GOVERNANCE

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CORPORATE GOVERNANCE IN CHINA | SEPTEMBER 2017

CORPORATE GOVERNANCE IN CHINA Scores for Chinese companies cluster around the median relative to global peers, VIEs and SOEs have distinct governance risks

September 2017

CORPORATE GOVERNANCE SCORE

RE DISTRIBUTION

0 1 2 3 4 5 6 7 8 9 10

MSCI China Index MSCI Emerging Markets Index MSCI ACWI Index

Laggards Leaders

This report is based on the 149 constituents of the MSCI China Index as at 11 September 2017.

Some references are made to other Chinese companies in coverage.

Top 5 Scores Bottom 5 Scores

China Shenhua Energy Co Ltd 7.2/10 Alibaba Group Holdings Limited 0.0/10

China Merchants Bank Co Ltd 7.2/10

CTRIP.COM International Ltd. 1.6/10

China Telecom Corporation Ltd 7.2/10 JD.COM Inc. 2.1/10

Sun Art Retail Group Ltd 7.1/10 Netease, Inc. 2.7/10

Lenovo Group Ltd 7.1/10 Huaneng Renewables 2.8/10

CHINA IN CONTEXT

Recognition of the importance of corporate governance principles has a long history in China. China’s first corporate governance

code was introduced by the China Securities Regulatory Commission (CSRC) in 2001, ahead of many APAC peers, and updated

further in 2011. In August 2016 a review of this code was announced by the Chairman of the CSRC, and other legislative reforms

are also under review. As more and more global investors consider investing in Chinese equities, the importance of these efforts

to adopt and adhere to global standards of good corporate governance can only continue to grow. Our report examines the

many opportunities – and risks – presented by current corporate governance practices in China, based on the expectations of

these potential investors.

The expectations of global investors regarding the governance of publicly traded companies have been guided by the adoption of

corporate governance codes and standards across virtually all global markets, beginning with publication in the UK in 1992 of

“Financial Aspects of Corporate Governance”, more widely known as the “Cadbury Report”. According to Cadbury, “The

shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate

governance structure is in place,” and “The responsibilities of the board include setting the company’s strategic aims, providing

the leadership to put them into effect, supervising the management of the business and reporting to shareholders on their

stewardship. The board’s actions are subject to laws, regulations and the shareholders in general meeting.” These core principles

have been used to inform the definition of good corporate governance ever since.

Contents Variable Interest Entities

Founders Favored 2 2

State Involvement 4 Misalignment of Interests 5

Ownership Snapshot 6

https://www.google.com.hk/url?sa=i&rct=j&q=&esrc=s&source=imgres&cd=&cad=rja&uact=8&ved=0ahUKEwjq85bPn4zTAhXGVbwKHTAQAYwQjRwIBw&url=https://en.wikipedia.org/wiki/Flag_of_China&psig=AFQjCNE0iIbnvq0KRrz3R7_rO_hbFyvdzA&ust=1491444970978467

CORPORATE GOVERNANCE IN CHINA | SEPTEMBER 2017

KEY FINDINGS

 China adopted its first corporate governance code in 2001, ahead of

many APAC peers, and with updates in 2011 and 2016. As China’s market

becomes more accessible to global investors, corporate governance

practices will likely face increased comparison to global standards. This

report examines the opportunities and risks to minority shareholders

presented by current corporate governance practices in China.

 In aggregate, constituents of the MSCI China Index cluster more around the median score on corporate governance relative to constituents of the MSCI ACWI Index. Key areas of concern include pay and board issues (no independent chair, no independent board majority), controlling shareholder and related party transaction conflicts, and limited shareholder protection rights. Regulatory oversight differences between A-share (Mainland China) and H-share (Hong Kong) listings, in some cases for the same company, contribute additional layers of risk and complexity.

 Companies employing variable interest entity (VIE) structures are large

(16 companies with constituent weights on the MSCI China Index of 12%

as of 1 August 2017) and show generally strong returns. But VIE

governance structures are often tilted to favor the founder and

ownership risk is increased due to legal uncertainties.

 In contrast to private enterprises, over the past five years shareholder returns at Chinese state-owned enterprises (SOEs) have underperformed the MSCI China Index. The Chinese State has undertaken a multi-pronged reform program aimed at improving returns, but the possibility of misalignment between the strategic interests of the state and those of minority shareholders remains a key governance risk.

MARKET CHARACTERISTIC |VARIABLE

INTEREST ENTITIES

Despite being some of the largest, most discussed companies in China, four of

the bottom five governance assessments for constituents of the MSCI China

Index utilize a variable interest entity (‘VIE’) structure.

Under current Chinese legislation, foreign investors are not permitted to

invest directly in Chinese companies that operate in key industries, e.g.,

internet, education and telecommunications.

RISK – GOVERNANCE STRUCTURE FAVORS FOUNDERS

 Many VIEs retain founder involvement. Due to the nature of the

contractual relationships and the associated risks, the reputation and

equity commitment held by the founder is often key to an IPOs success.

 Founders typically use three primary tools to maintain a tight grip on

the control of the listed SPV – a dual share class structure granting them

superior voting power; incorporation in a management-friendly

jurisdiction; and dominating the board, often via the key role of

Chairman while retaining executive powers.

CORPORATE GOVERNANCE IN CHINA | SEPTEMBER 2017

CAPITAL AND OWNERSHIP STRUCTURE

Dual Share Classes with Unequal Voting Rights

Among the 12 VIEs that are founder firms, eight utilize dual class share

structures with the share class held by the founders carrying superior voting

rights. This arrangement has allowed the founders to reduce their capital

investment while maintaining control of the company. With this dual class

share structure not permitted in Hong Kong, 1 these eight companies are listed

on U.S. stock exchanges as a foreign private issuer.

Figure 1 | Disparity between Founder Ownership and Voting Rights at VIEs

Source: MSCI ESG Research. Data as at 27 July 2017

1 This approach is not viable on Hong Kong Exchanges & Clearing (HKEX) as a result of the opposition

to dual class shares by the Securities and Futures Commission in October 2015 which aborted an

earlier consultation to allow dual class shares to be listed on HKEX. In June 2017, HKEX started a

consultation with a view to allowing dual class shares on a new board

http://www.hkex.com.hk/eng/newsconsul/hkexnews/2017/170616news.htm.

DEPRIVATION OF SHAREHOLDER PROTECTION RIGHTS

The VIEs are typically incorporated in the Cayman Islands with some utilizing

the Cayman Islands ‘Exempt Companies’ provisions. Two provisions are of

particular concern – the absence of legal requirement to hold AGMs and

setting the requisition threshold for an EGM at an excessively high level. Hong

Kong Listing rules specifically require the holding of AGMs.

 Last AGM …

Two VIEs have taken advantage of the flexibility under the ‘Exempt

Companies’ regime to avoid the holding of AGMs.

Last AGM >>

Baidu

2008

JD.com

None since 2014 IPO

In their respective Articles of Association, Alibaba, Baidu and JD.com have

taken advantage of the Cayman Islands ‘Exempt Company’ provisions to

impose unusually high thresholds to request an EGM.

 EGM Threshold versus Aggregate Voting Rights of Minority Shareholders

Baidu JD.com Alibaba

EGM Threshold >> 50% 33.3% 33.3%

Aggregate Voting Rights of

Minority Shareholders > 30.8% 20.0% 45.2%*

*Those shares not held by the executive officers (10.6%), Softbank (29.2%) or Yahoo (15.0%).

Given the size of the respective controlling interests at Baidu and JD.com, the

minorities are left unable to take remedial action through convening an EGM.

At Alibaba, some 75% of minority shareholders would need to collaborate to

request an EGM, a near impossible task.

25%

50%

75%

100%

58.COM Inc

Alibaba VIPSHOP Holdings

JD.COM Baidu,Inc. YY Inc. MOMO INC

TAL Education

% of Shares Held % of Total Voting Rights Held

http://www.hkex.com.hk/eng/newsconsul/hkexnews/2017/170616news.htm

CORPORATE GOVERNANCE IN CHINA | SEPTEMBER 2017

MARKET CHARACTERISTIC | STATE

OWNERSHIP

In contrast to VIEs, which dominate the MSCI China Index in terms of

capitalization but represent a small number of companies, about 90

companies in our dataset (59.7%) are State-owned.

ORGANISATION OF STATE OWNED ENTERPRISES

In China, some 102 central state-owned enterprises (SOEs) are supervised by

the State-owned Assets Supervision & Administration Commission (SASAC).

SASAC appoints and provides training to the directors of these central SOEs. It

decides on their remuneration and sets profit targets for these SOEs. There

are also local SOEs supervised by local bureaus of SASAC in the various

different provinces/municipalities.

HOW MUCH EQUITY IS HELD BY THE STATE?

The state typically holds a majority stake (MSCI ESG Research and local

regulations both utilize 30%+ of the voting rights as the threshold for a

majority stake).

Figure 2 | Percentage of State Holdings at MSCI China Index SOEs

Source: MSCI ESG Research. Data as at 27 July 2017

Figure 3| Relationship between Chinese Government, SASAC , SOEs, Huijin and MOF

Source: MSCI ESG Research

Figure 4 | Common Control in Banking Sector

Source: Company Annual Reports.

14.6%

19.1%

33.7%

30.3%

2.2%

10 - 30% 31-50% 51 - 60% 61 - 74% 75+%

State Council of the National

Peoples' Congress

Ministries

Ministry of Finance

Financial Institutions

SASAC

Central SOEs

Subsidiaries or Departments

Local Governments

Local SASACs

Local SOEs

Subsidiaries or Departments

China Investment Corporation

Central Huijin Investment

Financial Institutions

Ministry of Finance / Central Huijin Investment Ltd

Agricultural Bank of China

Industrial & Commercial Bank

of China Bank of China Ltd

China Construction Bank

64.6% 57.3% 79.2% 69.3%

CORPORATE GOVERNANCE IN CHINA | SEPTEMBER 2017

RISK – MISALIGNMENT OF INTERESTS IN SOE FIRMS

 Shareholder returns at Chinese SOEs underperform relative to both other

MSCI ACWI Index SOEs and other MSCI China Index constituents, given

possible misalignment of interests within SOEs.

 The SOE reform program represents an effort to address this possible

misalignment in the long term. The previous 2013-14 reform initiatives

have shown limited progress to date. SASAC set three key goals for listed

SOE companies in 2017, a sign of continued focus on the SOE reform

process.

 One of the SOE reform tracks is to make boards more autonomous. In general

Chinese SOE boards include government representatives and sector

expertise, but most boards do not have a majority of independent directors,

while 75% of Chairman roles are executive positions.

2013-14 SOE REFORM INITIATIVES

Since the November 2013 third plenum of the Central Committee of the CCP,

SOE reform has been on the agenda for the Chinese government. However,

instead of wholesale financial reform, the SOE reform process has been one

of incremental changes, using the various approaches below.

One of the themes of SOE reform has been to change state control from

management of company to management of capital.

 Management of Capital: establishing state-owned capital investment and

operation companies, transferring the equities in SOEs from SASAC to these

companies.

 Mixed ownership reform, allowing non-state capital to share ownership of

SOEs together with SASAC-controlled state-owned parents, with a view to

sharing board control with non-state interests.

 Giving company boards more autonomy to make decisions, segregating party

control and management/board control under the legal framework.

 Mergers in strategic sectors including railways, telecommunications, energy

(e.g., coal and power companies), shipping and steel.

 Increasing dividend payouts by SOEs.

In our June 2015 report “China’s Economic Transformation: A New Era of ESG

Opportunity,” we highlighted that the new round of SOE reform would aim to

enhance corporate efficiency through mixed ownership and incentivized pay.

However, progress has been limited to date.

Increasing Dividend Payments

In 2014 MOF raised the ratio of profits to be handed over by SOEs to the

government. More than 120 SOEs administered by the central government

would pay 5 percentage points more of their profits.The plan divided the SOEs

into five categories that would be required to pay between zero and 25

percent of after-tax profits as a dividend to the government. 2

Figure 5 | Required Dividend Payments at SOEs

Required % of Post-Tax Profit as Dividends to the State

Applicable Companies

25% China National Tobacco Corporation

20% 14 companies, including energy companies such as China

Petrochemical Corporation and telecom carriers such as

China Mobile

15% 70 companies, including railway-related companies such as

China Railway Engineering Corporation and resources

companies such as Aluminum Corporation of China

10% 30+ firms, including nuclear energy and culture companies

Source: MOF data (www.mof.gov.cn)

2 http://www.globaltimes.cn/content/858820.shtml

http://www.mof.gov.cn/

http://www.globaltimes.cn/content/858820.shtml

CORPORATE GOVERNANCE IN CHINA

OWNERSHIP SNAPSHOT Governance risks vary widely depending on the nature of the company’s ownership, the separation of ownership and management, and the design of the capital structure

and its impact on shareholders’ voting rights.

Largest Owner Classification Key Owner Types Complex Ownership Structures Control Enhancing Structures

Concentrated ownership dominates in China,

where 81.9% of MSCI China Index constituents

include a shareholder or shareholder group,

often the State itself, who controls 30% or

more of the voting rights,

Most Chinese firms are state-owned at 59.7%,

often controlled by other state companies via

intermediate holding companies. At 26.2%,

founder firms are the next most significant

group, and many of these are VIEs (variable

interest entities, see page 3).

Few MSCI China Index constituents are

party to cross shareholdings or

positioned at levels 3 or below in a

stock pyramid, although the pyramidal

nature of many of the SOEs (state

owned entities) is noted.

Companies with unequal voting rights are

generally listed on US exchanges (variable

interest entities, see page 3). In a market where

81.9% of companies are controlled, such control

enhancing structures are not really needed, and

yet they are employed anyway.

Controlling – Largest shareholder or shareholder

group holds 30% or more of the voting rights.

Principal – Largest shareholder or shareholder

group holds between 10% and 30% of the voting

rights.

Widely Held – No shareholder or shareholder group

holds more than 10% of the voting rights.

Founder – Founder serves as Chairman or CEO

Family – Family hold 10% or more of the voting

rights and maintain at least one board seat

State – State directly or indirectly controls 10% of

the voting rights

Corporate Parent – Issuer is a subsidiary (30% or

more) of a corporate, which itself may be listed

*Owner types may overlap or separate owners may be of

different types at a company

Cross Shareholdings – Two or more

entities hold at least 0.5% of shares in each

other, or via a circular or more complex

cross-shareholding arrangement.

Pyramids – Control is exercised through a

chain of non-controlled companies, which

ultimately results in a shareholder gaining

voting power that is misaligned with their

economic interests.

Multiple Share Classes with Unequal Voting Rights (or

no voting rights for one class) or classes which carry

different rights to vote on director appointments.

Voting Rights Mechanisms include ceilings on

ownership or voting rights, voting rights limits based

on nationality, or additional voting rights accruing

depending on ownership duration.

Golden Shares – Government veto rights for

transactions or changes to governing documents.

81.9%

14.8%

3.4%

68.3%

24.2%

7.5%

37.3%

28.2%

34.5%

Controlling Principal Widely Held

MSCI China Index MSCI Emerging Markets Index MSCI ACWI Index

26.2%

16.1%

59.7%

53.7%

5.4% 10.5%

8.9% 10.4% 12.1%

18.6% 11.8%

15.1%

Founder Family State Corporate Parent

MSCI China Index

MSCI Emerging Markets Index

MSCI ACWI Index

14.1%

2.0%

7.2% 3.5%

6.3%

1.7%

Cross Shareholdings Pyramid Structure

MSCI China Index

MSCI Emerging Markets Index

MSCI ACWI Index

6.0%

0.0% 0.0% 0.0%

4.2%

9.2%

0.0% 1.2%

9.7%

16.0%

2.3% 1.8%

Multiple Share Classes w/

Unequal Voting Rights

Voting Rights Limits

Extra Voting Rights -

Ownership Duration

Golden Shares

MSCI China Index

MSCI Emerging Markets Index

MSCI ACWI Index

CORPORATE GOVERNANCE IN CHINA

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CORPORATE GOVERNANCE IN CHINA | SEPTEMBER 2017

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