How China’s corporate governance framework is different than the US

– China’s governance differences start with nearly company has a controlling shareholder. Ownership is not as diffuse as it is in the US.
– Controlling shareholders can easily abuse minority shareholders, including engaging in related-party transactions.

I once met with representatives of China’s SEC – and quickly found out that they had trouble understanding the concept of what is an “independent director.” That’s because I was ignorant about how ownership of Chinese companies is so different compared to those in the US. This excerpt from this article about China’s “horizontal agency” explains:

In China, the main agency problem is the conflict of interest between large shareholders and minority shareholders. Because this agency problem is among shareholders, we can call this a “horizontal” agency problem, which is unlike the “vertical” agency problem that can exist between shareholders and managers in Western countries and in other developed nations.

The main reason why the agency problems are different between Western firms and Chinese firms is because unlike in the West, pretty much every Chinese listed-firm has a very large shareholder. On average a Chinese listed-firm’s largest shareholder owns at least 30% of the firm. In the West, ownership is largely diffuse, and so managers control the firms. However, in China, the large shareholders control their firms.

In China, the horizontal agency problem is quite significant. Throughout the 1990s and early part of the 2000s, controlling shareholders of listed-firms would simply take money from the firm. They claimed that these were “intercorporate loans,” but these loans were interest-free and almost never paid back. On the balance sheets, they were booked as “other receivables.” This outright theft from minority shareholders was not a trivial amount. On average, other receivables accounted for almost 10% of the firm’s total assets. Chinese securities regulators came down hard on this practice, and now it is essentially eradicated. However, as long as there are large shareholders, the horizontal agency problem will continue to exist.

For example, controlling shareholders can engage in related party transactions with the firm on favorable terms. An example would be the firm buying an asset from the shareholder at a high price. Note that this form of expropriation from minority shareholders is almost impossible to detect. Therefore, this gives rise to the crucial question of how China is dealing with this agency problem.