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.