SOX and FCPA Enforcement

Sarbanes Oxley was once the center of aggressive criticism.  See Criticizing the Critics: Sarbanes Oxley and Quack Corporate Governance.  Today, though, SOX doesn't get as much attention.   Occasional criticism surfaces but for the most part opponents have moved on to other targets such as Dodd-Frank.

Meanwhile, the legislation continues to produce salutary effects.  The number of securities fraud suits remain modest.  While there are no doubt a number of explanations, the prophylactic measures put in place by SOX are likely some of them. 

What other benefits might flow from SOX?  One of the most criticized provisions was the requirement that the CEO and CFO certify the financial statements.  A recent article in the WSJ noted one of the consequences of this requirement.  The article examined the current waive of enforcement by the SEC and Justice under the Foreign Corrupt Practices Act.  In explaining the increased enforcement activity, the article gave credit to SOX.

• Congress passed the [FCPA] in 1977, after the Watergate scandal revealed the use of corporate slush funds to bribe foreign government officials, but it was sporadically enforced until recent years. Justice Department officials have attributed the recent enforcement push, in part, to the 2002 Sarbanes-Oxley Act, which requires corporate officers to certify the accuracy of their financial statements. That has led to more companies discovering potentially illicit payments on their books and disclosing them to the Securities and Exchange Commission and the Justice Department, they say.

In other words, by requiring executives to take responsibility for their own financial statements, they have greater incentive to uncover and stamp out illegal behavior.  This can be seen with respect to the FCPA.  One suspects that the same effect is likely taking place in a less public manner with respect to financial fraud and other inaccuracies. 

The Palestinian Stock Exchange

The WSJ noted that a broker (Auerbach Grayson & Co.) has begun to make shares on the Palestinian Stock Exchange available to large investors.  The web site for the PSE is here.  The float of the exchange is tiny and, as the article in the WSJ noted, an "obvious deterrent is the constant threat of war and political upheaval". 

Of course, there's also the fact that the West Bank has no currency (the PSE trades in Jordanian Dinars and dollars) and is in Nablus, a place Wikepedia said "was a central flashpoint of violence between the Isreal Defense Forces (IDF) and Palestinian militant groups."

In addition, there is the problem of the applicable legal regime.  For a list of some of the laws that apply in the West Bank, go here.  While the West Bank has in place a company law (it uses the 1964 version of the Jordanian company law, the version that was in effect when Israel took control of the West Bank in 1967), it is sorely in need of updating.  Gaza, by the way, uses a version of the British Company Law from the 1920s, the version that was in effect at the time Gaza fell under the oversight of Egypt following the creation of Israel in the 1940s.

Tourre Seeks Reconsideration

Fabrice Tourre, the lone defendant from the SEC's case that originally included Goldman Sachs, lost a motion to dismiss mostly because the trial court found that the SEC had sufficiently alleged claims under Section 17(a).  With the Supreme Court's holding in Morrison in the background, the court focused on the language in Section 17(a) and held that the SEC had alleged sufficient facts to show that an offer had occurred in the US. 

Tourre argues that the analysis is inconsistent with Morrison, that the interpretation of the term "offer" was incorrect and that the offer/sale division in Section 17 is inconsistent with congressional intent.  The most interesting part of the motion is the argument that the lower court's analysis will influence private actions under Section 11 and 12 of the 1933 Act.  As the brief notes:

• Employing language that is materially similar to the “offer or sale” language of Section 17, Section 12 provides investors a private right of action against a defendant who “[o]ffers or sells” securities by means of a materially misleading prospectus or oral statement. See 15 U.S.C. § 77l(a)(2). Under the logic of the June 10 Order, a foreign investor in a foreign securities transaction has a claim under Section 12 if there is some minimal amount of pretransactional conduct in the United States that satisfies the statute’s very broad definition of “offer”—conduct that would never have been sufficient even to satisfy the pre-Morrison conduct test, under which the defendant’s U.S.-based conduct had to be “more than merely preparatory” to a securities fraud.

The SEC's brief pointed out, however, that there are differences between actions brought under the two Sections.  See SEC Response, at 14. 

The SEC's case against interlocutory appeal seems the stronger of the two.  The court should, therefore, decline to hear the appeal.  A decision to do otherwise may portend the outcome.  A decision to take the case may reflect a view of some on the panel that the decision should be reversed. 

For primary materials on SEC v. Tourre, go to the DU Corporate Governance web site.  For primary materials in Morrison v. NAB, including the many amicus briefs filed in the case, go to the DU Corporate Governance web site.

The Matter of Terminology: HP, Goldman Sachs, and "Activist Investors"

The WSJ has an article about HP hiring Goldman to "help the company defend itself against possible activist investors who could push for change at H-P".  Said another way, the company is, apparently, "an attractive target for investor activism." 

The term activist, of course, has a certain pejorative connotation.  These are shareholders that want to interfere with management's prerogative and force change on the business.  The implication of the article is that now that HP has hit a low point, sharks are swarming around and the board may need to defend itself.

But in fact, given the instability at the top of the company, the dramatic drop in share prices (by about 50% in the last year), and the questionable corporate strategies bantered around (getting out of the computer business), aren't all shareholders activists in the way its being used in the article?  Don't all shareholders want stability, better management, and improved profitability?  Yet somehow shareholders who want this are viewed negatively and branded with a pejorative term. 

The article notes that a common response to "activist" shareholders is the adoption of a poison pill, which effectively insulates the company from a hostile takeover.  Hopefully in this case, the tactic adopted by the board (upon the advice of Goldman Sachs) will not be a poison pill but a strategy designed to improve profitability and stability to HP.  That strategy, more than any other, will likely deactivate those pesky activist shareholders.   

Corporate Governance and Say on Pay: The Problem of an Advisory Vote and the Australian Response

Certain types of corporate governance reforms are slow to come to the United States.  Shareholder access has been in place in Britain for years.  Say on Pay was implemented in the UK in the early part of the new millenium and in Australia in 2005.  It took the US until 2010 to require the same practice. 

Say on pay provides shareholders with an advisory vote on the compensation of top officers.  In the US, it is the CEO, CFO and top three highest paid officers.  An advisory vote, however, is exactly what it says.  Boards are free to ignore any advice provided by shareholders, even if the compensation package submitted to shareholders is voted down. 

For countries that have adopted say on pay provisions before the US, there is some evidence that second generation statutes are emerging.  These statutes are designed to erode the advisory nature of the vote by providing management with incentives to respond to the concerns evidenced by shareholders opposing the compensation package. 

The most overt example of this is underway in Australia.  Legislation there to modify the say on pay process has undergone its third reading.  A history of the legislation as well as some commentary can be found here.  The legislation provides for a "two strike" policy with respect to say on pay votes.  To the extent the remuneration report is opposed by 25% or more of the voting shares in two successive meetings, shareholders have the right to vote on a "spill resolution." 

If the resolution passes, the company must hold another meeting within 90 days and shareholders have the right to replace certain non-management directors.   As one sponsor of the legislation described: 

• Once the second strike is triggered, shareholders are given the opportunity to vote on a resolution to spill the board and subject the directors to re-election. If this spill resolution is passed by more than 50 per cent of eligible votes cast, then a spill meeting is to be held within 90 days, at which shareholders will be given the opportunity to vote on the re-election of the directors, one by one. 

The legislation was introduced in order to penalize companies that routinely ignored the "advice" of shareholders on compensation for two consecutive meetings.  As the sponsor described: 

• This proposal targets the small number of boards that have not adequately addressed shareholder concerns over two consecutive years. The government believes that it is appropriate that these boards be subject to this  additional scrutiny and accountability.

In most cases, the spill resolution will probably not pass.  In particular, those say on pay resolutions that are opposed by more than 25% but less than a majority will likely not result in the spill resolution passing.  Moreover, even when say on pay resolutions fail by larger majorities, shareholders displeased with compensation may not want to force the company to go through the uncertainty and expense of a second meeting that could result in replacement of much of the board.

Nonetheless, the provision, to the extent it becomes law, does provide management with greater incentive to communicate with shareholders and develop compensation packages that are more reflective of the interests of shareholders. 

Compensation and National Culture (Part 3)

We have been discussing the differing approaches used by Europe and the United States in addressing the problem of excessive compensation. 

In Europe, the approach has been not to rely on the market but to instead impose caps.  The caps apply to the amount of the bonus and the percentage that can be paid in cash.  The approach arises from the belief that the market does not work and there needs to be affirmative, substantive regulation.  It also reflects a view that there is a role for the government in setting compensation levels. 

In the United States, the approach is entirely different.  Caps are seen as excessive interference in the market.  CEOs (and anyone else with unique skills) should be allowed to bargain for their services and obtain any price that they can obtain from the market.  Regulators here would no sooner limit the compensation of a CEO than they would restrict the total compensation that could be paid to an athlete like Michael Jordan.  Moreover, even for those who concede that executive compensation is out of kilter, there is a strong opposition to direct government involvement in the determination of compensation.  The Obama Administration found this out when it had to back off salary caps for executives at TARP companies (limitied to $500,000) almost as soon as the proposal was floated.   

Instead, in the US, the response is increased disclosure and improved process.  It is a recognition that in fact the market for executive compensation doesn't work but that the best approach is to fix the process rather than substantively limit compensation.

The two approaches reflect a significant cultural difference.  The US elevates the market and devalues the role of the government.  The Europeans do the reverse.  Of course, the Europeans will discover that the caps can be manipulated (for bonuses limited to a percentage of salary, the amount can be manipulated upward by increasing the base) and the US will discover that improved process is no panacea.

Compensation and National Culture (Part 2)

As noted, the Europeans have taken an approach to executive compensation that focuses mostly on caps.  The policies rely on caps on the size of the bonus relative to total compensation, caps on the amount of the bonus that can be paid in cash, and limits on the availability of the bonus.

What is the approach taken in the United States?  Process, process, process. 

The Dodd-Frank Wall Street Reform Act (DFA) contained several provisions related to executive compensation. 

First, was say on pay.  Shareholders received the right to an advisory vote at least every three years (we will review this provision in more detail in a subsequent post). See Section 951. 

Second, the Compensation Committee was strengthened, mostly by giving the SEC the authority to define "independent" for purposes of the Committee (by setting out "relevant factors" that the exchanges must consider) and by allowing the committee to act on its own in selecting compensation consultants, without the approval of the full board.  See Section 952.

The Act stops short of requiring independent compensation consultants.  It only requires that the committee consider the factors set out by the Commission (some of which are in the statute).  The provision is, therefore, far weaker than the independence requirements for auditors contained in SOX.  See Sections 201 & 202 of SOX.  In theory, committees could consider the factors and ignore them.  As a practical matter, however, this is likely to result in the widespread use of independent compensation consultants. 

Finally, the Act heightened to disclosure required for compensation.  While several provisions touched on the issue, the most interesting is the one that requires the company to disclose the ratio between the CEO's compensation and the compensation of the average worker employed by the company.  Ratios have often been used to demonstrate the escalating nature of executive compensation. 

As this provision is implemented, it will likely vary widely among companies, particularly given the anticipated variation in the median of total annual compensation of all employees (minus the CEO).  Nonetheless, it will provide another metric for judging the fairness of the compensation. 

In short, the DFA provides no caps and no substantive limitations.  The only possible exception is Section 956 of the DFA provides that federal regulators must adopt regulations or guidelines that prohibit incentive-based compensation arrangements from resulting in “excessive compensation” or lead to “material financial loss."  Covered financial institutions include broker-dealers and investment advisors but do not include any financial institution with assets of less than $1 billion.  The provision does not, therefore, impose caps but it does provide some authority to ban certain types of compensation practices or arrangements.

Compensation and National Culture (Part 1)

The EU just approved compensation requirements for financial institutions (although they will need to be enforced at the national level).  The US has likewise adopted new regulations designed to reign in executive compensation.  The two approaches, however, are widely different.  They reflect large cultural differences on how to approach the problem of excessive compensation.

With respect to the EU, the European Parliament focused less on process and more on firm caps. The legislation adopted on Wednesday, July 7, favored caps on the proportion of a bonus paid in cash, required vesting schedules, and provided for recapture of bonus amounts in the event that performance suffered.  In addition, the legislation called for over all caps in proportion to salary. 

More specifically, as the New York Times reports, the cash component of bonuses must be limited to 30% in most cases, 20% where the bonuses are particularly large (a standard to be determined at the national level, although based on EU guidelines).  In addition, as the European Parliament describes, a significant portion of the non-cash component would need to be deferred for up to three years and would be subject to recapture in the event the performance of the financial institution suffers.  Specifically, between 40-60% of the bonus must be deferred for at least three years and can be recaptured "if investments do not perform as expected."  At least half of the bonus must be paid in "contingent capital" and shares.  Contingent capital is described as "funds to be called upon first in case of bank difficulties) and shares."

Finally, bonuses must be limited in size as a proportion of salary.  The limit, however, was left to each financial institution to set, although they must be consistent with EU guidelines.  The limits on bonuses  will apply to "senior management, risk takers, controller functions and any employee receiving total remuneration that takes them into the same remuneration bracket as senior management and risk takers."  The provisions apply to the subsidiaries of foreign banks (read US banks) operating in the EU.  The provisions will go into affect in January 2011.

Corporate Governance, Executive Compensation and the Japanese Approach (Part 3)

So what impact will these disclosure requirements have on executive compensation?  The best case scenario is none.  The worst case scenario is a full blown escalation of executive compensation.  At least in the short term, however, cultural norms and, importantly, arm twisting by the Financial Services Agency will likely keep the worst case scenario from taking place. 

CEOs in Japan are already poorly paid by international standards.  As the WSJ noted:

• U.S. chief executives of companies with revenue of over one trillion yen, or $10.9 billion, received a total compensation package nine times greater than their Japanese counterparts, according to data compiled from 2004 to 2006 by New York-based human-resources-services firm Towers Watson. European compensation was 4.4 times greater.

Why?  Culture and history.

• Masato Shirai, a director in the human-resources-consultancy group at PwC, said the lower levels of executive compensation are a historical and cultural legacy of Japanese corporations where salary increases are largely set by fixed formulas, and not by performance or negotiation by individual executives. The lower pay, Mr. Shirai said, is also a trade-off for job security.

Yet there is already pressure on this system.  Foremost, disclosure will reveal disparity among companies in Japan.  For example, the aggregate pay to the top 20 officers showed that companies like Nissan and Sony paid much higher averages.  Second, the disclosure will reveal higher compensation paid to non-Japanese officers, a consequence of having to compete with compensation standards in other countries.  In short, disclosure will help build pressure for increases in executive compensation.

Culture will keep the numbers down to some degree but so will the strong arm of the government.  This can be seen with the recent treatment of compensation at Shinsei Bank. 

Shinsei is the successor to the the Long Term Credit Bank, a financial institution created in the aftermath of WWII to provide long term capital to Japanese corporations (long term credit banks had debenture issuing authority, ordinary commercial banks did not; see Brown,  Japanese Banking Reform and the Occupation Legacy:  Decompartmentalization, Deregulation, and Decentralization, 21 Denver J. Int'l Law 361 (1993)). 

This is a particularly sensitive institution in Japan.  With the economic collapse in 1989 and the demise of the compartmentalized banking system in Japan, the LTCB couldn't make the transition.  It went bankrupt and was ultimately acquired by a consortium of foreign investors, making it the first Japanese bank to be acquired by foreign interests.  Moreover, the government still holds a large percentage of the shares. 

As the executive compensation disclosure deadline loomed, Shinsei looked likely to announce a structure that paid foreign executives substantially more than Japanese executives.  In response, the WSJ reported that the FSA pressured the Bank to force the high paid executives out.  According to the Journal: 

• When the slate of board members was presented to the FSA, the regulator said the four executives with compensation of more than 100 million yen should leave so embarrassment could be minimized, according to the person. An FSA spokesman declined to comment on the discussion.

In other words, the FSA did not leave matters to culture or social pressure.  Those sources of restraint would likely have less impact on a financial institution with foreign ownership.  As a result, the government acted as the enforcement mechanism.

The approach -- to the extent true -- shows that the current system of "cultural" limits cannot be counted on to restrain executive compensation.  While banks can be pressured by the FSA, not all companies are subject to the same level of regulatory oversight.  Moreover, while the FSA may be in a good position to address outliers in the compensation area, it will not be in a good position to stop compensation from creeping upward.

So, with the new disclosure requirements, we can expect an increase in executive compensation in Japan, albeit slowly.  Onward and upward.  

Corporate Governance, Executive Compensation and the Japanese Approach (Part 2)

Until recently, Japan required public companies to disclose the compensation paid to officers as a group.  It did not require the disclosure of specific individuals leaving, in most cases, the actual compensation of the CEO a mystery.  The aggregate data provided only a crude basis for examining the compensation of top officers.

This has changed.  Disclosure is now required of any officer making more than Y100 million or approximately $1.09 million.  The rule was promulgated by the Financial Services Agency, the successor to the old Banking Bureau within the Ministry of Finance and applied to all listed companies (approximately 3800 companies).  As the regulation provides:

• (1) Disclose the total compensation etc. for each of four categories: directors other than external directors, audit officers other than external audit officers, executive officers, and external officers (external directors and external audit officers). Disclose the amounts by each compensation type (by basic compensation, stock options, bonuses, retirement benefits, etc.).

• (2) For each officer, individually disclose the total amount and amount by each type of compensation etc. as an officer of the submitting company, and if simultaneously serving as officers of major consolidated subsidiaries then their compensation as officers of those consolidated subsidiaries. People subject to disclosure can be limited to people with total compensation etc. of 100 million yen or more as officers of the submitting corporation and its major subsidiaries. Also, if there are employees who simultaneously serve as officers, if the employee salary portion is important, then disclose its content.

The change applied to fiscal years ending on or after March 31, 2010.  In short, it applies now.  

The change unsurprisingly drew objections from business interest, particularly from the Keidanren, Japan's Business Roundtable.  In addition to learning the specifics of CEO pay, the disclosure promised to throw light on another aspect of executive compensation in Japan:  The payment of foreign officers more than Japanese officers. 

We will discuss the impact of these changes in the next post.

Corporate Governance, Executive Compensation and the Japanese Approach (Part 1)

Some aspects of corporate governance are converging in the global markets.  Countries have increasingly turned to the use of independent directors to protect the interests of shareholders (usually, outside the United States, minority shareholders).  Similarly, there is movement towards the use of specialized committees of the board, particularly compensation and audit, with membership consisting at least in part (if not entirely) of independent (or, in some cases, non-executive) directors.

Another place where converging seems to be occuring is in the area of compensation disclosure.  Since 1992, the US has had robust disclosure requirements for executive compensation.  After the 2006 reforms, the requirements apply to the CEO, CFO, and top three highest paid officers.  Moreover, the US has moved towards a system where all benefits (including perqs) must be included in "total compensation."  Total compensation does not necessarily reflect the amount actually paid to the officers but provides a basis for comparability. 

Disclosure seems like an inherently good thing but there is clearly a cultural component to the requirement.  In the United States, the expectation is that compensation will largely be determined and regulated by the market.  To the extent excessive, unhappy shareholders can sell, depressing share prices.  In order for this dynamic to work, shareholders must know the amount of compensation. 

Of course, the whole approach is flawed.  Shareholders do not react solely because of a single variable that makes them unhappy.  Moreover, even if they sell their shares and prices fall, the board is still in a position to award excessive amounts to top officers.  Indeed, most years when share prices have fallen, average executive compensation has risen.  

As a result, disclosure of executive compensation has not had downward pressure on the amounts paid.  Quite the reverse.  Executive compensation has likely gone up as a result of disclosure.  CEOs and CFOs in comparable companies can use the higher pay awarded by their competitors as a basis for arguing for a raise.  

Nevertheless, pressure has increased in other countries to follow the lead of the US and require robust disclosure of executive compensation.  One of the most recent converts has been Japan.  Yet as public reports indicate, the impact of disclosure is likely to be very different than what occurred in the US. 

BRIC Project -- China -- Regulatory Structures in China (Part 1)

Introduction

Part one of the Race to the Bottom’s BRIC Project: China Series seeks to illuminate the regulatory structures, agencies, and institutions that make up the Chinese system of corporate governance (“gongsi zhili”).  While this discussion is not comprehensiave, it does provide sufficient detail to grasp the complexities and nuances of this blossoming market.  Specifically, this post will discuss (A) the historical evolution of corporate structures in China, and (B) the corporate statutory regulation in China.

 A. Historical Evolution of Corporate Structures in China

It is necessary to briefly summarize the development of Chinese corporations and the evolution of their structure in order to understand the nature of the current model for corporations, and the corporate governance and regulatory structures that evolved around them.  See Cindy A. Schipani & Junhai Liu, Corporate Governance in China: Then and Now, 2002 Colum. Bus. L. Rev. 1, 1-22 (2002) (summarizing the historical evolution of corporate models in China).

The State Owned Enterprise (“SOE”) traditionally dominated the Chinese market.  The SOE is the embodiment of the planned economy in China where the State exercises complete control and ownership of firms.  The SOE also held special social significance for individual Chinese citizens as the organizational unit of social welfare as well as economic sufficiency.   

The Traditional Model, as it has come to be known, began in the 1950’s and lasted until the mid-1980’s.  After World War II, the SOE was the only legal entity available for large-scale commerce in China.  The Traditional Model’s method safeguarded the “People’s” property; whereby the State exercised complete ownership and authority in commercial activity.  This model, however, depressed growth, deprived SOEs of independence, and hindered productivity because all decision-making authority was concentrated in State agencies, not in the management personnel of the individual SOEs.  Within the planned economy, the State gave all production and distribution requirements to the SOEs in the form of a quota, instead of letting market demand set output levels.  The Party appointed all Executives, instead of the board of directors.  

The Transitional Model, lasting from 1984-1993, ushered in the beginning of privatization with the enactment of the “State-Owned Industrial Enterprises Law.”  Under this law, SOE reform encouraged firms to earn profits and expand production.  The goal was to make SOEs responsible for their own financial viability.  It marked a separation of the SOE and the State to a certain degree, but the State’s ultimate ownership remained.  This Model is also referred to as the “Contracting Model,” whereby the SOE and relevant government agencies contracted to lock in the minimum amount of profit the SOE was required to pay back to the State.  The SOE was allowed to keep any surplus profits, but was also required to pay back any shortfall.  

The Transitional Model succeeded in making the first steps towards a market based economy by diminishing government control, but is was unsustainable for several reasons.  First, accurate quota estimates and projected profits were difficult to achieve, leading to drastic under or over production.  Second, SOEs were simply unable to pay back the State for any shortfalls in profits sustained.  Third, SOE executive exploitation of State owned assets remained pervasive.  Finally, the firms were left with no retained earnings, making expansion and capital investment nearly impossible. 

In Response, the Modern Corporate Model was adopted with the passage of the “Chinese Corporate Law of 1993” (“Corporate Law”).  According to Deng Xiaoping, former Chinese Paramount leader, the goal was to modernize and “set up a modern corporate system in the majority of backbone industries.”  This model is still in place today.  Essentially, under the Corporate Law, SOEs should be fully “corporatized,” as functioning, public, companies.  A major caveat, however, remained in that the State itself persisted as the major shareholder.  

B. Corporate Statutory Regulation in China

The Chinese Government saw comprehensive corporate legislation as essential to fostering and implementing the State’s plan to modernize SOEs into globally competitive market actors, as discussed specifically in the Schipani & Liu article.  Schipani & Liu, Corporate Governance in China: Then and Now,” supra at 1-22.  The Corporate Law, enacted by the National People’s Congress and its Standing Committee, is still in force today in an amended form.  The Act sets out the fundamental features of all available business entities in China.  This discussion, however, will focus solely on Publically Held Companies (“PHCs”) and SOEs.  It is helpful to bear in mind that the majority of all major companies in China are still to this day owned by the state.  

The Corporate Law recognizes both Closely Held (“Youxian Zeren Gonsi”) and Publically Held (“Gufen Youxian Gonsi”) Corporations.  Closely Held Corporations include both Wholly State Owned and Foreign Invested Corporations, both of which pre-date the Corporate Law but were incorporated into the Act.  However, as a condition of China’s inclusion into the World Trade Organization, foreign and domestic organizations are required to be governed by the same set of laws.  Therefore, the distinction between Wholly State Owned and Foreign Invested Corporations has become less important.  

Publically Held Corporations, on the other hand, consist of both Listed, and Non-Listed corporations defined as “corporation[s] in which the total capital shall be divided into equal shares, shareholders will assume liability towards the company to the extent of their respective shareholdings, and the corporation shall be liable for its debts to shareholders.” Corporate Law §§ 2-3.  A listed company is further defined as a “Joint Stock Limited Corporation which has its issued shares listed and traded on stock exchanges with the approval of the State Council or the Department of Securities Administration.”  Corporate Law § 151.  These listed corporations are typically corporatized SOEs, whose shareholders are entitled to rights in proportion to their ownership position.  

Salient features of Chinese listed corporations include: the company, not the state, retains full ownership of shareholder capital; the company owns all property and capital created in the course of business; the company is authorized to pay dividends to shareholders; and shareholders are entitled to net assets in the event of liquidation.  The Corporate Law defines eight legal relationships between: 1) the shareholder and corporation; 2) the shareholder and other shareholders; 3) the fiduciary relationship between the corporation and its governing bodies; 4) the corporation and its creditors; 5) the shareholders and the corporations creditors; 6) the corporation and its employees; 7) the corporation and its competitors; and 8) the corporation and consumers.  

In addition to the Corporate Law’s foundational and authorizing language, listed companies in China are also subject to “The Securities Law of 1998” (“Securities Law”).  The main function of the Securities Law is to regulate the shares of Chinese corporations available for sale.  It utilizes a quota system whereby the Planning Commission and various provincial leaders receive a listing quota for that particular region, which constitutes a certain amount of shares of government property that may be securitized and sold.  These bodies then assign their shares to Initial Public Offering (“IPO”) Candidates, which are usually SOEs.  See Qiao Liu, Corporate Governance in China: Current Practices, Economic Effects, and Institutional Determinants, CESinfo Economic Studies, Oxford Journals, Volume 52, Number 2, 415-453 (2005).  This system functions to mitigate the risk of bad information systemically related to IPOs in China.  It also incentivizes local leaders to choose only viable SOEs for an IPO.  This system has effectively regulated the emergence of the capital markets in China.  The main criticism of this system is that it has led to local leaders selecting only those firms that will provide them with the most benefits locally in the form of higher rents, highest potential employment rates, etc.  Schipani & Liu, Corporate Governance in China: Then and Now,” supra at 1-22.

Additionally, this system has been blamed for stalling the corporatization of China in that a firm can only sell its initial quota given at its IPO, making it difficult to raise necessary capital.  Schipani & Liu, Corporate Governance in China: Then and Now,” supra.  Moreover, the quota system may represent a suboptimal structure chosen to promote indefinite state control. Schipani & Liu, Corporate Governance in China: Then and Now,” supra. 

A continuation of the BRIC Project’s China series is forthcoming, and discusses regulatory structures in China.  Specifically, the next post will be a discussion of the Chinese Stock markets, as well as the CRSC and other voluntary regulations imposed on Chinese Listed Companies.  

BRIC Project -- China -- Regulatory Structures in China (Part 1 cont.)

Introduction

Part one of the blog’s BRIC Project’s China Series seeks to illuminate the regulatory structures, agencies, and institutions that make up corporate governance (gongsi zhili) in China.  This continued posting on the regulatory structures in China looks at the (A) Board of Directors and the (B) Board of Supervisors in Chinese companies and their role in corporate governance, as well as (C) China’s definition of director independence.  

Required Governing Bodies in Chinese Corporations

A. The Board of Directors 

The Corporate Law of China requires three governing bodies within any listed corporation:  the shareholder, the board of directors, and the board of supervisors.  Noticeably, no other bodies or committees (such as an audit or compensation committee) are required.  However, the Corporate Law was amended in 2006, and now contains strict guidelines for audit and accounting functions within listed companies.  See Cindy A. Schipani & Junhai Liu, “Corporate Governance in China: Then and Now.” 

In Chinese listed companies, the shareholders, however, are meant to exercise the majority of decision-making authority within the corporation via the annual shareholder meeting and any subsequent meeting of the shareholders.  However, the logistics of calling a shareholder meeting for every major corporate event has proved impracticable and cumbersome.  In reality, the majority of power rests with the board of directors, the senior management, and the board of supervisors.

 The board of directors, much the same as the familiar model in the U.S., hires, fires, monitors and compensates management with the goal of shareholder wealth maximization.  The drafters of the Corporate Law originally saw the primary duty of the board of directors to minimize the costs associated with the separation of ownership and decision making authority for the SOE from the State.  See Donald Clarke, “Corporate Governance in China: An Overview.”  Directors serve for a maximum term of three years.  There are two enumerated fiduciary duties owed to shareholders by directors:  the duty of good faith (chengxin) and the duty of diligence (qinmian).

B. The Board of Supervisors

The unique addition to the traditional governing structure is the board of supervisors, and represents the second tier of corporate management.  Supervisors are charged with monitoring the directors and senior management to ensure fulfillment of their responsibilities.  See Takeshi Jingu, “Corporate Governance for Listed Companies in China - Recent Moves to Improve the Quality of Listed Companies.”  However, unlike Germany (which also employs a two-tier governing structure), there is no hierarchical relationship between the board of directors and board of supervisors.  Indeed both are appointed and dismissed via shareholder action, and are meant to equally coexist within the management structure of the Chinese corporation.  

The members of the board of supervisors consist of shareholder representatives (elected by the shareholders), and employee representatives (who work for the CEO).  Some commentators, however, note that the intended supervisory role of the board of supervisors is actually quite low in most listed companies.  This is because the chair of the board of supervisors is typically also the head of the labor union, who in turn is appointed by the in-house Party chief, who in turn is also often times the chairman of the board of directors.  Some argue that the board of supervisors does operate as a sufficient check on the board of directors and senior management as intended.

C. Defining “Independent Director” in China

Chapter IV, Section 5 of the Corporate Law was amended in 2004 to require listed Chinese companies to have some proportion of independent directors.  This amendment was added in response to the “State Council’s 2004 Several Opinions on Promoting the Reform, Opening Up, and Stable Development of Capital Markets” (a.k.a. “The Nine Opinions”).  The CSRC implemented this initiative via the codes it promulgates to require that, by 2003, one-third of all directors sitting on the boards of directors should be independent.  See “Code of Corporate Governance for Listed Companies in China (2001),” and the “Provisional Code of Corporate Governance for Security Companies (2004)”).  Another code revision requires that as directors’ terms expire, non-independent directors should not exceed one-half of the entire board.  See Larry Li, Tony Naughton & Martin T. Hovey, “A Review of Corporate Governance in China.”

The regulatory laws of China define independence as not having a position within the company (i.e. the CEO).  Further qualifications for independent directors include: (1) subjectively meeting honesty and credibility standards, (2) knowledge of securities markets, (3) familiarity with all laws and regulations pertaining to listed companies, (4) five years of relevant experience, and (5) possessing sufficient time to review and having access to all corporate material necessary to do the job.  The CSRC requires that the views and attitudes of all independent directors should be explicitly stated in any board resolution, and related transactions may not close until they are approved by a majority independent of the directors.  Further, two or more independent directors can propose a special shareholder meeting, and can individually report directly to shareholders or regulatory agencies.  Independent directors are, in theory, to be on par with non-independent directors.

However, all of the requirements imposed by the CSRC apply only to overseas-listed corporations.  Domestically listed corporations are not bound by any requirement to have any independent directors on their boards.  They may, however, adopt a discretionary provision in the Memorandum of Associations (which is similar to a combination of the Articles of Incorproation and Bylaws in U.S. corporations) whereby “the listed corporation may appoint independent directors when it deems necessary.”  This leaves most independent directors in domestically listed corporatized SOE’s with a limited role.

The final installment of Part one of the BRIC Project’s China Series is forthcoming, and discusses the ability of a shareholder in China to bring a lawsuit against a listed company, the legal system in China as it relates to shareholder actions and the perceived difficulty of shareholders in China to seek redress for breaches of fiduciary duties by management.   

BRIC Project -- China -- Regulatory Structures in China (Part 1 cont.)

Introduction

Part one of the blog’s BRIC Project’s China Series seeks to illuminate the regulatory structures, agencies, and institutions that make up corporate governance (gongsi zhili) in China.  This continued posting on the regulatory structures in China looks at the (A) Stock Exchanges and Agency Regulation in China, and (B) Voluntary Regulations in China.  

A. Stock Exchanges and Agency Regulation in China

The regulatory body created to administer the Chinese stock exchanges is the China Securities Regulatory Commission (CSRC).  This agency has promulgated two codes: the “Code of Corporate Governance for Listed Companies in China (2001),” and the “Provisional Code of Corporate Governance for Security Companies (2004).”  These codes apply equally to all listed companies, and represent an attempt on the part of the CSCR to standardize operating procedures and promote healthy corporate governance.  

Investors see the level of compliance by Chinese companies with both codes as the best metric for the health of the corporate governance system for a given listed company in China, as discussed in an article by Larry Li, Tony Naughton & Martin T. Hovey.  Li, Larry, Naughton, Tony and Hovey, Martin T., A Review of Corporate Governance in China (August 18, 2008).

The codes flesh out the details of the ideal corporate governance system.  The codes also enumerate the basic behavior, rules and moral standards for members of the governing bodies of the corporation.  Specifically, some of the more important features include: (1) Shareholders and the Annual Shareholder Meeting, (2) Controlling Shareholders, (3) Memorandum of Associations, (4) Board of Directors, (5) Board of Supervisors, and (6) Disclosure. 

•  (1)  Shareholders and the Annual Shareholder Meeting

The codes promote cohesive treatment of shareholders under all of the corporate and securities laws in China and stress that shareholders are to be treated fairly.  The codes also outline the requirements of shareholder communications, and reiterate that corporate management is to bear the burden of compensating shareholders in the event that management breach their fiduciary duties leading to loss on the part of shareholders.  The codes also require that related-party transactions should be undertaken at market value.  Further, qualification standards for management are outlined, and there is a notification requirement where the CSCR must be told of any major changes in the composition of the management team in any listed company.

In addition, the codes reiterate the notion, contained in both the Corporate Law and Securities Law, that the shareholder annual meeting is to be the powerhouse and primary forum for corporate decision-making.  In actual practice, however, Chinese listed companies face the same difficulties with annual meetings that U.S. corporations do; expense, low turn out and lack of dissent.

• (2)  Controlling Shareholders

The codes also lay out the proper relationship of the controlling shareholders to the company itself.  Controlling members must obey all laws in exercising their rights as investors, and they may not harm the company or the interests of a minority shareholder. 

• (3)  Memorandum of Associations

The codes and Corporate Law specify the nature and content of this organizational and governing document.  The Memorandum is similar to a combination of both the Articles of Incorporation and Bylaws in an American corporation. 

• (4)  Board of Directors

The codes provide that election of directors is to be transparent; the identity and qualifications of director candidates are to be disclosed before the annual meeting.  

• (5)  Board of Supervisors

The codes encourage shareholders to appoint members to this unique governing body from the professions of law and accounting, or candidates who possess extensive experience in business or finance.  Their identity and qualifications should likewise be disclosed prior to the annual meeting.  

• (6)  Disclosure

The codes ask for extensive disclosure of major events facing the corporation.  They require the disclosure of information to be widely accessible to the public.  

B. Voluntary Regulation in China

The Chinese corporate governance regulatory structure is sometimes characterized as a Control Model, meaning that affirmative acts on the part of the State, via regulation and investigation, are meant to enforce compliance.  Chi Guotai, Yang Zhongyuan, Zhao Guzngjun, Li Gang, The Trends of Transparency, Laws and Regulations on Chinese Corporate Governance, Dalian University of Technology (China), School of Management.  In other emerging markets, however, compliance with corporate governance principles is merely voluntary.  

Disclosure is one aspect of corporate governance in China that may deviate from the Control Model.  It could be categorized as voluntary, despite extensive disclosure obligations imposed by both the Corporate Law and the CSRC.  For instance, some commentators note that the level of information disclosed by listed companies is far behind that of most international public companies.  See Guotai, Zhongyuan, Guzngjun & Gang, “The Trends of Transparency, Laws and Regulations on Chinese Corporate Governance,” supra.  Much of the disclosure requirements are discretionary, and companies vigorously exercise their discretion not to release important information.  When companies do disclose, some complain that the information is untimely, the necessary information is incomplete, and the public lacks easy points of access to this information.  Interestingly, in China, disclosure is done through appointed print newspapers.  A typical trick is to publish the disclosure in a provincial, instead of the nationally appointed, newspaper to bury the disclosure.  

One commentator illustrates the differences between the CSRC and the functional equivalent in the United States; the Securities and Exchange Commission (“SEC”).  Where the SEC is primarily occupied with the enforcement of disclosure rules, the CSRC affirmatively enforces merit requirements in a public company to ensure investment quality.  Clarke, Donald C., Corporate Governance in China: An Overview (July 15, 2003).  However, the CSRC, unlike the SEC, is engaged in only limited disciplinary actions to enforce compliance with the codes it promulgates. 

A continuation of the BRIC Project’s China series is forthcoming, and discusses regulatory structures in China.  Specifically, the next post will be a discussion of the Board of Directors and the second tier of management of Chinese corporations; the Board of Supervisors.  The next post also examines what “independent director” means in China and the associated difficulties of corporate governance reform from the perspective of the boardroom.  

Independent Directors and the Japanese Experience (Part 2)

As noted, listed companies on the Tokyo Stock Exchange must have one independent director.  They have until 2011 to conform to the requirement.  Progress, even for this modest requirement, has been slow.  As GovernanceMetrics reports:

• According to data from the TSE, almost one in ten of the 2,094 companies that reported as of March 31, 2010 had no independent directors. Companies with no independent directors include Toyota Tsusho Corp., Daihatsu Motor Co., and Hisamitsu Pharmaceutical Co.  Staggeringly, 43.5% of the 404 Japanese companies GMI covers do not have a single independent director on their board and these represent the largest listed companies in Japan.  Furthermore, less than 5% of the Japanese companies GMI covers have boards that are majority independent.  In contrast, 74.7% of the 3,644 developed markets companies GMI covers have majority independent boards.

A more detailed description of board membership can be found in The White Paper on Corporate Governance, published by the Tokyo Stock Exchange. 

Companies such as Toyota lack any directors who meet the requirements of the NYSE.  As the auto company reported in its most recent report filed on Form 20-F:

• Toyota currently does not have any directors who will be deemed as an “independent director” as required under the NYSE Corporate Governance Rules for U.S. listed companies. Unlike the NYSE Corporate Governance Rules, the Corporation Act does not require Japanese companies with a board of corporate auditors such as Toyota to have any independent directors on its board of directors. While the NYSE Corporate Governance Rules require that the non-management directors of each listed company meet at regularly scheduled executive sessions without management, Toyota currently has no non-management director on its board of directors. Unlike the NYSE Corporate Governance Rules, the Corporation Act does not require, and accordingly Toyota does not have, an internal corporate organ or committee comprised solely of independent directors.

As the TSE statistics suggest, the Toyota board structure is not unusual.  Insular boards are the practice.  Yet the current set of scandals surrounding Toyota indicate the need to revisit this board structure.

The slow acceptance of independent directors may have a cultural explanation.  After all, the purpose of independent directors is to provide a sometimes discordant voice in the board room, an approach inconsistent with a culture that places considerable weight on communal values and consensus.  The problem, of course, is that these values are not shared globally.  Large Japanese companies need a board that meets global rather than exclusively Japanese needs. 

Independent Directors and the Japanese Experience (Part 1)

We were alerted by GovenanceMetrics on recent information about Japanese corporate governance practices, particularly the Inter-Corporate Network Dealings and Minority Shareholder Protection — Cases in Japan, published by the Asia-Pacific Office of CFA Institute/CFA Society of Japan.  Japan's system of corporate governance is in transition but, as recent data indicates, it has a long way to go.

Through most of the post-war period, Japan relied for corporate governance primarily on the main bank system (for a bit of history on the securities markets in the post war period, see Of Brokers, Banks and the Case for Regulatory Intervention in the Russian Securities Markets).  Boards consisted mostly of former employees, with the position largely ceremonial.  Real control was exercised by main banks, both because of ownership control (indirectly through the keiretsu) and because it was a critical if not the critical source of financing.  The system was also used by the government, particularly the doyens in the Ministry of Finance, to guide industrial policy.  This is discussed at greater length in  J. Robert Brown, Jr., Industrial Policy and the Dangers of Emulating Japan, 27 GW J. Int'l L. & Econ. 1 (1993). 

Government influence has wained and so has the main bank system.  In the aftermath of the bubble economy of the 1980s, Japanese banks have begun to unwind their holdings in corporate clients.  Moreover, large companies are no longer dependent upon main banks for their financing, at least for those companies capable of tapping bond markets and international markets.  As a result, corporate governance in Japan has been in transition. 

Consistent with the global trend, Japan has increasingly turned to independent directors as the solution.  In 2009, the TSE adopted Rule 436-2 which required listed companies to have at least one independent director.  The definition of independent mostly screened for material financial and employment relationships with the company (or its affiliates), not for relationships with management or controlling shareholders.  See Guidelines, at III.5(3)-2.  Independent directors were charged with acting in the best interests of shareholders. 

How has the approach worked?  We address that in the next post.

Corporate Governance in India: A Review of Regulatory Structures

This is the first of a series of posts examining India’s corporate governance practices in contribution towards Race to the Bottom’s BRIC Project.  This post presents the framework of corporate governance in India by examining the nation’s regulatory structures.  Specifically, the post will discuss dynamics of the Ministry of Corporate Affairs (the “MCA”), the Securities and Exchange Board of India (“SEBI”), and the Listing Agreements of the respective stock exchanges, namely, the Bombay Stock Exchange and the National Stock Exchange (collectively the “stock exchanges”).

The Indian corporate sector witnessed numerous changes in law and regulations as a result of increased globalization efforts since the 1990’s.  SEBI’s origination was one of the most important developments in India’s corporate governance initiatives.  Moreover, corporate scandals during this liberalization period triggered a need for investigative practices and spreading awareness of ideal governance practices to compete in the global market.  The MCA and SEBI, through subcommittees and regulations, had maximum impact on changing the corporate governance in Indian companies.

Ministry of Corporate Affairs:

The Ministry of Corporate Affairs (“MCA”) is the main authority responsible for regulating and promoting efficiency, transparency, and accountability in the Indian corporate sector.  The MCA is specifically responsible for the administration of the Companies Act, 1956, and other allied legislation.

In addition, the MCA supervises three professional regulatory bodies, namely, Institute of Chartered Accountants of India (“ICAI”), Institute of Company Secretaries of India (“ICSI”) and the Institute of Cost and Works Accountants of India (“ICWAI”).

The Indian Companies Act, provided by the Central Government, is the key legislation for corporations in India.  It has elaborate provisions, including those that deal with accountants and audits, director remuneration, financial and nonfinancial disclosures, corporate democracy, powers of inspection, and prevention of mismanagement among others.  More specifically, through numerous committees, the central government has power to take independent actions, which can include inspection of a company’s book accounts, directing special audits, investigating company affairs and prosecuting for violating provisions of the Companies Act.  The inspections are designed to ensure compliance with provisions under the Act, to identify practices that are detrimental to public interest, and to detect mismanagement that adversely affects interests of shareholders, creditors, and employees.  Overall, the Act provides important basic guidelines for operating corporate entities with a single, comprehensive, and centrally administered framework.  The basic objectives for the Companies Act, 1956 can be found here.

In 2009, the Ministry submitted the Companies Bill 2009 to parliament.  It emphasizes increased shareholder democracy with less intervention by governing bodies.  Further, the proposed regulation encourages self-regulation with adequate disclosures and accountability.  At the same time, the new legislation imposes less control over internal procedures.

While the MCA is the primary governing body responsible for administering the Companies Act of 1956, the Securities & Exchange Board of India (“SEBI”) functions as the securities market regulator.

Securities and Exchange Board of India:

The central government of India set up regulatory control over the stock markets through SEBI in 1992.  Although SEBI was originally established in 1988 as an advisory body, the SEBI Act of 1992 (the “Act”) granted it authority to regulate the entire securities market.  Through the adoption of the Act, parliament established SEBI as an independent statutory authority but still required it to submit annual reports to the legislature.

The stated purpose of SEBI as an agency is to “protect the interests of investors in securities and to promote the development of, and to regulate, the securities market.”

The extent of SEBI’s authority is unclear.  This agency’s principal tasks according to Chapter IV of the SEBI Act include “regulating the business in stock exchanges and other securities markets… prohibiting fraudulent and unfair trade practices relating to securities markets…prohibiting insider trading in securities…regulating substantial acquisition of shares and take-over of companies…”  In carrying out these tasks, however, SEBI frequently amended the Act and expanded its powers with respect to inspection, investigation, and enforcement.  The remaining powers and functions of the board are available here.

One of SEBI’s significant powers is its rule-making authority.  It has made several significant amendments to the Listing Agreement, which greatly increases responsibility of publically listed companies.  In the article, Corporate Governance Convergence: Lessons from the Indian Experience, Afra Afsharipour argues that it is unclear whether SEBI was explicitly granted the authority to impose such corporate governance rules in the Listing Agreement.  The article adds that SEBI justifies such actions by considering the scope of its authority under Section 11A to “specify, by regulations, …matters relating to issue of capital, transfer of securities and other matters incidental thereto… and the manner in which such matters shall be disclosed by the companies.”  The extent of SEBI’s power is unclear to such an extent that it has constantly been in tension with the MCA, the major regulatory body.

Power conflicts between the MCA and SEBI began with SEBI’s formation in 1992.  A major reason for this tension is that many regulatory responsibilities stemming from legislation are carried out simultaneously by multiple agencies.  This results in separate charges being filed by different agencies.  Moreover, SEBI is looked upon as an agency that continuously expands its powers under the Act.

The Companies Act, 1956 prescribes that MCA is responsible for regulating all registered companies.  Similarly, the Act imposes responsibility for listed companies on SEBI.  This results in overlapping jurisdiction and often, regulatory gaps.  Therefore, there is a need to bring about coordination in the role and action of various regulatory agencies to enable effective regulation and protection for investors.

Listing Agreement:

India has two national stock exchanges, the Bombay Stock Exchange and the National Stock Exchange.  Companies that wish to be listed on either must comply with the requirements of the respective exchanges’ Listing Agreement.  These stock exchanges are self-regulating organizations that are registered with and regulated by SEBI.  SEBI Act of 1992 grants SEBI the authority to regulate the stock exchanges, including power to inspect them.

A Listing Agreement lays out rules and procedures to which companies must comply if they wish to remain listed on an Indian stock exchange.  Actions prescribed on the Listing Agreement include payment of listing fees and numerous governance standards that companies must adopt.  Specifically, the Listing Agreement on the exchanges require disclosures of financial statements, adherence to requirements concerning independent directors, and compliance with any additional rule that SEBI or another governmental agency may put forth.

Listing departments monitor compliance with provisions outlined in the Listing Agreement.  They have the authority to impose disciplinary measures for erring companies, up to and including delisting.

Overall, primary reforms in India’s corporate governance have been introduced through amendments to the Listing Agreement.  A prime example is the creation of Clause 49.  This regulation set up basic governance practices for listed companies in India.  It evolved to strengthen board practices by requiring a minimum number of independent directors to sit on boards, formation of audit committees and shareholder grievance committees, among other things.  A large portion of companies, including large public-sector corporations, have failed to comply with the existing requirements.  However, such companies have not been penalized for noncompliance and continue to be exonerated by SEBI.  A post by Umakanth V. on the Indian Corporate Law Blog reports that more than 1,000 companies failed to file corporate governance reports in 2008, thus indicating a need for strengthened enforcement measures ensuring compliance.

Historically, mandatory guidelines governed listed corporations in India.  While many public companies have been successful in turning their knowledge of corporate governance practices into company norms, there are still numerous entities that are not in compliance.  The Satyam scandal highlighted the failure of current corporate governance norms and the need for a new approach in regulation.  As a response, the Ministry of Corporate Affairs submitted a draft of voluntary guidelines to parliament for consideration.  These guidelines would be enforced under a “comply or explain” basis where companies would be expected to comply with regulatory provisions or issue an explanation to shareholders detailing reasons for noncompliance. 

The BRIC Project -- China -- An Introduction to Corporate Governance in China

The People’s Republic of China is a member of the “BRIC” group (Brazil, Russia, India and China) of emerging markets.  While it is universally understood that China has grown since the 1970’s by privatizing certain segments of its economy, its corporate governance (gongsi zhili) structures are still developing. Modernization and reform of China’s corporate governance institutions are vital to sustainable growth and investment opportunity. 

It is important to frame the importance of the discussion by recognizing the following:

• China’s GDP, year over year, grew by 11.4% in 2007

• China’s economy is the second largest in world measured in purchasing power parity

• 9 automobiles to every 1,000 Chinese’s, vs. 1,000 automobiles to every 1,000 U.S. citizens

•  The Shanghai and Shenzhen exchanges together are the 8th largest in the world

• There are over 70 million investor accounts in China, representing 300 million Chinese citizens

• 70% of the listed companies in China do not meet international corporate governance standards

• Within the next decade, China’s share of the global market should equal the U.S.’s share

• Within the next three decades, China will likely be the largest market in the world

While China copes with the stress of rapid growth and corporate governance reform, it is making concerted, substantial efforts to establish standards that bring health to its capital markets.  Lingering in the background, however, is the fundamental problem of China’s pervasive State ownership and control of private and public corporations.  Instituting meaningful, incentive based reform in China, therefore, is important to fill the regulatory gap as the State withdraws and investors move in as dominant shareholders of Chinese companies. 

Over the following weeks and months, the blog will post a four-part series analyzing the bourgeoning corporate governance régimes in China.  Part I will address the regulatory structures currently in place in China, and the nature of the corporate forms they authorize.  Part II will address the issue of executive compensation in China, and analyze its approach to controlling abuse.  Part III will address the nature of shareholder rights in China, and recent reforms.  Finally, Part IV will summarize current literature’s perceived strengths and weaknesses of corporate governance in China.

The BRIC Project -- Brazil -- The Novo Mercado: A Giant Step For Corporate Governance, A Small Step For Brazil (Part 7)

As mentioned in previous posts, in December of 2000, the Sao Paolo Stock Exchange, Bovespa, initiated a three-tiered scheme of corporate governance listing rules known as Level 1, Level 2, and Novo Mercado (New Market).  The scheme is broadly known as the Novo Mercado, the strictest of the three tiers.  Compliance with the scheme is voluntary.  Ten years after its creation, the existence of the Novo Mercado is undoubtedly significant in Brazil, both in terms of the rise of meaningful corporate governance and the benefits that such a trend has helped to bring to the nation’s once stagnant economy.  Currently, the strict Novo Mercado tier of corporate governance accounts for approximately 18.59% of the market capitalization of Bovespa. Gorga, Érica, 29 Nw. J. Int'l L. & Bus. 439, 452 (2009), Changing the Paradigm of Stock Ownership From Concentrated Towards Dispersed Ownership?  Evidence From Brazil and Consequences for Emerging Countries.  Among corporations listed on the Novo Mercado, the only tier that requires a strict one-share-one-vote rule, the controlling shareholder represents approximately 36.39% of total ownership of its corporation.  Id. at 448. 

That nearly 20% of the market capitalization of Brazil’s largest stock exchange is now comprised of corporations that voluntarily comply with strict standards of corporate governance that increase dispersed ownership and shareholders’ rights is impressive.  Also, corporations listed on the Novo Mercado’s strictest tier have been shown to receive higher prices for their securities.  Id. at 453.  Such data exists as encouraging evidence that even when compliance is voluntary, the pursuit of meaningful transparency, dispersed ownership, and shareholders’ rights allows firms to more easily attain financing, to become more competitive, and ultimately to create increased value to investors.  This is exactly the ideal upon which the Novo Mercado’s creation was based.          

However, further analysis of the Novo Mercado, its more lenient tiers, and Bovespa’s traditional market listings has suggested that it may be too soon to conclude that the Novo Mercado is actually changing patterns of corporate governance or ownership in Brazil.  Id. at 448.  Gorga’s empirical research showed that a mere 15.2% of companies listed on the Novo Mercado came from the traditional market, and that the vast majority of such firms were “new entrants,” with approximately 85% having been closely held corporations that went public and listed directly onto the Novo Mercado.  Id.  Furthermore, the vast majority of publicly listed firms that actually migrated from the traditional market to the Novo Mercado, migrated to the scheme’s most lenient tier, Level 1.  Id.  These statistics highlight the rarity and reluctance of Brazil’s larger and traditional firms that existed before the creation of the Novo Mercado, to evolve, to reform their practices, and to embrace more progressive standards of corporate governance.   

Therefore, given that Bovespa’s traditional, laissez-faire, market listings account for approximately 40% of the market capitalization of the stock exchange, and the most lenient Level 1 tier of the Novo Mercado comprises 38% of market capitalization, some 78% corporations listed on the exchange operate according to weak, or non-existent, standards of corporate governance.  Among Level 1 and Level 2 firms, controlling shareholders account for an average of 63.14% and 64.79% of the ownership of their firms respectively, suggesting that outside the strictest Novo Mercado tier, concentrated ownership by Brazil’s political and financial elite remains a serious issue.  Id. at 447-8.

Ultimately, nearly one-fifth of the market capitalization of  Brazil’s largest stock exchange is now comprised of corporations that are attempting to conduct business according to more modern standards of corporate governance.  This is an important first step, both for Brazil and for South America.  This is a particularly noteworthy shift in a nation that just ten years ago existed as a jurisdiction without a discernable approach to corporate governance.  

However, despite the definite benefits that the creation and climb of the Novo Mercado have yielded, compliance with meaningful standards of corporate governance remains overwhelmingly voluntary in Brazil.  While the Novo Mercado’s voluntary soft-model of regulation is certainly preferable to no regulation at all, Brazil and Bovespa face real challenges to expanding the reach and sharpening the teeth of meaningful corporate governance in Brazil.  It is important to remember that while Bovespa is Brazil’s largest stock exchange, it is not a government agency.  Therefore, Bovespa’s Novo Mercado scheme does not apply to Brazilian corporations that fail to list and its enforcement capabilities are limited to deciding on which tiers it will allow certain corporations to list.  

Bovespa’s three-tiered Novo Mercado scheme of listing rules undoubtedly represents an important first step for corporate governance in Brazil.  However, this is likely a first step on the very long path to Brazil’s emergence as a jurisdiction with progressive, comprehensive, and enforceable standards of corporate governance.

The BRIC Project – Brazil -- BOVESPA’s Novo Mercado: Modern and Meaningful Corporate Governance in Brazil (Part 6)

Throughout the BRIC Project posts regarding Brazil, we have focused mainly on Bovespa’s three-tiered scheme of voluntary listing standards of corporate governance.  This post will center on the tenants of the Novo Mercado. 

The Novo Mercado (New Market) is the strictest tier of the São Paulo Stock Exchange’s (BOVESPA) three-tiered scheme of corporate governance listing requirements. (See, Novo Mercado Listing Rules)  Compliance with the Novo Mercado is entirely voluntary, as is compliance with lower tiers, Level 1 and Level 2.  According to Bovespa’s website, compliance with the Novo Mercado is premised on the idea that “stock valuation and liquidity are positively impacted and assured by shareholders’ rights and by the quality of companies’ information.”   As of March 2010, 107 companies were listed on the Novo Mercado.  (See, list).  Companies that wish to list on the Novo Mercado must fully comply with all the requirements of Bovespa’s Corporate Governance Level 1 and Level 2.The Novo Mercado is distinguished from the two more lenient tiers by two paramount listing requirements.  First, companies’ capital stock must be entirely comprised of common, voting shares.  (§3.1(vi)).  In other words, all shares which make-up a company’s capital stock must conform with a one-share-one-vote rule.  Preferred and founding shares, which receive special voting privileges, are forbidden on the Novo Mercado. (§3.1(vii)).  Secondly, regarding any disposal of control via the sale of capital stock holdings, any “public tender offer must comply with the law and with these Listing Rules and the other shareholders must be given the same treatment as the Selling Controlling Shareholder.”  (§8.1).  While all three tiers of Bovespa’s corporate governance listing requirements encourage dispersed ownership, transparency, and broader access to investors, the Novo Mercado is the only tier that requires the one-share-one-vote rule which best enables dispersed ownership.  Gorga, Érica, 29 Nw. J. Int'l L. & Bus. 439, 446 (2009), Changing the Paradigm of Stock Ownership From Concentrated Towards Dispersed Ownership?  Evidence From Brazil and Consequences for Emerging Countries.      

These strict listing standards are comparable to many of the standards enforced by the American Securities and Exchange Commission.  However, it is important to remember that compliance with these stricter listing standards is completely voluntary, and thus far applies only to public companies that both decide to list with Bovespa and agree to conduct business in accordance with the aforementioned principles. 

In the following post, we will present a broader assessment of the impact that the Novo Mercado has had in Brazil and the challenges that the advance of modern and meaningful standards of corporate governance continues to face in Brazil.