The corporate straight and narrow

Proper governance is a milestone on corporate China’s road to modernised management. Its practical significance – and classic governance missteps – are broken down by vice chairman of Juneyao Medical, Hang Dongxia

AS CHINA NAVIGATES its journey of economic reform, many companies remain unfamiliar with the concept of corporate governance. For many readers engaged in this critical sphere, the immediate encounter is often characterised by a perception that corporate governance work is too difficult.

More than a century ago, Colombia University president Nicholas Butler proclaimed: “The limited liability corporation is the greatest single discovery of modern times.” But it is only with effective corporate governance that Butler’s “discovery” can continue to uphold its greatness.

Effective governance is the means for fulfilling vital functions such as power allocation, balancing interests, incentivising all parties and supervised constraint. These are the elements that enable any company to evolve, steering clear of pitfalls and structural vulnerabilities.

The perceived difficulty of embracing effective corporate governance stems not only from its paramount significance, but also from the inherent complexity of the task. Achieving it demands adept navigation of multifaceted dynamics and intricate systems.

First, corporate governance is critical. It is not only the institutional cornerstone that ensures a company’s sound operation, but it is also a focus of attention for regulators and a key area of inspection. Additionally, it serves as the foundation of rights and the source of solutions for resolving shareholder disputes and conflicts of interest.

Second, corporate governance poses great difficulties. It involves all levels of a company, from shareholders to employees and even external collaborating companies and regulators. A high degree of consensus is necessary for a harmonious corporate governance atmosphere.

Operating within the boundaries of a company’s existing framework documents, such as articles of association, corporate governance officers must consider and balance the opinions of all parties, promoting consensus on corporate decisions and opinions.

The job of a corporate governance officer places great demands on the holder’s individual capabilities. In current corporate practice, corporate governance responsibilities are generally assigned to the securities department’s board office or the legal department responsible for the routine work and implementation of specific projects.

Corporate governance entails formulating or drafting many corporate mechanisms, decision documents and meeting materials. At first glance, this might appear to be a simple task for the legal department. In practice, chief legal officers and legal departments regularly face challenges from corporate governance duties.

Documents on corporate governance must have a legal basis and link in a systematic document structure that provides a sound corporate governance system. These documents must be logical, interconnected and consistent, and conform to the system they are intended to support.

For example, a shareholders’ agreement and articles of association will necessarily have their respective content focuses. The shareholders’ agreement generally seeks to achieve a consensus among shareholders about major decisions on corporate strategy, operations, financial targets and shareholders’ rights and obligations. There will be solutions in advance for any sub-par operation of the company.

Therefore, to produce a robust shareholders’ agreement and articles of association, in-house counsel need detailed knowledge of their company’s industry and a thorough understanding of their company’s strategy. They must comprehend the shareholders’ visions and varied shareholder expectations – mere familiarity with the provisions of the Company Law is not enough.

Let’s look at the rules and procedures for the three top governance bodies: the shareholders’ meeting; the board of directors; and the supervisory board. As a broad statement, it is highly likely that an in-house counsel’s familiarity with these rules will fall below that of their familiarity with bilateral contracts, yet these rules are the main basis for the three bodies’ operation.

In reality, all these issues are addressed by rules of procedure for the three bodies. It is not an exaggeration to say that the fineness of detail of these rules determines the lower limit on the quality of corporate governance.

However, in-house counsel are not necessarily well-versed in making these rules. On the contrary, they may get bogged down in identifying a clear division between departmental powers and their one-sided habits for everyday work. It may be impossible to plan out the rules of procedure for the three bodies from the perspective of their company’s top-level design.

Furthermore, any lack of familiarity with the practical procedures of convening and holding meetings and passing resolutions can easily lead to the drafting of incoherent, illogical and impractical rules.

To duly perform corporate governance responsibilities, in-house counsel need to pay particular attention to “diligent practice and sound oversight”; that is, they need to delve deeper into the frontline business of corporate governance like strategy, meetings and systems. From this, they can then create an overarching system and rules for corporate governance from the perspective of their company’s overall structure and top heights.

In the course of actual corporate operations, an outstanding company is bound to have orderly corporate governance. Conversely, while other companies might fail for quite varied reasons, there will be a common key factor of deficient corporate governance.

There are innumerable cases of corporate governance failures leading to a failure in company operations.

Kangmei Pharmaceuticals is a typical case. Kangmei’s main corporate governance flaws were the absolute control exercised by the major shareholder over the board of directors and senior management, as well as the supervisory mechanism existing in name only. This ultimately led to financial fraud.

If financial fraud can be considered a typical manifestation of corporate governance failure, then the loss of control over a subsidiary is a relatively rare manifestation. Both Fucheng Holding and Kehua Bio-Engineering faced the embarrassment of losing control over a subsidiary they had acquired, even leading to a situation where financial statements could not be consolidated.

In recent years, the new dynamic in failures of corporate governance additionally includes issues from criminal offences and serious non-compliance by entrepreneurs. For example, there was the molestation case against Seazen Holdings’ former chairman, and the Volkswagen emissions scandal.

Once such an incident occurs, not only will the market and regulators begin to question the quality of the whole company’s corporate governance compliance, but share prices can tank in an instant.

Based on an analysis of various cases of failure of corporate governance in the market, the author’s new book, A Practical Handbook to Corporate Governance, summarises and discusses two typical scenarios: insider control; and manipulation by major shareholders. These issues frequently arise in practice. The author conducted a comprehensive analysis and elaborated on these two types of corporate failures, and proposed countermeasures.

The essence of corporate governance lies in the appropriate authorisation of various rights holders under an effective mechanism, and their execution of corporate decisions and operations within their scopes of authorisation, with such rights being subject to checks and balances.

Additionally, the process of exercising rights should be subject to scrutiny by independent third parties like independent directors and supervisors. The typical instances of corporate governance failures in the book are those where the essence of corporate governance has been violated.

In most instances, insider control manifests as senior executives within the company (who will usually be serving concurrently in such positions as director or supervisor) taking advantage of their day-to-day management roles while also being able to make major decisions to bar shareholders and other outsiders from information, and suppressing internal scrutiny, making them subordinate to, or even complicit with, the senior executives.

These senior executives have de facto control over the company and resolutions express only their views, often accompanied by the transformation of company interests into unlawful personal gain.

Under such a circumstance, if decisions of the shareholders’ meeting conflict with the interests of the senior executives, they will not be executed. The shareholders completely lose their forum to exercise their rights by way of the shareholders’ meeting and the board of directors. In this scenario, the shareholders are ultimately reduced to being bag holders who carry the loss for those senior executives that exercise insider control as they hollow out the company.

Manipulation by a major shareholder is another commonly seen instance of failure of corporate governance. The major shareholder utilises its controlling position to control all decision-making procedures and the matters to be implemented, including those relating to personnel, finances and material.

Under such a circumstance, the mutual constraint and scrutiny mechanisms in the corporate governance regime cease to exist, and the illegal passing of resolutions, non-compliant connected transactions, illegal appropriation of funds, and illegal provision of security for third parties become common manipulative practices.