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Chinese Corporate Governance Improved by Passage of Legislation and Adoption of a Code

By Jim Hamilton

The corporate governance of Chinese public companies has improved dramatically since the passage of the Company Law of 2006 and the Securities Law of 2006 and the adoption of a Code of Corporate Governance based on the legislation, according to an OECD report. Chinese corporate governance is characterized by the increasing reliance on independent directors and a strong role for independent audit and compensation committees.

The Company Law and the Securities Law provide the foundation for drawing up and developing a corporate governance framework in China. The Company Law improved companies? governance structure and mechanisms to protect lawful shareholders' rights and public interests. It highlighted the legal obligations and duties of those in actual control of the company, such as the directors and senior management. It improved companies' financial accounting systems, internal controls, and the systems governing corporate mergers, divisions and liquidation.

The Securities Law improved the system governing the issuance, trading, registration and settlement of securities and provided for the establishment of multi-tiered capital-market architecture. It improved the supervision of listed companies and increased the legal responsibilities of the controlling shareholders or those actually in control, namely the directors, supervisors and senior management of listed companies. The Securities Law strengthened investor protection, especially for minority investors, established a securities investor protection fund, and defined the system of civil responsibility to compensate for damages to investors.

The Code of Corporate Governance was drawn up in line with the basic principles established by the Company Law and Securities Law. The Code governs shareholders and shareholders? meetings, listed companies and controlling shareholders, directors and board of directors, and information disclosure and transparency. The Code comprises the main measurement criteria used to judge whether a listed company has a sound corporate governance structure.

The Code provides that independent directors must account for more than one-third of the board in a listed company. Independent directors must be independent of their employer and the company?s main shareholders. Independent directors must hold no other position but that of independent director. In China, an independent director may in principle serve on the board of at most five listed companies as an independent director.

An independent director has a fiduciary obligation and an obligation of diligence toward the company and all of its shareholders. Independent directors must perform their duties without interference from the main shareholders or actual controllers, or other entities or individuals that have a material interest in the company.

The Code says that a company?s board may set up special committees on audit, compensation and nomination, with independent directors making up more than half of the committee member. In audit committees, at least one independent director should have an accounting background. Each special committee may engage intermediaries to provide professional opinions, with expenses paid by the company.

The Code of Corporate Governance provides that the main duties of the compensation committee are studying the appraisal standard for directors and managers, conducting appraisals, and making recommendations, as well as reviewing the company?s compensation policies. The main duties of the audit committee are engaging the company?s outside auditor, overseeing internal audit and the interaction between internal and external audit, inspecting the company?s financial information and its disclosure; and monitoring the company?s internal control system.
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The Company Law requires directors to comply with the duties of loyalty and care. Under the duty of care, directors must not divert, misappropriate or lend the company?s capital, or serve as guarantors of the company?s capital. They must not misappropriate the company?s funds or deposit the company?s assets in their own personal accounts. They must not take advantage of their positions or seek for themselves or others a commercial opportunity that should fall to the company.

The Code of Corporate Governance stipulates that a listed company must establish fair and transparent standards and procedures for the assessment of the performance of directors and executives. The evaluation of the directors and executives must be conducted by the board of directors or by its compensation committee. The evaluation of the performance of independent directors must be conducted through a combination of self-review and peer review.

In addition, the Code requires a company to establish an incentive mechanism linking executive compensation with the company?s performance and the individuals' performance. The performance assessment of management must become a basis for determining the compensation and other pay and bonus arrangements for the person reviewed. Executive compensation is subject to approval by the board of directors, and must be disclosed and explained at the shareholders? meeting.

There are aspects to China's institutional framework for the equitable treatment of shareholders. First, the regime ensures shareholders' equitable participation in corporate governance through equal voting power, low-cost participation in corporate governance by shareholders, cumulative voting rights and the right to make proposals. The Company Law provides that shareholders individually or jointly holding 3 percent of the shares of the company may, ten days prior to the general meeting, submit a temporary written proposal to the board of directors. The board must, within two days of receiving the proposal, inform other shareholders and submit the proposal to the general meeting of shareholders for deliberation.

Full post as published by Jim Hamilton's World of Securities Regulation on January 31, 2011 (boomark / email).