(By Donald C. Clarke) 

INTRODUCTION

Corporate governance (gongsi zhili) is a concept whose time seems definitely to have come in China. Chinese definitions of corporate governance in the abstract tend to cover the system regulating relationships among all parties with interests in a business organization, usually spelling out shareholders as a particularly important group. But Chinese corporate governance discourse in practice focuses almost exclusively on agency problems, and within only two types of firms: state-owned enterprises (SOEs), particularly after their transformation into one of the corporate forms provided for under the Company Law, and listed companies, which must be companies limited by shares (CLS) under the Company Law. This article discusses Chinese corporate governance in this narrow sense, and attempts to explain some perplexing features of its discourse, laws, and institutions (abbreviated hereinafter as “corporate governance laws and institutions” or CGLI).

A fundamental dilemma of Chinese CGLI stems from the state policy of maintaining a full or controlling ownership interest in enterprises in several sectors. The state wants the enterprises it owns to be run efficiently, but not solely for the purpose of wealth maximization. If the state owned simply for the purpose of maximizing the economic value of its holdings, there would be no need for a policy mandating state ownership of enterprises. If the enterprise would be worth more managed by another,  the state should seek a share of that increased value by selling.

A policy of wealth maximization for the state requires simply that the state acquire, maintain, or relinquish control according to whatever will realize the most wealth for the state. Because the Chinese government clearly does not have such a policy, it follows that a necessary element of state control of an enterprise must be the use of that control for purposes other than the maximization of its wealth as a shareholder — purposes such as the maintenance of urban employment levels, direct control over sensitive industries, or politically-motivated job placement. This in turn creates several problems. First, many of these goals are not easily measured and there is no obvious way of balancing them one against the other. This creates monitoring difficulties. Second, the policy of continued state involvement sets up a conflict of interest between the state as controlling shareholder and other shareholders. In using its control for purposes other than value maximization, the state exploits minority shareholders who have no other way to benefit from their investment.

The major theme of this article is that the state wants to make SOEs operate more efficiently by subjecting them to a new and different set of rules — the rules of organization under the “modern enterprise system”. This is what the policy of corporatization is chiefly about. Policymakers then find, however, that they must change and adjust the rules to take account of continuing state ownership. Moreover, the need to provide for the special circumstances of state-sector enterprises ends up hijacking the entire Company Law, so that instead of state-sector enterprises being made more efficient by being forced to follow the rules for private-sector enterprises (the original ambition), potential private-sector enterprises are hamstrung by having to follow rules that make sense only in a heavily state-invested economy. 

Finally, corporate governance is about more than simply getting the rules right. The necessary supporting institutions must be present as well. Yet as I will argue, their existence in China cannot always be taken for granted.

BACKGROUND TO CHINESE CGLI REFORM

Chinese CGLI reform, and the Company Law that is a part of it, is designed primarily to address problems within the state sector, in particular the problem of the reform of traditional SOEs (TSOEs). The need of non-state actors for a convenient form in which to conduct business occupies a very low priority in the minds of state policymakers, and the Company Law is thus clearly concerned more with regulating and suppressing than with fostering and nurturing. Indeed, it would be anomalous were it otherwise. There is a deep-rooted official suspicion of accumulations of wealth not controlled by the state or its officials, coupled with the suspicion of any organized activity not firmly under state leadership. A government that bans unauthorized fishing clubs and associations for the study of antique furniture and paper-cutting is unlikely to welcome the unbridled blossoming of organizations whose purpose is to make real money.

The TSOE is not simply another name for a corporation such as Air France that happens to be wholly owned by the state. Instead, it can be analogized for economic purposes to a cost center or a division within the loosely organized firm of China, Inc. There was no formal law governing industrial TSOEs until 1988, and there is still no formal law governing commercial TSOEs. There was never any need. The things that an organizational statute does — for example, the regulation of relations among creditors, investors, and managers — were simply handled through internal state administrative procedures, since all three were state bodies or state employees. For the purposes of this article it is essential to distinguish TSOEs as defined here — state-owned enterprises as they existed under the planned economy — from enterprises organized under the Company Law that happen to be wholly state-owned or controlled by the state, even though such enterprises are commonly called “state-owned”. A crucial element of thinking about enterprise law and the Company Law in particular is that there are important differences between the two ways of structuring state-owned enterprises. Current policy respecting TSOEs is essentially to abolish the form by corporatizing them, i.e., converting them into some form of company governed by the Company Law: (a) a CLS, the approximate equivalent of the large stock corporation in Western countries, (b) a limited liability company (LLC),  intended for a much smaller and more closely-knit group of investors, or (c) a wholly state-owned limited liability company (WSOLLC), a special type of LLC that may be wholly owned by a state agency. This process, which does not necessarily involve privatization it all depends on who owns the shares in the converted company — is already well under way.

The corporatization policy has many purposes. They include the raising of equity capital for SOEs following conversion to the corporate form, the expansion of state control in some sectors through leverage, and the improvement of the management of state assets through the implementation of a new organizational form. A secondary consideration in passing the Company Law was also the promotion of growth in the non-state sector via the provision of a new organizational form. Some of these purposes are discussed below in more detail. A final point to note about CGLI reforms is that despite talk of the state withdrawing from the economy, it is firmly committed to retaining control over enterprises in several sectors: national security-related industries, natural monopolies, sectors providing important goods and services to the public, and important enterprises in pillar industries and the high-technology sector. Indeed, part of enterprise reform involves a magnification of the scope of direct state control through leverage. In the traditional economic system, the state (through one or more of its agencies) was the sole owner of a TSOE and exercised full control over it. Corporatization, through the institution of divisible equity shares, allows non-state investors to contribute to the enterprise without, while they remain in a minority, sharing in control. The state maintains the same level of control it had before, but now over a larger pool of assets.

PURPOSES OF CORPORATIZATION: IMPROVED MANAGEMENT THROUGH RESTRUCTURING While corporatization has many purposes, the chief one is the promotion of higher efficiency through better management. Corporatization is intended to address through structural reform three features of the traditional system of state ownership that are blamed for the inefficiency of that sector. First, commentators criticize the supposed unity of ownership and control in the hands of the state under the old system, with the resultant imposition of non-profit-maximizing objectives on enterprise managers through “bureaucratic interference”. Second, they point to the problem of conflicting objectives from multiple state agencies with authority over the enterprise. Third, they point to the absence of an effective ultimate principal with an interest in, and ability to, police managers and ensure efficient operations. I discuss these in order below. Ownership and Control and “Bureaucratic Interferenc” in the Traditional System It is often said that the corporate form, through its separation of ownership (in the hands of shareholders) from control (in the hands of management) will be a cure for the ills of the TSOE, which are diagnosed as stemming from the unity of ownership and control (in the hands of the state). Commentators paint a picture of harried managers trying to run a business subject to constant bureaucratic interference from the government agency in charge of the enterprise and told to meet various and conflicting goals. Corporatization is supposed to separate state ownership from state control, and thereby free managers from such interference so that they can pursue efficient and profitable operations.

But both the diagnosis and the solution are fundamentally flawed. The solution is flawed because it assumes that the goal of the state owner in the new system is profits. The policy of corporatization does not involve a renunciation by the state of its ambition to remain the direct owner of enterprises in a number of sectors, and this ambition makes no sense if profits are the only objective. The diagnosis is flawed because in the old system, ownership and control were just as separate as they are in the new, because the state is an abstract collectivity and not a person. Although perhaps it could meaningfully be said to own, it must necessarily operate through human agents. State-owned enterprises were thus always controlled, both at the enterprise level and at the level of the administrative body in charge of them, by human beings who did not own the enterprise. Devolving more power to enterprise managers or corporatizing TSOEs does not change this in the slightest.

Since the unity of ownership and control was never the problem, it follows that the separation of ownership from control cannot be the solution. Yet much Chinese commentary continues to view the separation of ownership from control not as a regrettable concomitant of the division of labor between suppliers and managers of capital (Berle & Means, 1968 [1932]), but as a positive good to be pursued for its own sake because it appears to be a necessary feature of the “modern enterprise system”. Far from fearing the Berle and Means model of the corporation, in which shareholders are widely dispersed and unable to exercise any meaningful control, reform-minded commentators have seemed to welcome it. Indeed, concentrated shareholding is viewed by many as almost a perversion of the ideal of widely dispersed shareholding. Yet calls for government-owned enterprises to be independent of government “interference” are calls for nothing short of utter non-accountability for management. Given that the assets were contributed to the enterprise by a government agency — certainly not by the managers — it seems reasonable for the agency to have some say in how the assets are used. The issue, of course, is what kind of targets the agency sets for the manager, and how it evaluates his or her performance. But that is a reason to propose changes in how the state manages its agents, not to cease managing them entirely.

Multiple Objectives

The problem of multiple objectives is certainly a real one. As a complex organization of human beings organized into various subgroups, all with their own objectives, the state does not, and arguably cannot, produce a single, consistent set of targets for its agents to maximize. Moreover, control over SOEs in the traditional system was often divided among multiple agencies — one or more for labor, management, production targets, inputs, etc. — none of which had to internalize the costs of the decisions of the other. Thus, it was difficult for anyone, had they been so inclined, to make and enforce a trade-off among competing objectives.

Even where there is a single monitoring body, that body may itself have several objectives.While profit maximization is a relatively straightforward index against which to measure the performance of managers, non-economic goals such as the preservation of an industry for national security purposes are much more difficult to measure, and hence to monitor for. The monitoring agency may not even know itself how the costs and benefits of achieving different state objectives should be measured and traded off against each other, and thus can hardly be an effective monitor of managers charged with achieving those objectives.

Corporatization is explicitly intended to solve the problem of multiple controllers with multiple objectives. First, the interests of the various state agencies involved in the enterprises are reduced to a common denominator — equity — and quantified. Second, the new shareholders have only a single way in which to voice their interests — shareholder voting — in which the majority rules, thus eliminating conflicting goals. Third, despite their conflicting interests, the new shareholders now also have a common interest: distributable profits. Thus, diversification of the shareholder base, even where share ownership is not private, is intended to result in a stronger focus on the single target of profitability. The theory has much to commend it. In practice, however, a large number of corporatized SOEs remain dominated by a single state shareholder that exercises its control either through formal channels, such as shareholder voting, or through traditional channels, such as the acknowledged authority of the Communist Party’s organizational department over personnel appointments in key state-owned and state-controlled enterprises, whether or not corporatized and listed on the stock market.

Absence of Effective Ultimate Principal

Many analysts of the monitoring problem in the state sector point to the absence of an ultimate principal as a key problem. According to this analysis, an agent of the state monitors the enterprise managers, and another agent must monitor the monitor, but no matter how far up the chain of monitors we go, we never run into an ultimate principal — or to be more accurate, the ultimate theoretical principal in the case of state ownership, the citizenry of China, is far too dispersed and powerless to play any real role. As a result, effective monitoring cannot take place because there is nobody in the chain of monitors with the appropriate incentives; nobody who is entitled to the increase in asset value that effective monitoring would bring about.

Corporatization is intended to replace a pliant and negligent state owner with profit-seeking shareholders that will monitor management more effectively. But was state ownership per se ever the problem? Certainly the current structure can be blamed for many problems. Even if the state as principal had mutually consistent and easily measurable goals, its agents — the monitors of the enterprise managers — might not monitor well for those goals. Actual supervision and monitoring is carried out by local officials who are appointed and salaried by local government. Even if those officials perfectly represented the interests of their principal, local government’s interests can often conflict with those of the center. And in practice, of course, the effectiveness of local officials’monitoring is compromised both by their incentives to shirk and in many cases by their simple lack of skills to understand which actions would increase or decrease enterprise value.

Yet while the lack of an ultimate human owner can be a source of considerable agency costs, these costs need not be crippling. There are many successfully functioning institutions such as non-profit organizations or industrial foundations that lack an ultimate human owner at the top of a chain of monitors capable of claiming residual earnings, and there are even more — governments and pension funds, for example — that function with an ultimate human “owner” so distant as to be absent for all practical purposes. Thus, although the absence of an ultimate owner — i.e., a human being with both control over the agent below him or her and a right to the residual — is an obstacle to efficient monitoring, it is not an insuperable one or the greatest one. It is hard, therefore, to see why state employees should be inherently incapable of monitoring effectively, given the right targets, skills, and incentives. The problem with state monitoring is far more likely to be found in the lack of these elements, not in the lack of an ultimate human principal. Whatever the importance of a human monitor at the top of the chain, corporatization as currently practiced will not bring it about. When TSOEs are corporatized and share interests allocated or sold, the new shareholders are, for the most part, either state agencies or other entities that are owned, directly or indirectly, by the state. This is true whether or not such companies are listed on China’s stock markets. Such entities may well be structured with the intention that they be profit-seeking, but if they are in fact able to pursue profits effectively, that would only show that private ownership was not necessary in the first place. No amount of restructuring can eliminate the cost of the absent principal if state ownership is retained, since the latter necessarily entails the former.

(Edited by: China West Lawyer)