinese experience

provides an interesting example of the interaction of two alternative approaches to

corporate governance. One approach is to focus on the internal governance

mechanisms of the company, and in particular the role allocated by the company

constitution to the companys organs of governance such as the board of directors

and shareholders meeting. Another approach is to focus on external regulation of the

company (either by courts or regulatory agencies) through rules relating to matters

such as employment contracts and environmental standards. The Chinese

experience provides an interesting perspective particularly in relation to external

regulation, which, unlike most countries in the west, has been pursued through

extensive state ownership of listed companies and intensive regulation of the

financial markets.

This paper aims to examine the emergence of listed companies in China from the

perspective of these issues. It begins by reviewing the current debate on comparative

corporate governance. This is followed by a short history of enterprise reform in

China and identification of the main features of the corporate and securities laws,

which were introduced as part of the reform process. The role envisaged for private

capital and shareholders in the Chinese system is then analysed. This leads on to a

discussion of the manner in which the state regulates the operation of financial

markets and directly influences listed companies through its role as controlling

shareholder. An important element of the states control over listed companies is the

legal framework for the operation of the board of directors, which is analysed from

the perspective of the structure, composition and role of the board of directors.

Finally, the paper considers the role of minority shareholders in Chinese listed

companies in the context of recent research demonstrating close links between

minority shareholders rights and the development of capital markets.

A. ADAPTATION AND CONVERGENCE IN CORPORATE GOVERNANCE

National systems of corporate governance can be placed at some point on an axis

between two extremes, the shareholder model and the stakeholder model. The

shareholder model takes the maximisation of shareholder wealth as the primary



3/56

objective of the company. 1 In this model corporate governance is characterised

largely as a set of solutions to the principal (shareholder)/agent (manager) problem

which arises from the separation of ownership and control in the modern company.

The essence of the principal/agent problem is that (a) the interests of the managers

may not always be aligned with that of the owners and (b) it is not possible ex ante

for the owners to specify the manner in which their capital should be employed (or

put another way, the principal/agent relationship in the corporate context is a classic

example of an incomplete contract). Corporate governance, as a set of solutions to

the principal/agent problem, has three main aspects. First, aligning the incentives of

managers with owners (e.g. through various forms of share ownership). Second,

protecting shareholders from expropriation by managers (e.g. through self-dealing).

Third, making managers accountable through mechanisms such as the market for

corporate control, which is assumed to make poorly performing companies

susceptible to takeover and the incumbent management susceptible to removal by a

successful bidder. The shareholder model is essentially a creation of market

expectation because it seems doubtful that there is (at least in the United Kingdom)

any legal duty imposed on directors to maximize shareholder value. 2

The stakeholder model takes a broader view of a company in which it is viewed as

being responsible to a wider constituency. While this wider constituency may in the

past have been regarded as open-ended, the new stakeholder model adopts a

more restrictive approach, categorising stakeholders as those who have contributed

firm-specific assets 3 or (in less technical terms) those who enter into long-term co-

operative relationships with the company. 4 Employees are always regarded as falling

into the category of stakeholders, but customers and suppliers may or may not be

regarded as stakeholders depending on their relationship with the company. The

nature of a stakeholders interest in a company differs from that of a shareholder in

that (a) there is no convenient unit for measuring stakeholder interest analogous to

1 For a justification of such an approach see A. K. Sundaram and A.C. Inkpen, The CorporateObjective Revisited at ssrn.com.2 See S. Worthington, Shares and shareholders: property, power and entitlement (part 2) 22(2)Company Lawyer 307 (2001).3 See M. Blair, Ownership and control: rethinking corporate governance for the twenty-first century,Brookings Institute, Washington DC (1995).4 See J. Parkinson, Company Law and Stakeholder Governance p149 in G. Kelly, D. Kelly & A.Gamble (eds.) Stakeholder Capitalism (Macmillan 1997). Parkinsons proposals for reform of UKCorporate Governance include (a) the reformulation of directors duties to accommodate stakeholdersinterests and (b) the introduction of a two-tier board to facilitate a stakeholder approach. See also G.

Kelly and J. Parkinson, The Conceptual Foundations of the Company: a Pluralist Approach in J.Parkinson, A. Gamble & G. Kelly (eds.), The Political Economy of the Company, (Hart Publishing,2000).



4/56

the role performed by the company share (b) there is no presumption of equality

between different stakeholders. In common law legal systems, the tendency has

been for the shareholder model to predominate, but within that there have been, at

different stages in the history of the company, differing perceptions of the respective

roles of the shareholders and the board of directors. 5

A number of influences have been identified in the development of national systems

of corporate governance, although it is not always clear whether these factors are the

cause or outcome of systems of corporate governance. 6 Berle & Means identified

ownership structure as a key issue in 1931. 7 The consequences, in their view, of the

widely-dispersed structure of share ownership which had emerged in the United

States was that directors powers had expanded to a point where they were virtually

in control of public companies, with shareholders being largely powerless. Berle &

Means classic analysis is now seen as having less relevance in a world in which

widely-dispersed share-ownership is the exception rather than the norm and in which

it is no longer apparent that widely-dispersed share-ownership will lead per se to

inferior monitoring of management by shareholders. 8 The more recent focus on

ownership structure has been on two issues. First, to compare the operation of

market-based systems of corporate governance, in which share-ownership is

relatively dispersed and financial markets play a major role in monitoring company

performance, with blockholder systems, in which most public companies have a

controlling shareholder and banks play a more significant role in corporate

governance than financial markets. 9 The main conclusion is that there no ideal model

of corporate governance. Both systems have advantages and disadvantages. The

market-based system emphasises disclosure of financial information so as to allow

shareholders to make informed decisions but tends to encourage a short-term focus

on performance and exit rather than voice. The blockholding system allows the

development of long-term relationships between shareholders and companies but

5 See J. Hill, Visions and Revisions of the Shareholder 68 Am Jnl Comp Law 39 (2000).6 See generally, M. Bradley, C. Schipani, A. Sundaram and J. Walsh, The Purposes andAccountability of the Corporation in Contemporary Society: Corporate Governance at a CrossRoads62(3) (1999) Law and Contemporary Problems 9.7 A Berle and G Means, The Modern Corporation and Private Property (Transaction Publishers NJ1991)8 See H. Demsetz and K. Lehn, The Structure of Corporate Ownership: Causes and Consequences,93(6 ) Jnl Political Economy 1155 (1985).9 See N. Dimsdale and M. Prevezer, Capital Markets and Corporate Governance (Clarendon Press,1994) for an extensive discussion of the relative roles of banks and financial markets in the UK,

Germany and Japan. See M. Maher and T. Anderson, Corporate Governance: Effects on FirmPerformance and Economic Growth in Renneboog L., McCahery J., Moerland P. and Raaijmakers T.(eds.) Convergence and Diversity of Corporate Governance Regimes and Capital Markets (OUP 2000).



5/56

tends to suffer from lower standards of disclosure and the appropriation of private

benefits by controlling shareholders at the expense of minorities. Second, to explain

why the market-based system emerged in some countries and the blockholder

system in others. Several theories have been put forward. Easterbrook and Fischel 10

have argued that efficiency considerations are the main factor in the evolution of

corporate governance structures: as the market prices the governance scheme,

companies are forced to adopt the most efficient structure or else suffer a competitive

disadvantage in the same was as if, for example, their raw materials were more

expensive than those of competitors. 11 Roe has explained the evolution of the

American system of corporate finance, characterised by relatively widely dispersed

share ownership and reliance on the monitoring function of financial markets, as the

result of politically-driven regulation of the financial sector, which was intended to

prevent excessive economic power being concentrated in too few hands. Underlying

the process of regulation was fear of the power of large corporations and trusts, an

ideological bias in favour of small business and the influence of interest groups (such

as small banks) who favoured fragmentation of financial power. 12 The evolution of

shareholder voting rights in the United States and Europe has also been promoted as

a significant influence in the development of national systems of corporate

governance. 13 According to this view, the one-vote-per-share rule, adopted in

corporation charters from the mid-nineteenth century onwards so as to displace the

old common law default rule of one vote per member, combined with the emergence

of anti-trust law later in the same century, contributed to the emergence of tightly-

controlled and industrially-concentrated companies in the United States. In Europe,

the survival of graduated voting scales into the twentieth century, combined with a

lack of anti-trust law, resulted in a broader distribution of shareholder power and

more reliance on cartels than mergers. A very different explanation is offered by La

Porta, Lopez-de-Silanes, Shleifer and Vishny (hereafter LLSV) who link the

emergence of financial markets to the development of investor protection regimes in

10 F. Easterbrook and D. Fischel, The Economic Structure of Corporate Law (Cambridge MA, HarvardUniversity Press 1991). 11 In its most extreme form, the Chicago school explanation of corporate governance formulated byEasterbrook and Fischel is an irrelevance theorem in which there is no need for the law to intervene incorporate governance structures as market forces will require them to evolve to their most efficientform. A milder version of this view is provided by Andrews, Corporate Governance Eludes the LegalMind 37 U Miami L. Rev. 213, 214-21 (1983).12 See M J Roe, A Political Theory of American Corporate Finance 91 Colum L. Rev. 10 (1991).13

See C A Dunlavy, Corporate Governance in Late 19th

Century Europe and the United States, TheCase of Shareholder Voting Rights in Hopt, Konda, Roe, Wymeersch, Prigge (eds) ComparativeCorporate Governance (OUP, 1998).



6/56

different countries and in particular to the protection given to minority shareholders. 14

The essence of their thesis is that strong minority protection is necessary to

encourage an equity culture and that unless this occurs, shareholders can only

protect themselves through the accumulation of the power associated with

blockholding. Path-dependence has also been viewed as a significant factor in

determining national systems of corporate governance. One version of its role is that

the corporate structures at any point in time will depend on those that existed at the

outset, and that corporate rules affecting ownership will also depend on those initial

structures. 15 Another is that differing national cultures and values can de directly

associated with characteristics of a system of corporate governance and are likely to

defeat attempts to import elements of governance systems from countries with

fundamentally different culture and values. 16

The extent to which there is, or should be, convergence in national systems of

corporate governance towards one model is a matter of some dispute. Some

commentators have argued for the superiority of the shareholder value system of

corporate governance in the United States, pointing to its increasing acceptance

worldwide and predicting its eventual worldwide hegemony. 17 Others have adopted a

much more cautious view of convergence, recognising that there are unique

institutional and cultural factors operating at the national level which preclude the

importation of foreign governance systems. Put another way, for convergence to

occur, features of corporate governance within one system must be detachable and

so capable of transfer from one system to another: the more they are embedded in a

unique institutional or cultural setting in one country the less detachable they will

be. 18 To the extent that convergence is predicted, the main driving force identified is

efficiency in governance structure, at least as viewed by investors in the global

capital market in which the shareholder value model dominates. A broader view,

however, would regard convergence in corporate governance as a sub-set of a more

14 See LLSV, Legal Determinants of External Finance 52(3) Jnl of Finance 1131 (1997); Law andFinance 106(6) Jnl of Political Economy 1113 (1998); Investor Protection and CorporateGovernance at ssrn.com (update reference).15 See L.A. Bebchuk and MJ Roe, A Theory of Path Dependence in Corporate Ownership andGovernance Columbia Law School Center for Law and Economic Studies Working Paper no 131 atssrn.com.16 See A N Licht, The Mother of All Path Dependencies, Towards a Cross-Cultural Theory of Corporate Governance Systems at ssrn.com.17 See H. Hansmann and R. Kraakman, The End of History for Corporate Law at ssrn.com.18 See W. Bratton & J. McCahery, Comparative Corporate Governance and the Theory of the Firm:

The Case against Global Cross Reference 38 Colum. J. Transnatl L. 213 , who present a useful matrixfor comparative corporate governance analysis at p17. See also E B Rock, Americas ShiftingFascination with Comparative Corporate Governance 74 Wash U.L.Q. 367.



7/56

extensive process of convergence in the structure and operation of capitalist systems.

From this perspective, the main driving force is the speed of technological change,

which, by making production more capital-intensive, encourages the globalisation of

product and financial markets. 19

If some degree of convergence can occur, what form will it take? Gilson provides a

useful categorisation of the different forms of convergence that occur in the field of

corporate regulation. Formal convergence involves change in the legal infrastructure

and therefore requires political support and resort to the legislative process. This type

of convergence is often associated with international harmonisation in the form of

treaties, conventions or legislation made by supranational bodies. 20 The most

significant step in this direction to date has been the limited harmonisation of

company and securities law in the European Union although the proposals made by

IOSCO for International Disclosure Standards may well represent a more significant

future development for listed companies. 21 Functional convergence occurs without

any formal legal change in circumstances in which the existing regulatory

mechanisms are sufficiently flexible to respond to new circumstances without the

need for formal change. The process by which the Combined Code of Corporate

Governance has been developed and implemented in the United Kingdom could be

cited as an example of such a process: the development occurred outside the formal

legal and regulatory framework and the Code itself is appended to but does not form

part of the UKLA Listing Rules. Contractual convergence occurs when the existing

regulatory framework lacks the flexibility to adapt to new circumstances without

formal changes and an ad hoc solution is adopted through the medium of contract. 22

Contractual techniques can move relatively easily from country to country without any

19 See S. Strange, The Future of Global Capitalism; or, will divergence persist forever? in C. Crouch& W. Streeck, Political Economy of Modern Capitalism, Mapping Convergence and Diversity (Sage

Publications 1997). Associated with the process of convergence, in Stranges view, are (a) a decline instate sovereignty (b) asymmetry of regulatory power among states (with the USA predominant) (c)denationalization of firms, who adopt a multinational perspective (d) increased government reliance onfinancial markets as a result of the latters role in funding current spending through government bondissues.20 Proposals for formal convergence can also emerge from private sources: see e.g. Black &Kraakmans proposal for a self-enforcing model of corporate law, developed from models adopted inthe privatization process in eastern Europe (B. Black and R. Kraakman, A Self-Enforcing Model of Corporate Law 109 Harv. L. Rev. 1911). See also J. Coffee Jnr. The Rise of Dispersed Ownership:The Role of Law and the Separation of Ownership and Control at ssrn.com.21 The proposal aims to establish minimum international standards for listing particulars andprospectuses, thereby making possible multiple listing based on a single document. See D W Arner,Globalization and Financial Markets: An International Passport for Securities Offerings? ???22

Gilson cites as an example the contract terms that are typically adopted in venture capital limitedpartnerships providing for distribution of the proceeds of investments that become liquid and theliquidation of the partnership after a fixed period.



8/56

need for change in the legal or regulatory framework. On the one hand, widespread

usage of ad hoc contractual governance techniques may indicate a failure of formal

legal and regulatory techniques to deliver appropriate forms of governance

mechanism. On the other hand, such usage may indicate the superiority of

contractual techniques as a governance mechanism by comparison with regulation

(e.g. as a result of their inherent adaptability) and suggest a re-evaluation of the

extent to which regulation is appropriate. Such an assessment of the appropriate role

of regulation by comparison with private ordering through contract parallels the

debate in company law over the appropriate balance between mandatory and default

rules. 23

Transposing this background to the context of corporate governance in Chinese

listed companies, a number of issues emerge. First the institutional and cultural

setting in China is quite different to the west and to the countries of the former Soviet

bloc. China has not, as was the case in the former Soviet-bloc countries, undergone

a rapid transition from a planned economy to a market economy. Market-based

reforms and adoption of the corporate form for enterprises were adopted in China as

a pragmatic solution to poor economic performance under state planning. 24 They

were grafted onto an ideological position that remained essentially collectivist and

socialist in its outlook. 25 Experimentation with the corporate form in China therefore

provides some indication of the inherent adaptability of the corporate form to

accommodate considerations wider than those dominating the shareholder value

model of corporate governance that is prevalent in the west. Second, Chinese listed

companies provide a practical example of the extent to which the global capital

market can drive convergence in corporate governance in an ideological environment

in which markets are regarded as means to end in a socialist society rather than an

end in themselves. This helps answer the question of the extent to which corporate

governance features are portable. It also provides some indication of how the overallsystem of enterprise organisation can be structured within a socialist society so as to

accommodate global capitalism but allow the survival of other forms of organisation

that are more inherently socialist in their structure.

23 See J. Gordon, The Mandatory Structure of Corporate Law (1989) 89 Columbia Law Review 1549.24 The inherent pragmatism of Chinas reform process is typified by the analogy used by DengXiaoping in 1962 to refer to reform of the system of production. He used a popular Sichuan saying, Itdoes not matter if it is a yellow cat or a black cat as long as it catches mice. While this may havelacked resonance in the 1960s (Deng was purged during the Cultural Revolution), it later came totypify the post-1978 reform process. See Lan Cao, The Cat that Catches Mice: Chinas Challenge tothe Dominant Privatization Model (1995) 21 Brook. J. Intl L 97.



9/56

B. ENTERPRISE REFORM IN CHINA

The process of economic liberalization in China, from which listed companies

eventually emerged, can be traced back to 1978 when the Communist Party resolved,

beginning in 1979, to focus the party's work on "socialist modernization". 26 This

change in policy away from state control of the economy and the effective exclusion

of private enterprise, recognized that China's economy had under performed for

many years, a realisation made particularly clear by the close proximity of several

examples of strong economic performance, such as Taiwan, Korea, Hong Kong and

Singapore (the four little dragons). The most important aspect of the modernization

was the gradual recognition of the role of private enterprise.

Practical development occurred first in the form of authorisation being given for

individual businesses to engage a maximum of five employees. 27 The 1982

Constitution recognized the role of individual business by providing for the protection

of its lawful interests. In association with reform of the rural economy, in which the

majority of the Chinese population is employed, the relaxation of state control

resulted in the emergence in the 1980s of a new and rapidly growing non-state

sector in which Town and Village Enterprises (TVEs) 28 and joint ventures with foreign

capital participation played a significant role. By 1988, the acceptance of the role of

private business was sufficient to result in an amendment to the Constitution so as to

refer expressly to the role of the private economy as a complement to the socialist

economy. 29 Later in 1988 the State Council 30 provided a basis for the authorisation

25 For a review of the ideological context within which enterprise reform in China has been pursued,see G. Crane, Globalization in China 4(2) New Political Economy (1995) 215.26 See A W Connor, "To get Rich is Precarious: Regulation of Private Enterprise in the People's

Republic of China", Journal of Chinese Law , Spring 1991 1.27 For a discussion of these regulations and more generally on the history of the emergence of privatebusiness in China see W. Kraus, Private Business in China (University of Hawaii Press 1991).28 TVEs are collective enterprises under the ownership and nominal control of governments at the localtownship, provincial and village level. They emerged as the post-1978 reforms permitted localgovernments to promote and engage in business. For an assessment of their significance to the Chineseeconomy, see H G Broadman, The Businesses of the Chinese State at ssrn.com. On TVE ownershipstructure, see H. Williams, Property Rights and Legal Reform in Township and Village Enterprises inChina 2 Asia-Pacific Law and Policy Jnl 227 (2001).29 The relevant article (11) was subsequently amended in 1999 to provide greater emphasis to theprivate sector. The words The individual economy of urban and rural working people, operatingwithin the limits prescribed by law, is a complement to the Socialist public economy was replaced bythe words the non-public sector, including individual and private businesses, is an important

component to the socialist market economy. See the Constitution of the PRC athttp://www.qis.net/chinalaw and J. Chen, Chinese Law, Towards an Understanding of Chinese Law Its Nature and Development (Kluwer 1999) Chap 3 (Constitutional Law).

http://www.qis.net/chinalawhttp://www.qis.net/chinalaw


10/56

and control of private businesses that employed more than eight people by issuing

the Preliminary Regulations for Private Business. In 1992, the Fourteenth National

Congress of the Communist Party of China adopted the policy of establishing a

socialist market system and gave priority to reforming State Owned Enterprises

(SOEs). 31 The main focus was on separating SOEs from the government

bureaucracy within which they had operated in the past and consequently to allow

them to operate independently from the government. 32

This policy was pursued in four different ways. 33 First, the introduction of business

autonomy: the State Enterprise Law of 1988 recognised SOEs as legal persons

separate from the state and defined the operational spheres of autonomy of SOEs

while a "contract responsibility system" was introduced to enhance the accountability

of SOE management. 34 This was followed by the introduction of fourteen

autonomous rights for SOEs in 1992, intended to enhance the autonomy of SOE

managements. Second, the transformation of SOEs into shareholding companies, a

process generally referred to as corporatization. This policy was implemented by a

series of administrative measures which recognised and created mandatory standard

forms for two types of company: Limited Liability Companies, which are broadly

comparable to private companies in the UK and Joint Stock Companies which are

broadly comparable to public companies in the UK. 35 Corporatization had the effect

30 The State Council is the executive body of the National Peoples Congress (NPC), which is thesupreme organ of state power (article 57 of the PRC Constitution). It includes the Premier, Vice-Premier and Ministers. As the NPC meets only once a year for several weeks, much of the detail of lawmaking is delegated to the State Council.31 State-owned enterprises are those with at least 51% state ownership and annual sales of at least RMB5m (US$0.6m approx). In principle, this definition can include listed companies but the term is mostcommonly applied to state enterprises that have not been listed.32 For a discussion of the problems which had in the past plagued SOEs and held back progress in theChinese economy see Mai Yinhua & F. Perkins, China's State Owned Enterprises, (EEAU Briefing

Paper No 7, Dept. of Foreign Affairs and Trade Australia 1997). For an assessment of the currentposition of SOEs in the Chinese economy see H.G. Boardman, The Business (es) of the ChineseState at ssrn.com.33 See China's Management of Enterprise Assets: The State as Shareholder (World Bank CountryReport, 1997 Washington DC).34 The contract responsibility system, which had already been introduced prior to widespreadcorporatization with objective of improving accountability, improved SOE performance. See Groves,Hong, McMillan & Naughton, "Autonomy and Incentives in Chinese State Enterprises" 109(1)Quarterly Journal of Economics (1994). See also Lan Cao (above n24) for a discussion of the systemin rural reform.35 The relevant measures were mainly (1) The Measures for Experimental Joint Stock Enterprises (May15, 1992) issued jointly by the State Commission for the Restructuring of the Economic System, TheState Economic Planning Commission, the Ministry of Finance, the Peoples Bank of China (The

Central Bank) and the Production Office of the State Council (2) The Opinions for the Standardizationof the Experimental Joint Stock Companies (May 15, 1992) issued by the State Commission for theRestructuring of the Economic System (3) The Opinions for the Standardization of the Limited



11/56

of formalising the separation of state from SOEs, as the state became a shareholder

rather than the direct owner of productive assets. This resulted in state control having

to be directed through the mechanisms provided by corporate law rather than being a

simple emanation of state authority. It also provided a long-term strategy for

integrating the state-owned sector of the economy into the global capital market, a

necessary adjustment if China were to fully embrace the concept of a market-

economy. The more immediate reasons for the process of corporatization were,

however, the inability of state firms to remain self-financing and solvent and the

desire of the state to tap into a pool of private capital in the non-state sector outside

its control. 36 The availability of a substantial pool of private capital, held primarily in

bank deposits 37 , made it possible for the state to envisage a re-organisation of SOEs

that involved a substantial injection of new capital and not simply a re-allocation of

ownership rights through privatization. The third element of the policy was

clarification of the role of the state as owner. The Supervision Regulations 38

introduced in 1994 provide the legal basis for the system under which the state owns

and supervises companies. State ownership is organised through a network of

organisations at the national, provincial, municipal and district level. Ultimate

responsibility rests with the State Council, which, as representative of the people, is

the ultimate owner of the state shareholdings. The fourth element of the policy was

clarification of the role of the state as regulator. This was necessary because in the

past the role of the state as regulator and owner had been merged. 39 The opening-up

of ownership in SOEs to the public, through shareholding, in principle required that

the role of the state as regulator and owner be separated, although, as noted later,

there remains some confusion between these roles.

Mass privatization, in the form pursued in Russia and other "eastern-bloc" countries 40 ,

has not been a feature of the re-organization of state owned enterprises in China

Liability Companies (May 15, 1992) issued by the State Commission for the Restructuring of theEconomic System.36 See Lan Cao (above n24).37 By 1996, bank deposits represented 56% of GDP; see R Gordon and Wei Li, Government as aDiscriminating Monopolist in the Financial Market: The Case of China Darden Graduate School of Business Administration, University of Virginia Working Paper No 01-20 at ssrn.com.38 Regulations Governing the Supervision and Management of State-Owned Enterprises' Property(1994).39 The World Bank commented in 1997 (above n33 at p38) on the confusion of the role of governmentas shareholder and regulator "Overall, in the absence of more substantive "separation", these[ownership] structures face inherent internal contradictions between governmental and shareholder-ownership incentives. In such circumstances, the scope of reform they can accomplish is very narrow."40

See J. Nellis, The World Bank, Privatization and Enterprise Reform in Transition Economies: ARetrospective Analysis (at ssrn.com), for an account of privatization in Poland, Czechoslovakia andRussia. The rationale for such mass privatization is explained by Wardle and Towle as follows: ".. it



12/56

even when those enterprises have been transformed into listed companies.

Corporatized SOEs have been listed on the Stock Exchanges and have raised new

capital but the state has generally retained a controlling shareholding. In effect, China

has rejected the conventional wisdom 41 underlying privatization in Russia and

elsewhere, that fundamental changes in ownership rights are necessary to transform

the performance of inefficient state enterprises. 42 The dominant model of privatization

was the big-bang approach in which there was a rapid change from state planning to

a market economy dominated by newly privatized companies. What emerged in

China differed in several important respects. 43 First, enterprise reform left in place a

wholly state-owned but organisationally reformed sector, which still plays an

important, albeit reduced, role in the economy. Second, there emerged from the

ranks of SOEs a group of companies which were listed on the stock exchanges and

issued shares to the public, but in which the state was controlling shareholder. Third,

the reform process gave rise to a vibrant non-state sector, comprising listed

companies with no state interest, TVEs and joint ventures, which have enjoyed rapid

growth. 44

C. CORPORATE GOVERNANCE: THE LEGAL FRAMEWORK IN CHINA

Two features of a particularly Chinese character were evident in the development of

shareholding companies. The first was that the formal legal framework, represented

by the company law, was put in place at a relatively late stage. By the time the

serves the political purpose of entrenching the break with the past by giving each citizen theopportunity to have a personal stake in their country's income-producing assets, thereby reducingsupport for any future attempts to nationalize. It also provides an expectant public with a tangible signof the political changes and compensation for past hardship and deprivation of individual rights" (D.Wardle and N. Towle, "Global Privatization" in International Privatization p7 (eds. D. Campbell and B.

Hollywood, Kluwer, London 1996).41 The conventional wisdom was evident in the approach of the World Bank and was supported by abackground of successful privatization in developed economies such as the UK Canada and NewZealand as well as a growing academic literature linking privatization with improved financialperformance. See J. Nellis (above, note?) and S Djakov and P Murrell, The Determinants of Enterprise Restructuring in Transition Economies World Bank. September 2000. (see p76 of NellisArticle).42 For a discussion of the potential effects of privatization on the economy, see A. Schipke, Why doGovernments Divest? The Macroeconomics Of Privatization (Springer-Verlag, Berlin-Heidelberg,2001) and J.J. Laffont and J. Tirole, "Privatization and Incentives", 7 Journal of Law, Economics and Organization 84-105.43 For a general discussion see Lan Cao (above n24).44 While SOEs share of the output of Chinese industrial enterprises fell from 47% to 28% between

1993 and 1999, the share of individually owned enterprises rose from 8% to 18%, collectives(including TVEs) from 34% to 35% and others (including companies with either a minority or nostate shareholding) from 11% to 26%. See H G Boardman (above n32).



13/56

Company Law 45 became effective on 1 July 1994, many companies had already

been established and the process of corporatization of SOEs was well established.

The formation of companies had in fact even preceded the "Standard Opinions" 46 ,

with several companies being formed in the 1980s 47 . This pattern of development

can be associated with the Chinese tendency to subordinate law to government (and

hence party) authority and to exercise detailed administrative control over economic

activities rather than permitting activity within a range defined by law. The need to

take account of the socialist structure into which the corporate form was being

introduced also delayed the passage of the Company Law. The second feature is the

experimental and localized manner in which the early forms of regulation of

shareholding companies was developed. Particularly significant in this respect were

the regulations 48 adopted in Shanghai, which had strong pre-communist trading links

with the west, and Shenzhen, a recently established city designated as a "special

economic zone (SEZ)" 49 , occupying an important strategic position on the Pearl River

delta between Hong Kong and Guangzhou. This process reflected both the

considerable decentralization 50 of government in China to the provincial level

(permitting provincial and city authorities to introduce such regulations) and also a

willingness to experiment with the corporate form at a local level before adopting a

national measure.

The Chinese Company Law has a number of distinctive features.

45 For an assessment of the company law see K.T. W. Ong and C.R. Baxter, "A comparative study of the fundamental elements of Chinese and English Company Law" 48 ICLQ 88 (1999); N.C. Howson,

"China's Company Law: One Step Forward, Two Steps Back? A Modest Complaint" 11:1 Columbia Journal of Asian Law 127 (1997); Png Cheong Ann, "Some concerns about Chinese company law",17(7) Company Lawyer 199 (1996); Lawrence Liu, Chinese Characteristics Compared: A Legal andPolicy Perspective of Corporate Finance and Governance in Taiwan and China at ssrn.com.46 These were the administrative regulations that preceded the Company Law. See footnote 35 above.47 See Fang Liufang, Chinas Corporatization Experiment (1995) 5 Duke J. Comp. & Intl L. 149.Companies created under ad hoc administrative measures in the 1980s and the 1992 "StandardOpinions" are the subject of a "grandfathering" provision in article 229 of the company law, whichprovides that such companies shall continue to be recognized but are required to meet the requirementsof the company law within a timescale set by the State Council.48 The Shanghai and Shenzhen Trial Measures (sometimes referred to as the Interim Measures).49 Shenzhen was one of five SEZs, the others being Xiamen in Fujian Province, Zhuhau, Shantou inGuangdong Province and (later) Hainan Island. The purpose of the SEZs was to facilitate interaction

with the global economy on a limited basis.50 See S. Breslin, Decentralization, Globalization and Chinas Partial Re-engagement with the GlobalEconomy 5(2) New Political Economy (2000) 205 for a discussion of this process.



14/56

(a) There is extensive state regulation of company formation. Approval

must be obtained from the relevant government departments in addition to

satisfying the requirements of the company law. 51

(b) Two types of company can be formed with private capital. They bear

some resemblance to private and public companies in the UK but there

are some differences. A limited liability company (LLC) must have

between two and fifty shareholders and cannot offer its shares to the

public. Shareholders have pre-emption rights over any sale of shares by

another shareholder, resulting in a closed shareholding structure. Joint

Stock Companies (JSCs, sometimes referred to as companies limited by

shares) are designed to allow capital to be raised through public share

issues. JSCs can be formed either by the public subscription method or

the promotion method. The former requires no less than 35% of the

capital to be subscribed by the promoters (the remaining 65% being

offered to the public) whereas the latter involves the promoters taking up

100% of the shares. Formation by the promotion method does not in itself

require listing, but as a public offering normally follows formation by the

promotion method, it is normal for such JSCs to be listed.

(c) The Chinese concept of the legal personality of a company differs from

western models. This is most apparent in two areas. First, every company

must have a legal representative, who is the natural person authorised

to act on behalf of the company. The legal representative bears greater

liability than an ordinary director of a Chinese company (both in respect of

civil and criminal law) and also greater liability than a director in a UK

company. 52 This qualifies the separate legal liability of the company by

interposing a human agent who acts as the personification of the

company. Second, the company law 53 provides that the state assets of a

company belong to the State. This provision appears to have resultedfrom confusion over the ownership rights of the state in former SOEs.

Following corporatization, the state exchanged direct property rights over

enterprise assets for a shareholding in a company that has separate legal

personality and owns the enterprise assets. By recognising continuing

51 See article 77 (approval) and article 73 (conditions) in respect of JSCs. The relevant governmentdepartments are the State Administration of Industry and Commerce (SAIC) or the Ministry of Foreign

Trade and Economic Co-operation (MOFTEC) for foreign-owned companies.52 See Ong and Baxter (above n45) p119.53 Article 4.



15/56

state ownership over assets in companies, the company law creates

confusion over property rights. 54

(d) There is more extensive reliance on mandatory rules in the structure of

Chinese company law than is the case in common law jurisdictions,

indicating a rejection of the contractarian model of company law. 55 This is

evident both in the Company Law itself and in the mandatory nature of the

articles of association. The company law, for example, requires

administrative approval for the incorporation of a company and sets

financial conditions for companies issuing shares. Such controls

generally have no counterpart in the west. All Chinese listed companies

are required to adopt standard articles of association and changes are

subject to regulatory approval 56 , with the result that tailoring of the

governance structure to individual circumstances is limited. The standard

articles differ for domestic and overseas companies. 57 There is also

extensive reliance on the criminal law to punish breaches of the company

law, rather than reliance on private action.

(e) Despite the rejection of a contractarian model of company law

apparent in the heavy reliance on mandatory rules, the Articles of

Association have a contractual status that appears to be even more

extensive than the concept of the articles as "statutory contract" in the UK.

The latter is a contract between the company and shareholders and

between shareholders inter se. The standard articles (both domestic and

overseas 58) envisage a contract with the following pattern of enforcement:

company versus shareholder (and vice-versa); shareholder versus

shareholder; shareholder versus director, supervisor, manager or other

54 On this issue, and its implications for rights on winding-up, see Howson (above n45) p142 and PngCheong Ann, Some Concerns about Chinese Company Law (1996) 17(7) Co Law 199,200.55 On models of company law and the structure of its rules see I MacNeil, Company Law Rules: AnAssessment from the Perspective of Incomplete Contract Theory 1 Jnl Corporate Law Studies 107(2001). Greater use of mandatory rules in transition countries has been justified by reference to theneed to protect minority shareholders and creditors: see J. Avilov, General Principles of CompanyLaw for Transition Economies 24 J. Corp. L 196 (1999).56 Article 11 of the Company Law.57 The articles for companies listed on a domestic exchange are contained in the China SecuritiesRegulatory Commission (CSRC) measure Guidance on the Articles of Association of domestic listedcompanies (16 Dec 1997). The overseas provisions are contained in measure Mandatory Provisionsin Articles of Association of Companies Listed Overseas (promulgated 27 Aug 1994 by the Securities

Committee of the State Council, reproduced in I A Tokley and T Ravn, Company and Securities law inChina, Sweet & Maxwell Asia 1998, p219).58 Article 10 of the domestic articles and article 7 of the overseas articles.



16/56

senior management personnel. 59 These rights are in addition to (a) article

111 of the company law which provides for shareholders to apply for an

injunction to prevent the implementation of resolutions of the

shareholders' meeting which violate law or administrative regulations (b)

article 118 which provides that directors shall be responsible for

resolutions which violate law, administrative regulations or the articles of

association and cause loss to the company.

(f) The roles of shareholders and board differ from western models in that

shareholders have more extensive control. This is discussed in more

detail in part G.

(g) Chinese companies are required to limit their business to that

described in the scope of business at the time of registration (or as

subsequently amended). Contracts outside the scope of business are

illegal contracts and therefore not enforceable. There are no provisions

that protect third parties who contract innocently with a company acting

outside its scope of business. 60

(h) The participation of workers in companies is ensured through the

requirement for JSCs to have a supervisory board that includes employee

representatives. 61 The board of directors is accountable to the supervisory

board, whose members are entitled to attend meeting of the board of

directors in a non-voting capacity. The Company Law also requires the

Board of Directors to consult employees and trade unions on matters

affecting their interests. 62

The development of a system of securities law and regulation of securities markets

was a natural accompaniment to the development of corporate law because the

objective of transforming some of the (substantial) savings in the personal sector of

the economy into investment in (corporatized and organizationally transformed)SOEs could only be met through the creation of securities markets. Another

consideration was that securities markets made it easier for the state to raise loans,

through the issue of bonds to domestic and international investors, to fund public

59 The potential difficulties arising from this provision are discussed by Tokley and Ravn (above n57 atp100).60 Howson (above n45), p150, notes that the 1992 Standard Opinion provided for liability for thoseparties responsible for companies acting outside of their registered scope of business. The CompanyLaw has no such provision.61 Article 124 of the Company Law.



17/56

spending. Shanghai and Shenzhen were selected as locations for experimentation in

the issue of shares and the first issue of shares occurred in Shanghai in 1984, with

trading in shares beginning in 1986. The same pattern evident in the development of

corporate law was repeated in respect of securities law and regulation. Thus, the

stock exchanges in Shanghai and Shenzhen were established and operating prior to

the adoption of national measures governing securities markets. 63 At this stage,

regulation of the securities markets was in the hands of the Shenzhen municipality

and the provincial government in Shanghai. National measures were introduced in

May 1992 when The State Council promulgated the Share System Experimental

Procedure of the PRC 64 , which set out the general objectives for stock-issuing

enterprises and the principles by which the national securities markets were to be

governed. 65 More detailed regulation followed in the form of the Provisional

Regulations on the Administration of Issuing and Trading of Shares, promulgated by

the State Council in April 1993. For share issues on the domestic stock exchanges,

the Provisional Regulations were the main source of law until the Securities Law

finally took effect on 1 July 1999. 66

An examination of the securities law 67 reveals much less in the way of adaptation to

Chinese circumstances than in the case of the company law. The extensive

regulation of the process of listing and issuing securities is the most obvious

difference between China and the west. While all countries regulate this process,

62 Article 121 of the Company Law. This represents a dilution of the power previously held by workersin SOEs, such as the right to dismiss directors subject to government approval. See Ong and Baxter(above n45) p114.63 The Shanghai Stock Exchange (SSE) was established in 1984 and officially opened in December1990. The Shenzhen Stock Exchange (SZE) was established in 1987 and officially opened on 3 July1991. Lan Cao (above n24) notes that officials of the Shenzhen Special Economic Zone decidedunilaterally to open a Stock Exchange without Beijings approval. Beijings response was not to stopthe process but simply to delay the opening for a few months.64

Two notices gave effect to the procedure. First, the Notice of the Central Office of the State CouncilConcerning Problems in Share System Experiment Enterprises Issuing Stock to the Public, 1990,stating that "Other than the two stock exchanges at Shanghai and Shenzhen which have already beenpermitted to issue shares to society, all others which have been approved by local governments butwhich have not been through the approval procedures of the concerned ministries and agencies of thecentral government, must within the designated period report to the State Commission on Reform of the Economic System, the State Bureau for the Management of State Property, and the People's Bank of China to once again undertake approval procedures."Second, the Notice of the State Commission on Reforming the Economic System Concerning

Renewed Approval for Share System Experiment Enterprises Issuing Shares to Society, reprintedCollection of Policies, Laws and Regulations for Share System Experiments (Shanghai Office forReform of the Economic System ed., 1992).65 See Fang Liufang, Chinas Corporatization Experiment 5 Duke J. Comp. & Intl L 149 (1995).66

These regulations were not repealed following the introduction of the Securities Law and in practiceare still followed by securities lawyers.67 See generally Zhu Sanzhu, Securities Regulation in China (Simmonds & Hill Publishing Ltd., 2000).



18/56

China is distinctive in that it has favoured regulation over market forces in respect of

a number of issues, discussed below in part E. The separation of regulation of the

main financial sectors in China is a feature of many other regulatory systems, despite

being recently abandoned in the United Kingdom. The China Securities Regulatory

Commission (CSRC) is designated as the regulator for securities activities. 68 The

Securities Law provides wide-ranging powers to the CSRC in respect of authorisation,

rule making, investigation and enforcement of all aspects of the securities market. 69

In the past, the Central Bank (the People's Bank of China) had been responsible for

the entire system of financial regulation. From 1998, following the east Asian financial

crisis, the government began to restructure the financial system and pursued a policy

of separation of regulation of the four main financial sectors - banking, securities,

insurance and trust 70 . This resulted in the emergence of the CSRC in its current form,

the creation of a new regulator for the insurance sector (the China Insurance

Regulatory Commission, CIRC) and the limitation of the regulatory role of the central

bank to banking and trust business. However, while each financial sector is

separately regulated, China has not required that ownership of enterprises operating

in these sectors be separated, as was the case in the USA for many years prior to

the repeal of the Glass-Steagall Act. 71

In other respects, the Chinese securities law follows very closely the pattern of

western models. This characteristic may be inherent in the nature of securities law.

To the extent that it represents entry into the global capital market, there is less room

for adaptation than in the case of company law. The tendency towards convergence

with western models becomes even more apparent at the level of stock exchange

listing rules where convergence with international norms is even more evident. 72 As

noted elsewhere 73 , there appears to be a pyramid structure in corporate regulation in

which there is some room for adaptation at the lowest level (company law) less in the

68 Article 7 of the Securities Law. On the constitutional position of the CSRC and SCSC, see Zhu(above n67) chapter 3. The regulatory structure is complicated by the existence of local securitiescommissions and the involvement in securities markets of the State Commission for Restructuring theEconomic System, the State Planning Commission and the State Bureau for the Administration of StateAssets.69 See Chapter 10 of the Securities Law in Zhu Sanzhu, Securities Regulation in China (TransnationalPublishers, 2000).70 Article 6 of the Securities Law now gives effect to the policy of separate regulation of each financialsector.71 An example of cross-ownership of different financial activities is the Pinan Group based in Shenzhen,which operates in the trust, insurance and securities sectors.72 See A Lau, The new Shanghai Stock Exchange Listing Rules: an egg hatched or an egg within an

egg? (1999) 20(7) Co Law 243.73 See I MacNeil and A Lau, International Corporate Regulation: Listing Rules and OverseasCompanies 50(4) ICLQ 787 (2001).



19/56

intermediate level (securities law and regulation) and almost none at the top level

(listing rules).

The most recent development in the legal framework of corporate governance in

China is the promulgation by the CSRC of corporate governance guidelines for listed

companies. 74 The guidelines contain 95 articles and, once implemented, will

represent a substantial modernisation of corporate governance in Chinese Listed

companies. The Guidelines have several notable characteristics. First, there is

considerable evidence of convergence with western models of corporate governance

as almost all the articles contained in the guidance have parallel provisions in the law

or codes of corporate governance of the United Kingdom or United States. Second,

there is a clear attempt to strengthen the independence of listed companies from

controlling shareholders. This represents a limitation of the role of the state as

controlling shareholder and shows willingness on the part of the state to subordinate

its own interests as shareholder to the introduction of an effective system of

corporate governance. This differs to the approach taken at the time of the

introduction of the company and securities law, when there was greater emphasis on

protecting the role of the state. Third, there is no clear demarcation between

corporate and securities law and administrative regulations introduced by the CSRC.

This is evident in the fact that several of the provisions of the Guidelines (e.g. the

requirement in article 31 to use cumulative voting to elect directors in companies with

a controlling shareholder)

represent changes to the company law, a point made clear by the preamble to the

Guidelines, which requires amendment of articles of association that do not comply

with the Guidelines. This confusion of the legal basis of rules is a retrograde step,

reminiscent of the period before the introduction of the company and securities laws,

when administrative regulations were the only basis for the organisation of

shareholding companies. It would be better if the company and securities law wereamended to contain those articles of the Guidelines in respect of which there is an

overlap, leaving the Guidelines to cover points not included in the company or

securities law.

D. PRIVATE CAPITAL AND SHAREHOLDING

74 The Notice Concerning the Announcement of Corporate Governance Guidelines for ListedCompanies, promulgated by the CSRC on 7 January 2002 and effective from that date.



20/56


21/56

business are exercised by local government officials and the significance of extended

family connections in business networks. 79

Second, it is evident in the regulatory regimes for both domestic and foreign capital

that a primary concern was to protect the control of the state over the economy. 80

The presence of the state as controlling shareholder in most listed companies in

China made the adoption of a shareholder primacy model of corporate governance

relatively attractive because it provided continuity with the previous system in which

the state directly owned and controlled SOEs. Perversely, and in contrast to the

historical developments from which it emerged in the United Kingdom, the

shareholder primacy model was a mechanism by which the state could pursue the

socialist market objective through its controlling interests in most listed companies.

It leaves open the question, however, if there will be any substance left to the

socialist market objective when (as seems likely) the state reduces or even

completely ends its direct ownership of shares in listed companies. 81

For small unincorporated businesses, the introduction of private capital mainly

required the sanctioning of the employment of a limited number of workers, which

had generally not been possible under the stricter interpretation of Communist

principles that had previously prevailed. There were no issues here regarding

transfer of state assets. Corporatization of SOEs, however, was more complicated as

reform of the old enterprise system of necessity involved some change in the rights

over SOEs previously vested in the state. Without such a change it would not be

possible for the company form to be introduced as a method of business organisation.

Prior to corporatization, SOEs could be regarded as part of the state 82 but once

corporatized they have a separate legal personality and therefore the role of the state

as shareholder/owner must be clarified and in particular it must be distinguished from

the role of the state as regulator.83

There were several reasons for this. First, there

79 See Teemu Ruskola, Conceptualizing Corporations and Kinship: Comparative Law andDevelopment Theory in a Chinese Perspective 52(6) Stanford Law Review (2000) 1599.80 See the constitutional provisions discussed at note 29 above.81 This is discussed in more detail below.82 The State Enterprise Law of 1988 recognised SOEs as legal persons, but they were still at that stagewholly owned by the state and had not yet been corporatized.83 This was the conventional view articulated in Communist Party Policy and endorsed by internationaladvisers such as the World Bank. Others regarded the property rights issue as less significant. Simontook a pessimistic view of the effect of corporatization on property rights (W H Simon, The LegalStructure of the Chinese Socialist Market Enterprise 21 Iowa J. Corp L. 267). He argued that property

rights in the SOE and TVE structures of the 1980's were relatively clear, with managers and workershaving strong control and income rights but relatively weak capital rights, the latter being preserved forthe benefit of the society at large. He saw the main problem as that of enforcing the rights against, for



22/56

was a perceived need to ensure that the process of corporatization did not result in

the misappropriation or transfer at an undervalue of state assets. 84 Second,

clarification of property rights was necessary to make possible the sale of shares in

SOEs to outside shareholders. In principle, that could only occur in an environment in

which the role of the state was re-defined in a manner in which the rights of new

shareholders were made clear. Third, the introduction of a market-based system

involved a recognition that enterprises would be formed in which the state had no

ownership interest and therefore it would no longer be possible for the state to

continue to act in relation to these enterprises in the mixed role of owner and

regulator. Fourth, although in principle all productive assets were owned by the state,

corporatization required identification of which government department or

ministry/agency was an investor in a particular SOE, so as to make clear to whom

property rights were being assigned.

While, in the main, the rights of shareholders are made clear by the company law,

there remain some problems. First, the ownership rights of the state in respect of

assets owned by SOEs that have been coporatized is not entirely clear. Article 4 of

the Company Law provides that The State assets of a company belong to the State.

Howson described this provision as nonsense and noted that there was no similar

provision in the Standard opinion that preceded the Company Law. 85 It is difficult to

disagree with this conclusion as it does not seem possible for assets that belong to a

company, as a separate legal person, to be owned by another entity at the same time.

The provision confuses the direct ownership rights previously held by the state over

SOE assets with the ownership rights now held by the state in the form of

shareholding. 86It does not, however, appear to have given rise to much practical

example, managers who abused their position. Simon argued that the western experience in developingcompany law to facilitate the participation of many small investors in an enterprise was of littlerelevance to China where the expectation is that the state will remain the controlling shareholder inmost listed companies. It was therefore not surprising that the rights of minority shareholders remainedweak and uncertain even after the introduction of the company law, as the main objective of thecompany law was to reduce the state shareholding while still leaving the state in control. Lan Cao,CAT article, (above n24) discussing TVEs, also argued that the clarification of property rights was nota critical issue.84 As discussed below, some of this concern was misplaced as it resulted from a failure to recognize thefundamental change in ownership structure resulting from corporatization, which replaced direct stateownership of assets with shareholdings.85 See Howson fn p 142.86 It is an explicit example in Chinese law of an implicit tendency noted by Ireland in respect of English

company law, whereby the conflating of shareholders ownership of capital paid into the company andof the companys assets has led to the emergence of the view that companies should be run exclusivelyfor the benefit of shareholders (see P. Ireland, above n75 at p49).



23/56

difficulty, although that might change if the state were no longer the controlling

shareholder in most listed companies.

Second, the system of landholding in the PRC does not allow private ownership of

land. Land users (including companies) can only acquire a land-use right for a

specific time period and there are limits on the transfer of such rights. 87 The result is

that major assets of a company, represented by land and buildings, are not directly

owned by the company.

Third, the presence of the state as controlling shareholder creates some difficulty in

defining the rights of other shareholders. Two factors are relevant. The first is the

constitutional and ideological support for the role of the state as controlling

shareholder and the second is the regulation of marketability of shares.

While neither has a direct bearing on the rights of shareholders as defined in the

Company Law, they have important implications for corporate governance because

they effectively entrench the position of the state as controlling shareholder and

confine non-state shareholders to a minor role. This issue is discussed in more detail

in part E below.

The dominant role of the state is also evident in the development of the regulatory

regime in respect of foreign capitals participation in Chinese business. It reflects the

concern that China's economy, especially in strategically important industries, should

not fall under the control of foreign investors. 88 Foreign capital has been invested

mainly in joint-ventures, which can be organized either as limited liability companies

or contractual joint ventures. 89 The main source of foreign capital has been Hong

Kong 90 and it has been targeted mainly at cities on Chinas eastern seaboard. 91

87

See Png Cheong Ann, (above n45).88 One commentator viewed the position as follows: "..the PRC struck a compromise which continuesto animate China's policy and laws respecting foreign investment and corporate law: China wouldstrive to absorb enough foreign capital to bring about desired developmental benefits, while at the sametime maintaining state control over the terms of such investment through a system of approval controls,taxation policy, access to foreign exchange and production and distribution requirements": see N CHowson, "China's Company Law: One Step Forward, Two Steps Back? A Modest Complaint" (11) 1Columbia Journal of Asian Law 127,133.89 See generally, Guiguo Wang, Business Law of China chapter 8 "Organizations with a foreigninterest" (Butterworths Asia, 1999). The shares of foreign direct investment into China represented bydifferent forms of business enterprise between 1979-1997 was as follows: equity joint ventures 46%;contractual joint ventures 23%; wholly foreign-owned enterprises 30%; joint resource exploration 1%.(Source: OECD Financial Market Trends No 77, pp105-121 October 2000).90

On the role of Hong Kong as a bridge between global markets and China see D. Crawford,Globalization and Guanxi: The Ethos of Hong Kong Finance 6(1) New Political Economy (2001) 45.91 See S. Breslin (above note 50) pp212/13 for details.



24/56

Since 1986, it has been possible for wholly foreign-owned enterprises to be

established in China in the form of a LLC or JSC. The conditions to be met to gain

approval for establishing such an enterprise are more stringent than is the case for

joint ventures. 92

Participation in listed companies accounts for a relatively small proportion of foreign

investment in China, and one reason for this is that the options for participating in

listed companies are quite limited. 93 China has adopted a policy of restricting foreign

investors access to its capital market. 94 They cannot own A shares, which represent

the majority of the marketable shares of listed companies. 95 There are, however,

several ways in which foreign investors can participate in such companies. First,

through the purchase of B shares, which are denominated in RMB, listed in China

and traded in a foreign currency. 96 Until recently, such shares were only open to

purchase by foreigners, but are now open to purchase by PRC residents. 97 In

aggregate, B shares account for only 5% of the share capital of listed companies.

Second, foreign investors can buy foreign shares of Chinese companies, which are

listed and issued in an overseas market. Such shares are most commonly listed and

issued in Hong Kong( H Shares), the NYSE (N Shares) and London (L Shares). In

aggregate, they account for 5% of the capital of listed companies. 98 Approval is

required from the CSRC for the issue of securities in an overseas market although

the issue of admission to listing is a matter for the overseas market to determine. As

discussed in more detail below, the Articles of Association of a company intending to

issue securities on an overseas market must be amended to include the Mandatory

Provisions for Articles of Association of Overseas Listed Companies. Third, since

1995 it has been possible for foreign investors to invest directly into a (listed) Foreign

Investment Company limited by Shares ("FICLB"). 99 This type of company is

essentially the same as a JSC established under the Company Law with three main

exceptions. First, it is also subject to the laws and regulations governing enterprises92 See Wang pp258-261.93 See Table 4 in the Appendix, which shows foreign equity capital and foreign bonds as a percentageof total foreign investment in China.94 On the rationale for this policy, see Gordon and Wei Li (above n37), who show that the Chineseownership restrictions are equivalent in their economic effects to taxes on income from equity.95 See Table 1 in the Appendix.96 B shares listed in Shanghai are denominated in US dollars, while B shares listed in Shenzhen aredenominated in HK dollars. The regulatory framework is contained in the "Listing of Foreign Firms inChina by a Company Limited by Shares Provisions". See Tokley and Ravn (above n57) p197.97 The restrictions on domestic investors owning B shares were partially lifted in February 2001 andcompletely removed in June 2001.98 See Table 1 in the Appendix.



25/56

with foreign investment and in particular the requirement that at least 25% of the

shares must be held by the foreign investor. Second the establishment of a FICLB is

subject to a minimum registered capital requirement of RMB 30m compared to RMB

10m for a JSC established under the company law. Third, the establishment of this

type of company has been limited to the promotion ("private placement") method as

the CSRC has not authorised the listing and public issue by such companies. 100

Finally foreign investors can participate in listed companies through the purchase of

bonds, although as shown in Table 4 of the Appendix this has been a relatively minor

part of total foreign investment in China.

E. FINANCIAL MARKETS

Financial markets, and in particular the legal and regulatory environment in which

they operate, are closely related to the development of national systems of corporate

governance. 101 At the most basic level, there is a clear relationship between the

presence of strong investor protection and well-developed financial markets. 102

Beyond that, there are more specific influences such as disclosure obligations for

major shareholdings, takeover regulation and ownership restrictions (e.g. on banks

ownership of equity).The manner in which market participants are regulated is also

significant as it may influence the pattern of shareholding in a country. 103 So too is

the relationship between ultimate investors and intermediaries (banks, fund

managers, pension funds) in respect of issues such as voting rights over shares held

by intermediaries. 104

The transformation of the Chinese economy into a socialist market system 105 is

evident in the rapid development of financial markets over the last ten years. As

99 See Wang (above n89) pp304-312 for a discussion of the enabling regulations contained in the "JointStock Company with Foreign Investment Provisions".100 Some change in this policy on the part of the CSRC seems likely in the near future. See "Foreignfirms gain rights to China listing" South China Morning Post 9-11-2001. On 11 January 2002, theCSRC published on its website for public consultation rules governing information disclosure in aprospectus relating to a FICLB.101 See LLSV, Legal determinants of external finance 52 Jnl of Finance 1131-1150 (1997) and A.Shleifer and R. Vishny, A survey of corporate governance 52(2) Jnl of Finance 737-783 (1997).102 See LLSV, Investor Protection and Corporate Governance at ssrn.com (update reference).103 See M Roe (above n12) arguing that (politically driven) regulation in the USA has been the mainfactor shaping the modern system of corporate finance. (Political roots etc article)104 See R. Buxbaum, Institutional Owners and Corporate Managers: A Comparative Perspective 57

Brook. L. Rev. 1 (1991) for a comparison between the USA and Germany on this issue.105 This term has been used extensively since its adoption in 1992 at the 14 th National Congress of theChinese Communist Party.



26/56

shown in Table 3, the ratio of stockmarket capitalization to GDP now stands at over

50%, which places China ahead of most EU members other than the UK in terms of

the significance of the stockmarket to the economy. 106 What is less clear is whether,

and if so how, the socialist character of the system has been preserved in the midst

of these developments. The key to that issue lies in the peculiar mix of regulation and

market forces that has been adopted in the operation of financial markets in China.

What has emerged is a system in which there is such extensive state control of the

financial markets that the role of market forces has been marginalized.

(I) Regulation of Markets and Marketability of Shares

Prior to the introduction of national measures, regulation of the stock exchanges in

Shanghai and Shenzhen was left to the respective provincial/municipal governments.

The re-organisation of financial regulation in 1998 resulted in the CSRC assuming

responsibility for the stock exchanges. The exchanges themselves have a significant

regulatory role in setting rules for the operation of the market, but ultimately its is the

State which is in control as the CSRC is appointed by the State Council. The

Securities Law also contains important provisions in respect of the exchanges,

providing that they should be non-profit organisations (article 95) with a mutual

ownership structure (article 98). The effect of these provisions, taken together with

the observation that exchange members (viz. Securities Companies, discussed

below) are generally controlled by the state, is that the state is ultimately the owner of

the exchanges, the regulatory authority and the controlling shareholder in most listed

companies. 107

The confusion between the different roles of the state is also evident in the complex

manner in which marketability of shares is regulated. An examination of the

provisions of the Chinese company law relating to share types and transfer rightssuggests, at first glance, a relatively simple picture. Article 130 provides that the

conditions and price of shares issued as part of the same issue shall be the same

and article 143 provides that shares may be transferred in accordance with law.

106 For comparable data on the relative size of stockmarkets see Maher and Anderson, CorporateGovernance: Effects on Firm Performance and Economic Growth at ssrn.com. See also

www.FIBV.com , the website of the Federation International des Bourses de Valeurs.107 The control of the state was reinforced when, in October 2001, Premier Zhu appointed two formervice-chairs of the CSRC to head the national exchanges.

http://www.fibv.com/http://www.fibv.com/


27/56

However, the effect of regulations 108 made by the State Council, and state policy in

respect of its shareholdings, is that shares are classified into two groups: marketable

and non-marketable. 109 Categories 1 to 6 in Table 1 in the Appendix are designated

as non-marketable shares. 110 Categories 7 to 9 in Table 1 are designated as

marketable shares. The result is that the fraction of shares of Chinese listed

companies that is available for trading in the market (the "free float") is just over one

third of the total shares in issue.

The different types of share and shareholder require some explanation, as the rules

on transfer are formulated by reference to both. The concept of different share types

relates essentially to the marketability of shares held by different shareholders rather

than to different rights attaching to different types of share. Shares held by the state

(category 1) are held either by the state (through agents at the national, provincial or

local level) or by state legal persons. The latter are legal persons established with

state capital and directed by the State. 111 Domestic promoter legal person shares

(category 2) are shares held by the promoter involved in the formation of a JSC

(either by way of promotion or by way of public offer for subscription). The "domestic"

descriptor distinguishes this type of promoter from a foreign promoter. 112 It is possible

for shareholders in category 2 to be state legal persons and therefore such

shareholders can appear in either category.

The limits on marketability within these two categories are also more complex than

suggested by their designation as non-marketable . As discussed below 113 , state

shares can be transferred in several ways, an outcome referred to rather obliquely by

article 148 of the company law which simply refers to the possibility of state-owned

investment institutions selling state shares and buying shares held by others in

accordance with the law and administrative regulations. The non-marketable nature

of state shares is a matter of state policy regarding its ownership rather than an108 The Provisional Regulations on the Administration of Issuing and Trading Shares (April 22, 1993)and The Provisional Regulations on the Administration of State Equity in Companies Listed by Shares(3 Nov, 1994).109 The terms marketable and non-marketable refer to whether or not the relevant shares can be tradedthrough the stock exchanges in Shanghai or Shenzhen. Some authors use the terms transferable/non-transferable or negotiable/non-negotiable to refer to the same distinction. However, as non-marketableshares can be transferred outside the recognised exchanges, it is submitted that the more accuratedistinction is between marketable and non-marketable shares.110 Title to shares is recorded in electronic form. Paper copies of the record distinguish transferablefrom non-transferable shares.111 See article 4 of the Opinion on the Implementation of the management of state-owned shareholdingsin experimental JSCs, March 11 1994, State Assets Administration Bureau.112 Article 75 of the company law provides that half of the promoters must reside in the PRC



28/56

aspect of the rights attaching to shares. Even if state shares are sold by the state (by

one of the methods indicated below) they remain in principle non-marketable as it is

not possible for shares other than those issued to the public to become freely

marketable. Promoters are required to hold their shares for three years after the

establishment of a JSC and therefore the limit on the transfer of their shares is

temporary rather than permanent. However, even after transfer, promoter shares will

continue to be non-marketable. 114

Overseas legal persons (category 3) can become holders of non-marketable shares

through share issues made overseas by Chinese incorporated companies. This type

of issue is less common than issues made to foreign investors of marketable shares.

It is possible to make such non-marketable issues as some foreign investors are

keen to hold equity in Chinese companies for the long-term, regardless of restrictions

on marketability, which might be eased or abolished in due course. Social legal

persons (category 4) are domestic legal persons other than those in which the state

has a majority shareholding. This category includes LLCs and JVCs as well as co-

operatives and TVEs.

There are three share types that are designated marketable. They differ only in

respect of the currency in which the shares are traded and who is entitled to hold

them as the rights attaching to the shares are the same. A shares are denominated

in RMB and can be held only by domestic investors. B shares are denominated in

RMB, traded in foreign currency and until recently could only be held by foreigners.

Recent changes to the regulations have permitted B shares to be held by domestic

investors. 115 In overall terms, B shares represent a relatively small part of listed

companies' capital. 116 H shares are shares issued by PRC incorporated JSCs to

foreign investors through a listing on a foreign market. The most common option is to

issue in Hong Kong (hence the H designation) although several issues have alsobeen made in other markets.

The implications of this system of regulation of the market and marketability are

considerable. The dual role of the state as regulator and controlling shareholder

113 See section F for further discussion of the state shareholding.114 The restrictions on marketability are supported by the electronic systems in which legal title toshares is recorded: non-marketable shares are identified as such and this is shown on paper versions of the electronic record.115

One result of the change in regulations was that the value of B shares rose sharply and is now closerto that of A shares - see Table 5 in the App

Documents

Adaptation and Convergence in Corporate