Li Yang, Vice-President of Overseas Chinese Town (Asia) Holdings Ltd, looks at the governance implications of China’s mixed-ownership reform drive.

Mixed-ownership reform �� the attempt to encourage a more diversified ownership of China’sstate-owned enterprises (SOEs) �� is a key feature of the current round of reforms for China’sSOEs. With the support of national and local policy measures, the implementation of mixed-ownership reform has been generally smooth, but the results are yet to be seen. In 2016, total operating income and profits of all SOEs had a year-on-year growth of 2.6% and 1.7% respectively, while total tax paid reduced by 0.7% over the year before. Year-on-year growth in non-governmental fixed assets investment was 3.2%, representing a decline of about seven percentage points. The low effectiveness of SOEs and the lack of strength of non-governmental investment show that mixed-ownership reform has not so far been effective in invigorating SOEs and attracting social capital, because the emphasis has been on reforming ownership structures rather than building the governance structures and capabilities needed.

The ownership dispute of China Vanke Co Ltd, that started in the second half of 2015 was essentially a conflict between the modern governance structure of �泟upervision by owners and governing by managers�� and the classical governance mechanism of �焝ontrol by major shareholders��. The incident is significant in that it reveals the many uncertainties and difficulties in the process of mixed-ownership reform. The governance structure of the company formed over the years, under which �勇he major shareholders supervise but do not operate and the managers govern but do not control��, effectively stimulated the entrepreneurship of the management and achieved for all shareholders a return much higher than the market average, making it a widely recognised model in its sector. The roles of the key parties in corporate governance, namely the major shareholder (that is the SOE), independent directors and the management, were highlighted by this incident and became a subject of debate.

The fundamental objective of the reform of SOEs is to remove structural obstructions to the development of the enterprises. A possible way to achieve this objective is to pursue mixed-ownership reform, but the success of mixed-ownership reform relies on the establishment of a modern governance structure of �泟upervision by owners and governing by managers��. To reform the governance structure, the powers, responsibilities and inter-relationship between the various parties in corporate governance must first be clearly defined. Only by taking this step-by-step approach can the reform objective be achieved.

Highly diversified ownership structure is characteristic of modern governance

Currently, major shareholders hold 39.5%, 43.7% and 48.9% of the share capital of state controlled A-share, H-share and red chip listed companies respectively. In comparison, the largest shareholders of the constituent stocks of the Dow Jones Industrial Average account for only 7% of the shareholding of the companies on average. This dominance of the major shareholder is contrary to the intention of mixed-ownership reform and is against the global trend of development in corporate governance. The situation should be changed through mixed-ownership reform in the following aspects.

1. The proportion of mixed ownership should be refined. Priority should be given to social capital, in particular non-governmental capital and foreign capital, to complement state capital. The cross ownership between SOEs should focus on whether governing efficiency could be promoted after the mix. In particular, in those enterprises categorised as �𦿞ommercial I Class��, state-ownership can be reduced to below 50% or 30%, and control by non-state-owned capital should be allowed.

2. Restrict trading of shares by major shareholders. Trading of shares by major shareholders should be restricted. The threshold and cost of trading should be raised through more stringent information disclosure requirements, extended completion time, and restricting the volume per transaction and cumulative volume of transactions. The incentive for major shareholders to control the companies should be reduced by strengthening the vote-abstention system of connected shareholders, setting up different shareholding classes and introducing differential voting rights. Shareholding distribution of a listed company can be improved through regulatory means, such as by reducing the shareholding ratio of financial institutional investors and levying estate duty.

3. Establish a mechanism for custodians to vote as proxies. To raise the voting rate, custodians should be allowed and encouraged to proactively exercise their voting rights, provided that they have fully explained the motion to shareholders before voting and have not received contrary instructions.

4. Enhance legislative protections. Legislation to protect public and private property rights and minority shareholders should be enhanced so as to give assurance to various parties participating in mixed-ownership reform.

Independence of independent directors assures the effectiveness of corporate governance

With the prevalence of major shareholder control, independent directors in state-owned listed companies account for merely one-third of the number of directors on the board, barely meeting the statutory minimum requirement. Meanwhile, in US companies, this proportion is as high as 66%. The minority of independent directors is a serious mismatch with the majority public shareholders they represent. Furthermore, other procedures and safeguards are not sufficient to ensure the independence of independent directors, making it difficult for them to function properly. It is proposed that attention be paid to the following aspects during mixed-ownership reforms.

1. Refine the selection and appointment system. The existing requirements of �𤑛t least one-third of the members of the board of directors of a listed company should be independent directors�� and �泟hareholders who individually or jointly hold 1% or more of the issued share capital of a listed company can nominate an independent director�� should be amended to require the proportion of independent directors to be not less than 50%, or not less than the proportion of public shareholding. The right to nominate independent directors should be conferred on a nomination committee made up of a majority of independent directors, or on minority shareholders who elect independent directors through classified voting arrangements. Other possible reform measures include reducing the shareholding requirement for shareholders qualified to nominate an independent director, restricting the number of independent directors that a controlling shareholder can nominate, establishing a system of convener of independent directors, and refining the closed-door meeting mechanism of independent directors.

2. Improve the remuneration system. It is suggested that the standard of remuneration of independent directors across the market be determined by a national self-regulatory organisation (for example the China Association for Public Companies). The remuneration package for independent directors of individual companies should be determined by the remuneration committee of the company and paid out of the membership fees
paid by listed companies to the self-regulatory organisation.

3. Safeguard independent directors�� performance of duties. The exercise of independent directors�� functions should be safeguarded through the establishment and improvement of detailed information disclosure requirements, immunity from prosecution, investigation of interference with voting by independent directors, etc. Independent directors should be encouraged to disclose matters that would harm the interests of minority shareholders and to express independent views without fear.

Reforming the supervisory board system

Redefining the functions of the board of supervisors is necessary in line with governance trends. The system of the board of supervisors had its origin in the two-tier governance structure of German companies. The original intention was to put in place effective supervision of the board of directors and the managers and protect the interests of all shareholders. In practice, however, the board of supervisors, like the board of directors, is basically controlled by the major shareholder, and there are many overlaps in its functions with those of the independent directors. Its position is getting less clear.
Stakeholders of modern enterprises have expanded from only shareholders to include employees, community, clients, working partners, creditors and so on. With the development of mixed-ownership reform, it is proposed that the composition of the board of supervisors be redefined to establish a new system of board of supervisors oriented towards the needs of stakeholders so as to fulfil a unique supervisory role to serve the interests of both the enterprise and the community.

Reforming the professional manager system

The professional manager system is core to the smooth operation of corporate governance mechanisms. The practice of modern corporate governance is based upon the principal-agent theory. The governance structure of �泟upervision by owners and governing by managers�� typical of large US listed companies is superior to the structure of �焝ontrol by major shareholders��. It can effectively reduce information asymmetry and reduce agency cost. �𡜺overning by managers�� has to be supported by a large team of professional managers. Only with this support can the agency relationship between the owner and the operator be clearly defined. Over the years, the dysfunction of the professional manager system has been the crucial reason for many deep-rooted problems in the corporate governance of SOEs, and should be a core problem to be resolved in this round of mixed-ownership reform.

1. Establish a system to select and appoint professional managers suitable for mixed ownership. The board of mixed-ownership enterprises should select and appoint managers by the rules of the market, fully drawing reference from the successful experience and rigorous criteria of the party-managing-cadres mechanism. A market-oriented assessment and evaluation system should be adopted, and the source of talent and room for development of talent should be expanded. A modern culture of professional managers should be built, promoting the interchangeability of roles and results orientation.

2. Establish a market-oriented incentive and restraint system. A remuneration system that differentiates managers by their performance should be set up, and long-term incentives should be actively explored, such as employee stock ownership plans, project co-investment schemes, stock incentives, increasing shareholdings in the secondary market, etc. A partnership system should be established to bundle the personal objectives of managers with the common interests of the entire body of shareholders.

3. Enhance external supervision. A credibility record system of managers, a lifelong system of accountability where necessary, and a class action
and derivative action system for shareholders should be set up. This is to strengthen external monitoring to prevent governing by managers from developing into insider control.

4. The roles and functions of the board secretary should be redefined. With the development of mixed-ownership reform, corporate governance is moving from the shareholder-centric mode to a mode that caters to the interests of diverse stakeholders. As the pivot of corporate governance, board secretaries are facing great changes in the working environment and an ever-rising expectation of performance. With a more diversified shareholding structure, it will be necessary to grasp the core concern of different groups of shareholders and ensure adequate communication and reporting. The governance structure should be reviewed from time to time, effective communication among the shareholders, directors, supervisors and managers should be maintained, and reforms in management culture should be pursued as necessary. In the context of diverse stakeholders, board secretaries should be familiar with their different languages and communication channels, and enhance their communication skills and ability to handle contingencies. In face of hostile takeovers, board secretaries should consolidate their knowledge of policies and rules, keep abreast of market changes and public opinion, assist the board and the management to work in compliance with laws and regulations, and uphold the overall interests of all shareholders.

The author sincerely thanks Professor Oliver Hart and Professor Hua Sheng for their research and views referenced in this article.

Li Yang, Vice-President
Overseas Chinese Town (Asia) Holdings Ltd






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