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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.

Hang Dongxia
Hang Dongxia

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.

Usually, articles of association set out only general principles for these three bodies, and cannot effectively address the actual operating scenarios. Articles of association are often unable to answer questions like:

  • What advance notice should be given of a shareholders’ meeting?
  • What are the authorisation document requirements for appointing a proxy to attend a board meeting?
  • How are resolutions issued for online shareholders meetings?
  • What is the specific submission procedure for an extemporaneous motion by a shareholder or director?
  • Can a shareholder resolution be amended, withdrawn or added to within a specific period?
  • What is to be done if an independent director’s opinion to a special board committee is not consistent with his or her opinion expressed at a full board meeting?
  • What is the specific procedure for electing a new board of directors?
  • How are resolutions of shareholders and the board of directors transformed into key tasks and assessment factors for senior management?

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.

Quote 1 The corporate straight and narrow

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.

The most extreme version of a failure of corporate governance is the frequently seen internal “civil wars” triggered by a corporate control conflict among shareholders. For example:

  • Conflict between new and old boards of Xinchao Energy
  • Seizure of official seal and business licence by senior executives of Transtrue

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.

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