Studies by the Asian Development Bank allow us to compare the ownership structure of Chinese listed companies with that in some Western countries. In terms of concentration, China is somewhere in the middle. The ownership structure is concentrated, but at levels similar to those in most western European countries. What is different about China the identity of the controlling shareholders.
A similarity with ownership structures in some western European and East Asian countries is the dominant position of other corporate entities as shareholders. In terms of types of largest shareholders, China is differentiated by the absence of significant ownership by individuals and families, the negligible role of financial institutions and institutional investors, and the large state role. These features have a direct bearing on the types of corporate governance issues that China faces.
Perhaps the most important implication of the dominant role of state ownership in China's listed companies is the control the government can exert over management appointments and incentives, and thereby over companies' behaviour. Most corporate managers still aspire to a civil service rank and are concerned about how their superiors in the political and administrative hierarchy assess their performance. This assessment may be quite arbitrary or subjective and be based on indicators such as profits, political correctness and the discharge of social obligations. Furthermore, local governments may have incentives that are not aligned with the plans of companies that operate on a national or international scale.
The dominant position of corporate entities as controlling shareholders is not unique to China. However, the nature of the listing process in China compounds the risks of conflicts between controlling and minority shareholders. Listing and parent companies are often in the same business sector and may compete with each other, have business transactions with each other, or share resources and functions. In some cases, the listed company may depend on the rest of the group for the distribution of products or supply of raw materials. Senior managers often work for both the listed and unlisted parts of the group. This type of interdependence creates fertile ground for agency problems.
Corporate control mechanisms and shareholder activism can do little to alleviate such agency problems under the existing ownership structure. The high degree of ownership concentration and the non-tradability of more than two-thirds of the shares imply a low contestability of control. In addition, tradable shares are held largely by individuals, who have few incentives and resources to perform monitoring functions.
The board of directors is the crucial link between ownership and corporate governance. This is where governance takes place and where some of the solutions to corporate governance problems can be sought.
According to a Shanghai stock exchange survey of 257 companies listed in the city, shareholders appoint 76 percent of the directors of listed companies. Holders of state-owned legal person shares are the most influential, selecting 48 percent of all directors, followed by owners of state shares at 21 percent. Thus, directly or indirectly, the state is in absolute control, selecting almost 70 percent of all directors.
State enterprises appoint 45 percent of all the directors appointed by shareholders. In line with their insignificance as shareholders, financial institutions play a relatively minor role in the selection of directors. Trust and investment companies, securities companies and banks together account for the selection of 1.3 percent of executive directors and 9.3 percent of non-executive directors. Private enterprises appoint 1.5 percent of all directors appointed by shareholders. Those holding state shares and tradable shares tend to appoint a larger proportion of executive than non-executive directors. The owners of state shares select a higher proportion of executive directors, while the owners of state-owned legal person shares, who typically represent the interests of the parent SOEs, select the majority of non-executive directors.
Like ownership, control is highly concentrated. Typically, the largest shareholder accounts for slightly less than 50 percent of all shares but controls more than half of board seats. The average share of the three largest shareholders is 59 percent, but they appoint 79 percent of all directors.
Furthermore, considerable disparity is apparent between the shares of board seats and the ownership of different shareholders – or between control and cashflow rights. A comparison of the control and cashflow rights of the largest three shareholders in the survey shows that the discrepancy is higher for the second and third largest shareholders than for the largest shareholder, conditional on the latter's having obtained majority control. The marginal value of control diminishes after majority control has been obtained. The share of board seats controlled by the largest shareholder is higher than that shareholder's ownership share, but this situation is reversed after the shareholder obtains a majority stake.
Thus to a significant extent, parent companies control the boards of listed companies. Few board seats are available for non-shareholders, and the notion of independent directors is new to most listed companies. The directors appointed by non-shareholders account for 24 percent of total directors. The executive directors appointed by non-shareholders are mainly recommended by company staff, but are sometimes appointed by the government. Independent directors are mainly recruited by the companies. They tend to be former advisors to the companies and are usually elected because of their reputation and professional expertise.
Board composition and trends
According to the Company Law, a board of directors should consist of five to 19 directors. The average size of boards in 1999 was 9.9, compared with 10.1 in 1996. Two-thirds of all directors are executive directors. Only 54 directors, or 3.1 percent of the total in the 257 listed companies surveyed, have some degree of independence. About half of the executive directors take senior management positions. Comparatively fewer directors hold professional positions, such as chief engineers, advisers and economists.
In about 22 percent of the companies surveyed, the board chair is also the general manager. In one-third of the sample companies, the chair is not a company employee. In about 45 percent of listed companies, the board chair and general manager are two different people, but the chair does hold a position in the company.
The average percentage of executive directors in a board decreased from 56 percent in 1996 to 49 percent in 1999, and the average total of directors appointed by shareholders increased from 65 percent in 1996 to 70 percent in 1999. A significant number of directors come from connected companies, and their representation appears to be increasing. This is also true for associated companies that either hold shares in the listed company or provide credit to or have business transactions with it.
Almost 60 percent of the directors of listed companies have a graduate or higher degree. Non-executive and independent directors tend to be more highly educated than executive directors appointed by shareholders. About half of all executive directors, two-thirds of non-executive directors and almost all independent directors hold degrees in management-related subjects or finance and accounting. An insignificant number or directors have studied law.
In terms of background, most directors have worked in the fields of engineering, marketing and sales. Independent directors have more experience in technological research, education and Chinese Communist Party and Chinese Communist Youth organisational work. Most executive and non-executive directors are former SOE employees, while independent directors are drawn mostly from government departments, research institutions and universities. This accounts for the description of listed companies as 'old wine in new bottles': on the surface a new corporate governance framework appears to be in place, while in reality companies still operate more or less like the old SOEs.
Most executive directors were with the listed companies at the time of their initial public offering (IPO), and most of them had previously worked in the firm's parent company. Regarding non-executive directors, 32 percent were with the company at the time of the IPO and 16 percent had worked in the parent company. More than one-third of all directors also sit on other boards. This percentage is higher for non-executive and independent directors (56 and 43 percent respectively), and lower for executive directors not appointed by shareholders (25 percent).
Chinese corporations still lack nominating committees for directors and corporate governance committees. Listed companies do not disclose their procedures for nominating directors or their corporate governance principles. Most directors believe that their companies have internal criteria for selecting directors. When surveyed, they cited management experience, followed by professional expertise and reputation, as the main criteria. Other criteria included share ownership and personal connections.
The Company Law stipulates that the shareholders' general meeting is responsible for selecting and removing directors, but it does not stipulate who is responsible for nominating them. International practices typically include a nominating committee under the board – composed mainly of outside or independent directors who do not hold a position in the company other than as board directors – that formulates selection criteria and nominates new directors. In China, large shareholders nominate new directors in 57 percent of listed companies, the board of directors does so in 34 percent of companies, the chair of the board in 6 percent and existing directors in 3 percent.
The May 2001 China Securities Regulatory Commission rules on independent directors stipulate that the board of directors, the board of supervisors or any shareholders who separately or jointly hold 5 percent of the shares in the listed company can nominate candidates for independent directorships. In all cases the nominees must consent to being nominated. The final decision is made by a vote at the shareholders' meeting.
Compensation and incentives
Most directors are paid less than Yn50,000 a year. None of the independent directors receive more than this amount. Listed companies provide most executive directors with benefits such as a company car and a house and independent directors with allowances. Few non-executive directors receive benefits from the company. Bonuses average 24 percent of directors' annual incomes, with more for executive directors and less for independent and non-executive directors. Simple tests of the survey data failed to identify any statistically significant correlations between directors' compensation and various measures of company performance.
Non-executive shareholders hold more shares than the other three types of directors, both at IPO and subsequently, while independent directors hold the smallest amount of shares. Directors' shareholdings are increasing rapidly, with the highest increase for executive directors and a moderate increase for non-executive directors. However, this largely reflects the internal distribution of shares prior to an IPO, a practice that has recently been restricted.
This is an edited extract from Corporate Governance and Enterprise Reform in China: Building the Institutions of Modern Markets, a new book by Chunlin Zhang and Stoyan Tenev, published by the World Bank. It explores the corporate governance issues impacting companies involved in ownership diversification. Copies can be bought online at http://publications.worldbank.org