Venture Capital and the Corporate Governance of Chinese Listed Companies

Venture Capital and the Corporate Governance of Chinese Listed Companies

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Lin Zhang

Venture Capital and the Corporate Governance of Chinese Listed Companies

Lin Zhang College of Humanities and Law Shandong University of Science and Technology Qingdao, Shandong, China [email protected]

ISBN 978-1-4614-1280-9 e-ISBN 978-1-4614-1281-6 DOI 10.1007/978-1-4614-1281-6 Springer New York Dordrecht Heidelberg London Library of Congress Control Number: 2011936298 © Springer Science+Business Media, LLC 2012 All rights reserved. This work may not be translated or copied in whole or in part without the written permission of the publisher (Springer Science+Business Media, LLC, 233 Spring Street, New York, NY 10013, USA), except for brief excerpts in connection with reviews or scholarly analysis. Use in connection with any form of information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed is forbidden. The use in this publication of trade names, trademarks, service marks, and similar terms, even if they are not identified as such, is not to be taken as an expression of opinion as to whether or not they are subject to proprietary rights. Printed on acid-free paper Springer is part of Springer Science+Business Media (www.springer.com)

Preface

State-controlled listed companies have always dominated Chinese stock markets. As a result of the rampant scandals related to them, there have been voluminous academic efforts to explore their corporate governance, underpinned by agency costs. However, the attempt to examine it from the perspective of venture capital and adaptive efficiency is still absent. Therefore, this is the research gap filled by this dissertation. During the last 10 years, China has made remarkable progress in the development of its venture capital market. However, the striking expansion of China’s venture capital market cannot cover the embarrassing fact that Chinese domestic venture capital has been marginalized by American competitors. Given the different performance between them, this book hypothesizes that the corporate governance system of Chinese state-controlled listed companies has hampered the presence or the full functioning of the institutional factors which are responsible for the prosperity of American venture capital in Chinese domestic venture capital. With the practice of American venture capital as the mirror, this book empirically demonstrates that Chinese domestic venture capital lacks the four factors related to the success of their American counterparts – large and independent funding, application of incentive mechanisms, efficient exit channels and high-risk tolerance level. More importantly, these defects as a whole are closely linked to the corporate governance of state-controlled listed companies. The findings that the corporate governance of Chinese state-controlled listed companies imposes negative effects on the healthy development of Chinese domestic venture capital and in turn the increase of adaptive efficiency of Chinese society tell us that the efficient proposal for the improvement of the corporate governance of Chinese state-controlled listed companies must harmonize agency costs and adaptive efficiency. Qingdao, Shandong, China

Lin Zhang

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Contents

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An Introduction to Adaptive Efficiency and Corporate Governance ..................................................................... The Status Quo of Corporate Governance of Chinese Listed Companies ..................................................................................... 2.1 Introduction ....................................................................................... 2.2 A Historical Perspective: The State-Owned Enterprises .................. 2.2.1 Traditional Model (1950–1984)............................................ 2.2.2 Transitional Model (1984–1993) .......................................... 2.3 Modern Corporate Model (1993 to Present): A Substantial Transformation of SOEs? ........................................... 2.3.1 The Shareholder Meeting ..................................................... 2.3.2 The Board of Directors ......................................................... 2.3.3 The Supervisory Committee ................................................. 2.4 Conclusion ........................................................................................ The Difficulty of Fundraising Suffered by Chinese Domestic VCs........................................................................ 3.1 Introduction ....................................................................................... 3.2 The Profile of the Fundraising of American VCs ............................. 3.3 The Reflection of Chinese Domestic VCs’ Fundraising in the American Mirror ..................................................................... 3.3.1 The Absence of Pension Funds from Their Real Involvement in the Chinese VC Market ............................... 3.3.2 The Lack of Independence of Venture Capitalists in GVCs ................................................................................ 3.4 Conclusion ........................................................................................ The Underdevelopment of Incentives in the Operation of Chinese Domestic VCs......................................................................... 4.1 Introduction ....................................................................................... 4.2 The Answers Provided by the American Model ...............................

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The Underdevelopment of Incentive Mechanisms in Chinese Domestic VCs: The Shadow of the Control-Based Model ............... 4.3.1 Limited Partnership............................................................... 4.3.2 Staged Financing and Board Representation ........................ 4.3.3 Convertible Preferred Stocks ................................................ 4.3.4 Stock Options........................................................................ Conclusion ........................................................................................

The Lack of Efficient Exit Channels for Chinese Domestic VCs ........................................................................................... 5.1 Introduction ....................................................................................... 5.2 The Availability of Tailor-Made Stock Markets to American VCs............................................................................... 5.3 The Exit of Chinese Domestic VCs Through Chinese Domestic Stock Markets: An Uneven Road ..................................... 5.3.1 Main Boards.......................................................................... 5.3.2 The SME Board .................................................................... 5.3.3 The GEM .............................................................................. 5.4 Conclusion ........................................................................................ The Lower Level of Risk Tolerance of Chinese Domestic Venture Capitalists ................................................................................... 6.1 Introduction ....................................................................................... 6.2 The Comparison of Risk Tolerance: Findings from Empirical Studies ..................................................................... 6.3 The Lower Risk Tolerance of Chinese Domestic Venture Capitalists: What the Control-Based Model Explains ......... 6.3.1 Risk Absorption and Incentive Inadequacy: The Reflection of Parentalism............................................... 6.3.2 Severe Funding Shortage: An Old Problem.......................... 6.4 Conclusion ........................................................................................

60 60 65 65 68 71 73 73 76 80 80 83 87 88 89 89 90 96 96 103 104

Conclusion ................................................................................................ 7.1 Chinese Political Reform: The Establishment of a Public Servant Government ....................................................... 7.2 The Reform of Corporate Governance: Divesting State-Owned Shares.......................................................... 7.3 The Harmonization Principle: Agency Costs and Adaptive Efficiency .................................................................... 7.4 The Prospect of the Two Reform Missions: Political Entrepreneurs Versus Path Dependence .............................

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Bibliography ...................................................................................................

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Index ................................................................................................................

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Chapter 1

An Introduction to Adaptive Efficiency and Corporate Governance

The issue of corporate governance has gained unprecedented attention in the international community after the ravages of the Asian financial crisis. In recent years, laying down the more sophisticated governance guidelines has become a vibrant campaign with the favour and participation of various interested groups: academics, media, regulatory authorities, legislatures, companies, institutional investors, international organizations, intermediaries, etc.1 For instance, the government of South Korea has taken a series of steps to reform the corporate governance of Chaebol since 1998.2 The Organization of Economic Cooperation and Development (OECD) also released “OECD Principles of Corporate Governance” in 1999 in order to provide member and non-member countries with specific guidelines to improve the legal, institutional and regulatory frameworks that underpin corporate governance.3 In addition, intermediaries, such as McKinsey & Company, are also urging the overhaul of corporate governance in emerging and transitional economies.4 Given the ongoing lacklustre performance of its state-owned enterprises (SOEs) and the substantial competition from its entry into the World Trade Organization

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Bai C-E, Liu Q, Lu J, Song FM, Junxi Z (2004) Corporate governance and market valuation in China. J Comp Econ 32:600. 2 Black B, Metzger B, O’Brien TJ, Young Moo Shin (2001) Corporate governance in Korea at the millennium: enhancing international competitiveness. J Corp Law 26:537–608. In this report, with the request of the South Korean government, Professor Black and his colleagues proposed a systematic legal reform framework to the Ministry of Justice of South Korea for the purpose of improving the porous governance structure of Chaebol. 3 OECD (2008) Principles of corporate governance. http://www.oecd.org/dataoecd/32/18/31557724. pdf. Accessed on 29 Feb 2008. Since its first issuance, this document has been revised in 2003 and 2004. The above hyperlink leads to the 2004 revised version. 4 McKinsey & Company (2002) Corporate governance in emerging markets. McKinsey on Finance 3:15–18. L. Zhang, Venture Capital and the Corporate Governance of Chinese Listed Companies, DOI 10.1007/978-1-4614-1281-6_1, © Springer Science+Business Media, LLC 2012

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(WTO), China has also put considerable emphasis on corporate governance in recent years.5 At the core of such attention is the debate on how China can design an effective corporate governance system for its listed companies through the perspective of agency theory.6 The Chinese government opened stock exchanges in the early 1990s in order to raise capital for its moribund SOEs.7 At the very beginning, there were only eight companies listed on the Shanghai Stock Exchange.8 However, in the following less than 20 years, the total number of listed companies on the Shanghai Stock Exchange and the Shenzhen Stock Exchange has increased to 1,633 with a market capitalization of RMB28,173 billion yuan.9 In addition, according to the statistics of the Chinese Securities Depository and Clearing Corporation Limited, 94,976.6 thousand valid accounts had been set up in the above two stock exchanges by the 22nd February 2008.10 Notwithstanding that the aforementioned data is sanguine, poor governance practices are rampant in Chinese listed companies. For example, in 2001, the largest shareholder of Mailyard and other related parties conspired with one another and embezzled $44.6 million or 41% of the listed company’s total equity. In the same year, the largest shareholder of Sanjiu Pharmacy illegally transferred $301.9 million or 96% of the total equity out of the listed company.11 The consecutive corporate scandals in 2001 severely undermined investors’ confidence in the next 4 years. Consequently, as vivid reflection of the tremendous decrease of public investors’ confidence, the Shanghai Composite Index once slumped to less than 1,000 points on the 6th June 2005.12 China’s stock market was criticized as being worse than a casino.13 In order to restore investors’ confidence and rescue the stock market which was on the brink of collapse, the China Securities Regulatory Commission (CSRC) launched the equity division reform among Chinese listed companies at the end of April 2005.14 To some degree, this reform 5

Li S (2003) Company control of China and the reform in its transition. Trib Polit Sci Law (J China Univ Polit Sci Law) 21:3. 6 Liu Q (2006) Corporate governance in China: current practices, economic effects and institutional determinants. CESifo Econ Stud 52:415–416; Clarke DC (2003) Corporate governance in China: an overview. China Econ Rev 14:494. 7 Luo P (2004) The contractual perspective of the company law and the legitimacy of Chinese company law rules. CASS J Law 26:80. 8 Xinhuanet (2008) The Shanghai stock exchange has become the third biggest bourse in Asia. http://news.xinhuanet.com/fortune/2002-08/10/content_519167.htm. Accessed 1 Mar 2008. 9 The data is available at http://www.hkex.com.hk/csm/highlight.asp?LangCode=en. Accessed 1 Mar 2008. 10 These statistics are available at http://www.chinaclear.cn/. Accessed 1 Mar 2008. 11 See footnote 1 above, p 600. 12 Xinhuanet (2008) Witnessing 998 points of the Shanghai composite index on 6 June. http://news. xinhuanet.com/stock/2005-06/06/content_3051529.htm. Accessed 2 Mar 2008. 13 In an interview, Jinglian Wu, a famous Chinese economist, sharply pointed out “China’s stock market is worse than a casino. At least in a casino there are rules”, available at http://202.99.23.223/ BIG5/jinji/35/160/20010213/394537.html. Accessed 2 Mar 2008. 14 CSRC (2008) Notice regarding the Equity Division Pilot Reform among listed companies. http:// www.csrc.gov.cn/n575458/n776436/n804935/n2466682/2652975.html. Accessed 2 Mar 2008.

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Table 1.1 The annual numbers of administrative penalty decisions made by the CSRC from 2002 to 2007 The pre-reform period The reform and post-reform period Year 2002 2003 2004 2005 2006 2007 No. 20 42 20 46 40 31 Total: 82 Total: 117 Source: The China Securities Regulatory Commission (CSRC) (These statistics are available at http://www.csrc.gov.cn/n575458/n575742/n576221/index.html. Accessed 2 Mar 2008)

has rekindled investors’ interests in China’s stock market and temporarily alleviated the public antagonism towards regulatory authorities and supervised enterprises.15 However, its effects cannot be overestimated. The corporate governance of Chinese listed companies has not yet been fundamentally changed. Fraudulent disclosure, insider trading and controlling shareholders’ tunnelling are still common. Table 1.1 is a summary of the annual number of administrative penalty decisions made by the CSRC from 2002 to 2007. According to the data in Table 1.1, the total amount of penalty decisions was 82 during the 3 years before the equity division reform and this number increased to 117 in the 3 years amid and after that reform. On the one hand, the change reflects the greater efforts of the CSRC to purify China’s stock market which was riddled with fraud and speculation. On the other hand, it also shows that the corporate governance of Chinese listed companies is still badly conducted. Confronted with the torrent of corporate scandals, it is not difficult to understand that the concern of legal scholars with the corporate governance system of Chinese listed companies is to minimize agency costs through the improvement of legal rules and other institutional settings. In terms of the subjects that they deal with, their discourses can be classified into two groups: the group focusing on the whole governance framework of Chinese listed companies and the group concentrating on some specific governance institutions of Chinese listed companies. In the first group, the intellectual contributions by legal scholars are not as abundant as the ones in the second group. Shuguang Li drew a general picture of the Chinese listed companies’ governance framework. First, he analyzed the status quo of financial markets, product markets, political and legal environments, social governance, company law and the market for control in China. Then, he pointed out the shortcomings of these factors and proposed the reform suggestion for them. Finally, he concluded that the key point of the improvement of China’s listed companies’ corporate governance was to achieve the transition from the state-oriented pattern to a market-oriented pattern.16 Along a similar path, Layhong Tan and Jiangyu Wang

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Cao G, Li H, Lai P (2006) Positive research on the market reaction of the execution of the shareholder structure reform scheme. J Chongqing Univ (Nat Sci Ed) 29:122–135; Xinhuanet (2008) The Shanghai composite index overpassed 5000 points for the first time. http://big5.xinhuanet.com/ gate/big5/news.xinhuanet.com/fortune/2007-08/24/content_6595444.htm. Accessed 2 Mar 2008. 16 See footnote 5 above, pp 3–15.

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explicated the practice of internal governance mechanisms and external governance mechanisms in Chinese listed companies. Then they compared the outsider-based model in the Anglo-Saxon jurisdictions, and the insider-based model in Japan and Germany. Lastly, they considered the German model to be the most suitable one for China to transplant and localize.17 Guanghua Yu proposed a unique insight into the search for the optimal governance framework for Chinese listed companies. On the basis of persuasive evidence, he moderately criticized the efforts to seek the best corporate governance model for large public companies and to connect one country’s existing governance practice to its economic performance. Then he suggested that a more pragmatic way to promote the quality of corporate governance in Chinese listed companies and their counterparts in other countries would be to encourage competition between equity financing and debt financing.18 The literature in the second group accounts for the overwhelming majority of extant academic papers by legal scholars on the corporate governance of Chinese listed companies. According to the findings of literature review, they are principally concerned with four governance institutions of Chinese listed companies as follows: 1. State shares are concentrated in Chinese listed companies. Leping Shen argued that the central government and local governments were the controlling shareholders in most Chinese listed companies. Consequently, the separation of ownership and control in those companies was incomplete. Then he pointed out that the controlling position of the state directly led to the absence of the ultimate principal and the bureaucratic interference in the operation of those companies.19 Likewise, Peizhong Gan also recognized the harms of concentrated state shares to the performance of both Chinese listed companies and China’s economy. After that, he analyzed the flaws of the method to reduce state shares in Chinese listed companies designed by the State Council in 2001 and proposed his own advice to redress them.20 2. The board of directors of Chinese listed companies is just a “rubber stamp”. Clarke thought that the board of directors was manipulated by controlling shareholders in Chinese listed companies. Therefore, it was necessary to bring in the mechanism of independent directors to monitor and curb controlling shareholders and to protect minority shareholders from expropriation. Then he illustrated the practice of independent directors in the USA for Chinese authorities’ reference.21 17

Tan L, Wang J (2008) Proposing a model of corporate governance for China’s listed companies: problems and prospects. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=526942. Accessed 5 Mar 2008. 18 Yu G (2006) Toward an institutional competition model of comparative corporate governance studies. In: Yu G (ed) The essence of company law. Law Press, Beijing, pp 114–146. 19 Shen L (2003) Analysis of the current situation of enterprise group corporate governance structure and counter-measures. J Jinan Univ (Philos Soc Sci Ed) 25:28–29. 20 Gan P (2002) Government and market in the reduction of state shares – the analysis of this failed reform through the perspective of economic law. Jurists Rev 4:87–90. 21 Clarke DC (2006) The independent director in Chinese corporate governance. Del J Corp Law 31:125–228.

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Fuqing Guo criticized the company law of China for allocating too much governance power to the shareholder meetings of listed companies and then weakening the function of their boards of directors. Thus, he suggested that the company law should be revised for the purpose of transferring more power to the board of directors from the shareholder meeting.22 Given the successful practice in the USA, Zengyi Xie recommended that Chinese company law ought to add articles regarding the establishment of sub-committees in the board of directors of Chinese listed companies in order to assist independent directors to play their roles.23 3. Although insider trading and illegal affiliate transactions are common in Chinese listed companies, the corresponding legal rules and regulations are not developed. With regard to insider trading in China, legal scholars have almost adopted the approach of comparative study. For instance, Lingling Mao made a comparison between the legal and regulatory frameworks for clamping down on insider trading in the USA and those in China. She concluded that the American model was worthy of being replicated by China.24 Jian Fu analyzed the pros and cons of China’s legal institutions related to insider trading with Australia’s practice as the mirror.25 As for affiliate transactions in China, Haoyan Ni indicated that a series of files issued by the CSRC were not operational in practice. In the interests of listed companies and minority shareholders, she thought that China’s legislature should revise and improve related statutes on affiliate transactions.26 Ansheng Dong and Baohua Zhang realized that affiliate transactions had seriously challenged the traditional contract law in the civil law jurisdiction, especially in China, because of the absence of rules in relation to this kind of deal. Therefore, in order to guarantee the fairness of affiliate transactions, the contract law of China must transplant related articles for disciplining them from other countries.27 4. Fraudulent information disclosure is rampant in China’s stock market. Liufang Fang did not agree with the claim that the flooding of fraudulent information disclosure in China’s stock market was due to the undeveloped legal rules on disclosing information and the lax regulation by the CSRC. Conversely, he mainly ascribed this problem to the over-regulation of the CSRC and the bureaucratic interference of local governments.28 Baohua Zhang noticed that the securities

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Guo F (2003) The transition from shareholders’ ownership absolutism to relativism. Sci Law (J Northwest Univ Polit Sci Law) 4:53–60. 23 Xie Z (2005) Board committees and corporate governance. Chin J Law 5:62–71. 24 Mao L (2007) The comparison between the legal and regulatory framework on insider trading in the United States and those in China. Legal Sci 7:101–107. 25 Fu J (2005) The comparison between the legal institutions on insider trading in Australia and those in China. Law Appl 12:78–82. 26 Ni H (2006) The legal institutions for affiliate transactions in Chinese listed companies. Shandong Soc Sci 2:117–119. 27 Dong A, Zhang B (2007) Shortness of effectiveness rules of contract – on challenge of affiliated transactions upon traditional civil law. Jurists Rev 3:59–66. 28 Fang L (2008) The setback stemming from over-regulation. http://www.civillaw.com.cn/article/ default.asp?id=17186. Accessed 8 Mar 2008.

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law of China omitted the stipulation of forward-looking information disclosure. He suggested that it ought to be added into the securities law so as to enhance the quality of disclosed information.29 Shourong Lan, Jinghui Ren and Hongfang Wu discussed the interaction between the legal rules and the media’s monitoring of information disclosure in China.30 Through the above brief overview of existing literature, one can see that legal scholars, both domestic and foreign, have almost exclusively linked the corporate governance of Chinese listed companies to the minimization of agency costs. As this book mentioned before, it was unsurprising as a result of the rampant scandals among Chinese listed companies. However, it is really unfortunate because another crucial efficacy of the governance system adopted by Chinese listed companies has been omitted by legal academics. The second efficacy is in relation to entrepreneurial innovation and to a society’s “adaptive efficiency”.31 As Nobel Prize laureate Douglass North defined: “Adaptive efficiency…is concerned with the kinds of rules that shape the way an economy evolves through time. It is also concerned with the willingness of society to acquire knowledge and learning, to induce innovation, to undertake risk and creative activity of all sorts, as well as to resolve problems and bottlenecks of the society through time”.32 Nowadays, the pace of technological changes has been remarkably accelerated; the life span of products has been substantially shortened. Therefore, in the context of globalization, a country’s competitive ability in the international community has mainly rested on its adaptive skills.33 The wheels of history have run into the age when “there are only the quick and the dead”.34 On the basis of North’s description above, adaptive efficiency is reinforced by an institutional structure that fosters technological innovation. According to taxonomy, technological innovation is usually divided into two kinds: “in-house innovation” and “external innovation”.35 In-house innovation typically occurs in large, wellestablished firms and existing industries.36 On the contrary, external innovation generally takes place in the start-ups set up by entrepreneurs.37 Those start-ups 29

Zhang B (2003) Research on the disclosure of forward-looking information in Chinese listed companies. Law Appl 4:17–20. 30 Lan S, Ren J, Wu H (2003) The legal rules and the media’s monitoring on information disclosure in China. Law Sci Mag 24:23–25. 31 North DC (1990) Institutions, institutional change and economic performance. Cambridge University Press, Cambridge, p 80. 32 Ibid. 33 Milhaupt CJ (1997) The market for innovation in the United States and Japan: venture capital and the comparative corporate governance debate. Northwestern University Law Review 91:866. 34 Gilson RJ (1996) Corporate governance and economic efficiency: when do institutions matter? Washington Univ Law Q 74:337. 35 See footnote 33 above, p 874. 36 Ibid. 37 Ibid.

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do not only have impacts on existing industries, but also develop entirely new industries.38 Since both in-house and external innovation contribute to the enhancement of adaptive efficiency, an ideal institutional environment should be compatible with each of them. When an institutional environment principally focuses on financing in-house innovation, it actually strengthens the vested interest and the monopolistic position of large, well-established companies. It cannot simultaneously facilitate the booming of external innovation which represents the competition and challenge to large companies from entrepreneurs. However, when an institutional environment aims to sponsor external innovation, in fact, it encourages the increasing magnitude of competition in its economy by bringing in new participants. In turn, the intensified competition provides incentives for large companies to more efficiently and with more initiative to conduct in-house innovation. Therefore, theoretically and logically, the conjecture that an institutional framework with an orientation to external innovation is the Holy Grail to promote adaptive efficiency can be reached. The existing comparative studies on the innovation patterns of the USA, Germany and Japan have provided persuasive evidence to support the above postulation. According to those studies, the USA has been considered to typically promote external innovation and Japan and Germany have been thought to spotlight in-house innovation.39 With regard to specific measurements, the indicator which those studies used to stand for in-house innovation in the three major commercial jurisdictions was the annual research and development (R&D) expenditure disbursed by their large companies, especially those in the high-technology industry.40 The indicator displaying external innovation was the sizes of their respective venture capital (VC) markets.41 Table 1.2 shows the R&D expenditure of the top ten high-technology manufacturing enterprises in the world in 2004. The ten enterprises included four American companies, four Japanese companies, one German company and one Korean company. Through the “Expenditure of R&D” column, it is clear to see that each of the large companies disbursed a bulk of money to carry out in-house innovation. While these firms only account for a small fraction of well-established companies in the USA, Germany and Japan, to some degree, they reflect the roughly equal weight on in-house innovation applied by the three economic rivals. Table 1.3 illustrates the VC amounts invested by the USA, Germany and Japan, respectively, in 2004. In light of these data, the total amounts of VC invested by Germany and Japan in 2004 only amounted to 10% of that by the USA in the same year. Thus, there is almost no doubt that Germany and Japan have fallen far behind the USA in the dimension of VC markets and in turn, external innovation. 38

Gilson RJ (2003) Engineering a venture capital market: lessons from the American experience. Stanford Law Rev 55:1068. 39 See footnote 33 above, p 874; Black BS, Gilson RJ (1998) Venture capital and the structure of capital markets: banks versus stock markets. J Financ Econ 47:243–277. 40 Bowonder B, Racherla JK, Mastakar NV, Krishnan S (2005) R&D spending patterns of global firms. Res Technol Manag 48:51–59. 41 See footnote 33 above.

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Table 1.2 The R&D expenditure of the top ten high-technology enterprises in the world in 2004 Expenditure Sales amounts of R&D (million R&D No. Name Nation (million US dollars) US dollars) magnitude (%) 1 IBM USA 96,293 5,673 5.89 2 Hitachi Japan 84,365 3,375 4.00 3 Siemens Germany 81,556.2 5,493.36 6.74 4 Panasonic Japan 81,158 6,282.4 7.74 5 HP–Compaq USA 79,905 3,506 4.39 6 Sony Japan 72,081 4,947 6.86 7 Samsung South Korea 55,677.7 2,900 5.21 8 Toshiba Japan 52,636.85 3,176.55 6.03 9 Pfizer USA 52,516 7,684 14.63 10 Boeing USA 52,457 1,879 3.58 Source: Zhang X, et al. (2006) China high-tech industry development almanac. Beijing Institute of Technology Press, Beijing, p 16

Table 1.3 The VC amounts invested by the USA, Germany and Japan in 2004 Amount Nation (billion US dollars) Percentage in the world Percentage of GDP USA 113.7 64 1.0 Japan 6.6 4 0.1 Germany 4.7 3 0.2 Source: China Venture Capital Research Institute Limited (2006) China venture capital yearbook (2006). Democracy and Construction Press, Beijing, p 170

Table 1.4 The competitive ability of high-technology industries of the USA, Germany and Japan in 2005 Nation Socioeconomic Technological Productive Nation orientation infrastructure infrastructure capacity Total USA 79.2 84.2 91.9 88.7 344.1 Japan 70.3 65.5 71.1 88.9 295.9 Germany 71.6 75.5 64.5 74.6 286.3 Source: Zhang X, et al. (2006) China high-tech industry development almanac. Beijing Institute of Technology Press, Beijing, p 16

Table 1.4 compares the overall competitive ability of high-technology industries of the USA, Germany and Japan in 2005. It is clear that the result is consistent with the data in Tables 1.2 and 1.3. Given that Germany and Japan have similar intensities of in-house innovation and the competitive ability of their high-technology industries principally rely on the R&D capability of large companies, the values of their high-technology industries’ competitive ability are roughly equal just as are those in Table 1.4. Likewise, with a similar size of in-house innovation and a much larger scope of external innovation in comparison to Germany and Japan, it is not

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difficult to understand that the competitive ability of American high-technology industry is apparently stronger than those of her two rivals as Table 1.4 shows. According to the above brief comparison of the three major commercial jurisdictions in the world, the international ramification of America’s success in fostering external innovation with a vibrant VC market is clear. As four European scholars once put it in a journal article, “a vibrant venture capital industry is a cornerstone of America’s leadership in the commercialization of technological innovation”.42 Black and Gilson defined “venture capital” as “investment by specialized venture capital organizations in high-growth, high-risk, often high-technology firms that need capital to finance product development or growth and must, by the nature of their business, obtain this capital largely in the form of equity rather than debt”.43 According to the definition, we can see that the presence of VC is due to the need of funds by small firms which are surrounded by uncertainty, information asymmetry and opportunism and thus face the difficulty of acquiring money from traditional sources.44 Given the significant enhancement of adaptive efficiency by the institutional environment oriented to external innovation and VC as the catalyst to promote external innovation by financing start-ups, a connection between the institutional environment and VC has been established. To put it simply, the institutional structure facilitating the development of VC is what ought to be desired. In the last decade, western corporate law scholars drew a strong linkage between the corporate governance systems of large public companies and institutional environments for the vitality of VC markets. For example, Black and Gilson analyzed the importance of a highly developed stock market for the exit of VC45; Milhaupt examined how VC failed to fit into the corporate governance system of Japanese large, well-established public companies.46 These academic papers have been a new insight to observe and estimate the corporate governance system of listed companies. The efficacy of listed companies’ governance frameworks is not just to minimize agency costs along the path set by Berle and Means.47 It also imposes substantial influences on the legal and other institutional settings for the booming of VC and in turn the enhancement of adaptive efficiency. Therefore, any proposal to reform the corporate governance of listed companies in a country must be on the basis of a thorough evaluation of that system from the perspectives of both agency theory and adaptive efficiency. Otherwise, it is probable that one value will be improved at the

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Bottazzi L, Da Rin M, Van Ours JC, Berglöf E (2002) Venture capital in Europe and the financing of innovative companies. Econ Pol 17:231. 43 See footnote 39 above, p 245. 44 Milhaupt CJ (1998) The small firm financing problem: private information and public policy. J Small Emerg Bus Law 2:177–195. 45 See footnote 39 above. 46 See footnote 33 above, pp 865–898. 47 Berle AA, Means GC (1933) The modern corporation and private property. Macmillan, New York. http://www.heinonline.org/HOL/Page?handle=hein.beal/mcpp0001&id=1&size=2&c ollection=beal&index=beal/mcpp. Accessed 17 Mar 2008.

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Table 1.5 Total VC amounts under management from 2003 to 2006 in China Year 2003 2004 2005 2006 Amount (Billion RMB) 32.534 43.87 46.45 58.385 Source: China Venture Capital Research Institute Limited (2007) China venture capital yearbook (2007). Democracy and Construction Press, Beijing, p 107

Table 1.6 Annual amounts of VC investment from 2003 to 2006 in China Year 2003 2004 2005 2006 Amount (Billion RMB) 3.715 3.783 11.757 14.364 Source: China Venture Capital Research Institute Limited (2007) China venture capital yearbook (2007). Democracy and Construction Press, Beijing, p 107

expense of damaging the other thereby making the final result worse. As this book mentioned before, there have been a lot of efforts made to explore the corporate governance of Chinese listed companies underpinned by agency theory. However, the attempt to examine it from the standard of VC and adaptive efficiency is still absent. That is exactly the research gap which this book intends to fill. In China, the concept of “venture capital” burgeoned in the early 1980s. However, until 1998, the development of VC consisted purely of theoretical discussion and the pilot trial stage. In 1998, the Central Committee of the Chinese National Democratic Constructive Association presented the “Proposal for Developing China’s VC Industry” at the Ninth Chinese People’s Political Consultative Conference (CPPCC). Since then, VC has become frequent practice and a fast growing segment in China’s financial system.48 During the last 10 years, China has made remarkable progress in the development of its VC market. Table 1.5 shows the total amounts of VC under management from 2003 to 2006 in China. From Table 1.5, it is easy to reach the conclusion that the trend of total VC amounts in China is ascending. The number in 2006 was almost twofold in comparison with that in 2003. Table 1.6 reflects the annual amounts of VC investment from 2003 to 2006 in China. Likewise, the tendency of annual VC investment is also upwards. The number in 2006 was nearly three times that of 2003. However, the striking expansion of China’s VC market cannot disguise the embarrassing fact that Chinese domestic VCs have been marginalized by foreign VCs. In China’s VC market, foreign VCs are playing a leading role. Table 1.7 displays the differences in the annual investment amounts between Chinese domestic VCs and foreign VCs from 2005 to 2007 in China. It is clear that the percentage of the annual investment made by Chinese domestic VCs in the overall annual investment in China is shrinking. As Table 1.7 shows, this number sharply decreased from 43.1% in 2005 to 24% in 2007.

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Dixon R, Ritchie J, Guo D (2008) The impact of governance structure and financial constraints on risk tolerance of VCs: an empirical work on China’s venture capital industry. http://www.cass. city.ac.uk/emg/seminars/EMGpapers1stOct/Dixon_Guo_Ritchie.pdf. Accessed 19 Mar 2008.

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Table 1.7 Differences in the annual investment amounts between domestic VCs and foreign VCs from 2005 to 2007 in China Investment size Domestic VCs Foreign VCs Total 2007 Project number 412 329 741 Percentage of projects 55.6 44.4 100 Investment amount (billion RMB) 9.554 30.250 39.804 Percentage of amounts 24 76 100 The average investment amount in 2006 23,885.6 12,2470.4 61,521.5 (thousand RMB) 2006

Project number Percentage of projects Investment amount (billion RMB) Percentage of amounts The average investment amount in 2006 (thousand RMB)

219 59.03 3.43 23.91 16,432.6

152 40.97 10.93 76.09 79,774.6

371 100 14.36 100 41,513.1

2005

Project number 215 143 358 Percentage of projects 60.1 39.9 100 Investment amount (billion RMB) 2.358 3.110 5.468 Percentage of amounts 43.1 56.9 100 Sources: China Venture Capital Research Institute Limited (2007) China venture capital yearbook (2007). Democracy and Construction Press, Beijing, p 230; China Venture Capital Research Institute Limited (2008) China venture capital yearbook (2008). Democracy and Construction Press, Beijing, p 258 Table 1.8 Differences in the total registered capital between domestic VC institutions and foreign VC institutions from 2005 to 2007 in China Type Domestic VCs Foreign VCs Total Amount in 2007 (billion RMB) 22.335 44.078 66.413 Percentage in 2007 33.63 66.37 100 Mean value in 2007 (thousand RMB) 65,000 98,125 66,000 Amount in 2006 (billion RMB) 14.951 45.874 60.825 Percentage in 2006 24.58 75.42 100 Mean value in 2006 (thousand RMB) 65,000 88,125 66,000 Percentage in 2005 35 65 100 Sources: China Venture Capital Research Institute Limited (2007) China venture capital yearbook (2007). Democracy and Construction Press, Beijing, p 221; China Venture Capital Research Institute Limited (2008) China venture capital yearbook (2008). Democracy and Construction Press, Beijing, p 235

Table 1.8 exhibits the differences in the total registered capital between Chinese domestic VC institutions and foreign VC institutions from 2005 to 2007 in China. In this regard, consonant with Table 1.7, foreign VCs also have an overwhelming advantage over their domestic rivals in China. Table 1.9 is the ranking of the top ten foreign VCs in 2003 in China by Zero2ipo which is a famous research institute on China’s VC market. In light of this, it is clear to see that American VCs occupied seven positions that year. On the one hand, this fact confirms the dominating role of the USA in the global VC market with their

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An Introduction to Adaptive Efficiency and Corporate Governance

Table 1.9 Top ten foreign VCs in 2003 in China No. Name Nation 1 IDG Technology Venture Investment USA 2 Walton International Investment Group USA 3 SAIF Partners USA 4 The Carlyle Group USA 5 Dragon Tech Ventures Hong Kong 6 JAFCO Asia Hong Kong 7 Intel Capital USA 8 Warburg Pincus USA 9 ING Baring The Netherlands 10 WI Harper Group USA Source: Zero2ipo (Available at http://www.zero2ipo.com.cn/cvcf2003/pm/index_ cn2.htm#e. Accessed 21 Mar 2008)

China practices. On the other hand, it also implies that American VCs are still the major competitors of Chinese domestic VCs in both domestic and global VC markets. Given the competitive advantage of American VCs over Chinese domestic ones and the strong linkage between the corporate governance of listed companies and the institutional environment for the vitality of VC markets, this book assumes that the corporate governance system of Chinese listed companies has hampered the presence or the full functioning of the institutional factors which are responsible for the prosperity of American VCs in Chinese domestic VCs. In other words, it aims to use the mirror of the successful institutional environment for American VCs to reflect the negative effects of the corporate governance of Chinese listed companies on adaptive efficiency. With regard to the institutional environment to guarantee an active VC market in the USA, western legal and financial scholars have already held thorough discussions. On the basis of their contributions, this book have isolated four key traits of the institutional structure for the success of the American VC market: the availability of large and independent funding, the application of organizational and contractual incentive mechanisms, the existence of efficient exit channels and the high-risk tolerance level of venture capitalists. The first three key traits also constitute the whole cycle of VC. According to the above analysis, the remaining parts of this book proceed as follows. Chapter 2 provides an overview of the history and status quo of the Chinese listed companies’ governance system. Through this description, it intends to show that state-controlled listed companies have always been the majority of Chinese listed companies. The purpose of the governance framework of state-controlled listed companies is to guarantee the state’s control over them. In turn, this kind of control has aligned the interests of the state with the listed companies controlled by them. Therefore, the state has the incentive to use its power to transfer as many resources as possible to these listed companies and to protect them from potential competition. In addition, the existing governance framework of state-controlled

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An Introduction to Adaptive Efficiency and Corporate Governance

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listed companies has also retained and continued the inertia of the state’s active participation in the competitive industry featured in the age of planned economies. Thus, when a new commercial field emerges, the state is reluctant to just provide public goods. It will take part in this competition against private participants. Chapter 3 explores how the corporate governance of state-controlled listed companies has hindered the existence of large and independent funding for Chinese domestic VCs. On the one hand, the Chinese legislature has enacted regulations to channel pension funds which are the largest source of VCs in America into the Chinese stock market and further into state-controlled listed companies and to forbid it from being invested in the VC industry. Meanwhile, alternative fund sources with similar sizes are also unavailable to Chinese domestic VCs due to legal barriers. This has given rise to the shortage of large funding for Chinese domestic VCs. On the other hand, the Chinese central government and local governments have set up hundreds of VC companies with their financial incomes, which constitute the overwhelming majority of Chinese domestic VCs. In these VC companies, governments play the role of both investor and venture capitalist. Consequently, the investment decisions of government VCs are generally not made by independent and professional venture capitalists but by government officials. Nowadays, even though pilot funds established by governments are popular in China, they do not substantively steer clear of the tradition that project recommendation and estimation are in the charge of government officials. With regard to the above two aspects, it is demonstrated that each of them can be attributed to the corporate governance of Chinese state-controlled listed companies described in Chapter 2. Chapter 4 discusses the negative influences of the corporate governance of state-controlled listed companies on the application of organizational and contractual incentive mechanisms in Chinese domestic VCs. First, the organizational form of limited partnership which is usually adopted by American VC funds had been absent for a long time in China. Although the revised partnership enterprise law has accepted this organization, Chinese domestic VCs still hold an indifferent attitude towards it. In addition, the amount of partners has been confined to a small number which has reduced the function of this organization substantially. Second, staged financing and board representation are commonly applied by Chinese domestic VCs. But in most cases, their real functions have been significantly distorted and weakened. Third, stock options as an incentive device to VC-backed entrepreneurs in America are undeveloped in Chinese domestic VCs. Fourth, convertible preferred stocks as a kind of protective tool for American VCs had been prohibited from being used by Chinese domestic VCs for a long time. Even though it has been liberalized since 2005, the effects of path dependence and soft budget constraints have hindered its full application and efficacy. In the light of the defects of the four incentive mechanisms in Chinese domestic VCs, it is proved that this situation can be at least partially ascribed to the corporate governance of Chinese state-controlled listed companies. Chapter 5 examines how the corporate governance of state-controlled listed companies has blocked the efficient and smooth exits of Chinese domestic VCs through the Chinese domestic stock market. First, the listing requirements of the main boards of the Shanghai Stock Exchange and the Shenzhen Stock Exchange are too high to be achieved by the enterprises backed by

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Chinese domestic VCs. Likewise, the Small and Medium-sized Enterprises Board of the Shenzhen Stock Exchange (SME Board) has also adopted high listing standards, which have made it less workable and attractive for Chinese domestic VCs. Moreover, the Growth Enterprise Market (GEM) was absent from China’s stock market for a long period. Even though it was opened in 2009, it has put too much emphasis on financing and ignored the authentic exits of Chinese domestic VCs to a large degree. In addition, the forbidden liquidity of state-owned shares and legal person shares on the Chinese stock market before the equity division reform and bureaucratic listing approval procedures, have also handicapped the prompt and smooth exits of Chinese domestic VCs from their portfolio companies. It is explicated that the corporate governance framework of Chinese state-controlled listed companies should be responsible for the uneven exit road of Chinese domestic VCs. In Chapter 6, the risk tolerance levels of American venture capitalists and Chinese domestic ones are empirically compared. Through this comparison, it is shown that Chinese domestic venture capitalists are less risk-tolerant than their American competitors. More importantly, it aims to prove that the disadvantage of Chinese domestic venture capitalists in this aspect is largely attributed to the corporate governance of Chinese state-controlled listed companies. The last chapter concludes the role played by the corporate governance of Chinese state-controlled listed companies in hampering the healthy development of Chinese domestic VCs and then briefly reexamine the latest proposals for its improvement. The research of this book has both positive and normative significance. Positively, with the four key traits for the prosperity of American VCs, this book proves the role played by the corporate governance of Chinese state-controlled listed companies in hampering the healthy development of Chinese domestic VCs and further show the negative restraints of this framework on adaptive efficiency. Normatively, it re-evaluates the latest proposals for reforming the corporate governance of Chinese state-controlled listed companies and see if they harmonize agency costs and adaptive efficiency. Four caveats should be noted. First, this book objects to simply ascribing the differences between American VCs and Chinese VCs to their different time spans of development. In Italy, the bourgeoning of VCs appeared in Julius Caesar’s Rome.49 However, nowadays, the size of the Italian VC market is much smaller than that of America.50 Second, this book does not mean that the corporate governance of Chinese state-controlled listed companies has equal influence on each of the four key traits and their respective components. Actually, this influence is stronger on some elements and weaker on others. However, the aggregation of these impacts as a whole is vigorous and substantial. Third, some readers may doubt the legitimacy

49

See footnote 33 above, p 865. In 2004, the annual VC investment amount in Italy was only 1.8 billion dollars. However, that amount in America in the same year was 113.7 billion dollars. The former was just a little more than 1% of the latter. See China Venture Capital Research Institute Limited (2006) China venture capital yearbook (2006). Democracy and Construction Press, Beijing, p 170. 50

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of choosing the American VC template as China’s mirror. They may argue that the successful experience in America might not be suitable for China as well. For this question, Gilson has made an excellent answer. With the evidence from Germany, Israel and Chile, he has proved that the American VC template as the existing optimal one can be duplicated by other countries while the path along which the American VC market has developed is surely unique.51

51

See footnote 38 above, pp 1068–1103.

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Chapter 2

The Status Quo of Corporate Governance of Chinese Listed Companies

2.1

Introduction

At the very beginning of the 1990s, the primary purpose of setting up the Shanghai Stock Exchange and the Shenzhen Stock Exchange was to raise funds to save moribund SOEs.1 This policy, favoured by the Communist Party of China (CPC) and the Chinese government, has led to the fact that state-controlled listed companies have constituted the overwhelming majority in comparison with private listed companies in the above two stock exchanges. By the end of 2006, there were 998 state-controlled companies and 405 private companies listed on the two stock exchanges.2 In addition to the listing numbers, Table 2.1 shows the ratios of the market capitalization of state-controlled listed companies issuing A shares3 in the Shanghai Stock Exchange and the Shenzhen Stock Exchange to that of A shares of the two stock exchanges from 1995 to 2005. According to the data in Table 2.1, it is clear that state-controlled listed companies are almost the synonym of A shares in mainland

1

Shanghai Stock Exchange (2008) The introduction to the Shanghai Stock Exchange. http://www. sse.com.cn/sseportal/ps/zhs/sjs/jysjs.shtml. Accessed 28 May 2008; Shenzhen Stock Exchange (2008) The introduction to the Shenzhen Stock Exchange. http://www.szse.cn/main/aboutus/bsjs/ bsjj/index.shtml. Accessed 28 May 2008. 2 Chen B, Che J, Wang X, Lai J (2008) Positive research on Chinese private listed companies. http://www.szse.cn/main/files/2008/02/25/091811911155.pdf. Accessed 28 May 2008. 3 The issuers of A shares are companies incorporated in mainland China and are listed on the A-share markets of the Shanghai Stock Exchange and the Shenzhen Stock Exchange. The prices of A shares are quoted in RMB. Currently, only mainlanders and qualified foreign institutional investors (QFII) are permitted to trade A shares. In addition, there also exist B shares in the mainland stock market. The issuers of B shares are companies incorporated in mainland China and are listed on the B-share markets of the Shanghai Stock Exchange and the Shenzhen Stock Exchange. The prices of B shares are quoted in foreign currencies. In the past, only foreigners were eligible to trade B shares. From March 2001, mainlanders with legal foreign currency accounts are allowed to trade B shares as well. Given that the market capitalization of A shares is much bigger than that of B shares in mainland China, A shares are usually used as an indicator to analyze Chinese stock markets. L. Zhang, Venture Capital and the Corporate Governance of Chinese Listed Companies, DOI 10.1007/978-1-4614-1281-6_2, © Springer Science+Business Media, LLC 2012

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The Status Quo of Corporate Governance of Chinese Listed Companies

Table 2.1 The ratio of the market capitalization of state-controlled listed companies to that of A shares of the Shanghai Stock Exchange and the Shenzhen Stock Exchange Market capitalization of state-controlled listed Market capitalization of companies (billion RMB) A shares (billion RMB) Ratio (%) Year 1995 369.501 377.43 97.9 1996 958.967 984.24 97.43 1997 1,693.46 1,752.93 96.61 1998 1,858.029 1,952.18 95.18 1999 2,476.938 2,647.12 93.57 2000 4,393.121 4,809.09 91.35 2001 3,936.228 4,352.22 90.44 2002 3,424.463 3,832.913 89.34 2003 3,826.047 4,245.771 90.11 2004 3,266.196 3,720.923 87.78 2005 2,867.365 3,243.015 88.42 2006 8,141.694 8,940.352 91.07 Source: Chen B, Che J, Wang X, Lai J (2008) Positive research on Chinese private listed companies. http://www.szse.cn/main/files/2008/02/25/091811911155.pdf. Accessed 28 May 2008

China. Likewise, Table 2.2 displays the ratios of the annual IPO numbers of statecontrolled listed companies issuing A shares in the Shanghai Stock Exchange and the Shenzhen Stock Exchange to those of A shares of the two stock exchanges from 1993 to 2006. In terms of the statistics in Table 2.2, it is fair to say that A-share markets in mainland China principally serve SOEs to be listed and to raise funds as the initial intention to develop Chinese stock markets. Taking into consideration the huge difference between the market capitalization of A-share markets and that of B-share markets in China,4 it is legitimate to reach the conclusion that statecontrolled listed companies have dominated Chinese stock markets. Meanwhile, the socialist regime and long-term tradition of state ownership have also made the CPC and Chinese government focus on state-controlled listed companies which are the backbone of the Chinese state-owned economy. Therefore, in this book, the corporate governance of Chinese listed companies is confined to that of state-controlled listed companies because they have much more clout to influence the distribution of resources and the design of institutions due to their economic and political advantages in China. Since current state-controlled listed companies are the transformative results of traditional SOEs,5 invariably, their corporate governance cannot be understood thoroughly apart from their history.6 Thus, the first section of this chapter aims to provide 4

By 30 May 2008, the total market capitalization of A shares of the Shanghai Stock Exchange and the Shenzhen Stock Exchange was RMB22315 billion and that of B shares of the two stock exchanges was only RMB172 billion. The data is available at http://www.hkex.com.hk/csm/highlight.asp?LangCode=en. Accessed 1 June 2008. 5 See Clarke, “Corporate governance in China” (footnote 6, Chap. 1). 6 Schipani CA, Liu J (2002) Corporate governance in China: then and now. Columbia Bus Law Rev 1:6.

Table 2.2 The ratio of the annual IPO number of state-controlled listed companies to that of A shares of the Shanghai Stock Exchange and the Shenzhen Stock Exchange Money raised by Money raised state-controlled listed Annual IPO number by IPOs of A shares Ratio (money Ratio (IPO number/ companies through Total IPO number of state-controlled (billion RMB) raised/percentage) percent-age) IPOs (billion RMB) of A shares listed companies Year 1993 132 45.50396 134 45.91896 99.1 98.51 1994 110 14.60469 117 15.56369 93.84 94.02 1995 36 7.52793 36 7.52793 100 100 1996 217 27.37527 212 28.11527 97.37 97.64 1997 209 72.74739 222 75.60139 96.22 94.14 1998 103 43.37885 111 45.34085 95.67 92.79 1999 89 54.01944 100 58.45944 92.4 89 2000 120 89.38579 143 99.95579 89.43 83.92 2001 65 62.63109 79 70.74109 88.54 82.28 2002 57 63.89842 71 67.58842 94.54 80.28 2003 46 48.14532 67 55.26532 87.12 68.66 2004 53 39.49901 100 52.70901 74.94 53 2005 8 30.47922 15 32.20922 94.63 53.33 2006 36 26.42957 66 27.29957 96.81 54.55 Source: Chen B, Che J, Wang X, Lai J (2008) Positive research on Chinese private listed companies. http://www.szse.cn/main/files/2008/02/25/091811911155. pdf. Accessed 28 May 2008

2.1 Introduction 19

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The Status Quo of Corporate Governance of Chinese Listed Companies

an overview of the evolutionary path of SOEs before the adoption of corporatization. Through this kind of historical retrospect, it intends to indicate the following two points. First, from the establishment of the People’s Republic of China (PRC) to the middle of the 1980s, the function of SOEs was merely to satisfy the production plans made by government agencies and guarantee social stability. Not only did the state own all the assets of SOEs, but it also completely held their managerial powers. The governance structure of SOEs was an integral layer of the governmental hierarchy.7 Hence, SOEs were not real business entities from the beginning and they were just a type of government affiliate. Second, from approximately 1984 to 1993 when the first company law in the PRC was promulgated, the contracting system was dominant in the movement of SOE reform. In accordance with the contracting model, the goal of reform was to grant SOEs the status of legal person and to make them responsible for their own profits and losses.8 This strategy revealed that the CPC and the Chinese government wanted the enterprises which they owned to be operated efficiently through authorizing them managerial autonomy to some degree. However, the state’s consideration behind the above expectation was not to render SOEs solely concerned with the maximization of wealth. Conversely, it just intended to implement its policies better with the support of robust SOEs.9 Therefore, it meant that there were no possibilities for the state to abandon control over SOEs even if it had tactically authorized a share of power to them. The personnel power as the core component of the governance framework of SOEs was tightly held in the hands of the local CPC committees.10 On the basis of the above analysis of the governance structures of SOEs during the pre-corporatization era,11 the second section of this chapter elaborates on the governance framework of state-controlled listed companies. In this section, the initiative, the underlying motive and the influence of corporatization in China are firstly explicated. The official initiative of establishing a modern corporate system in the majority of pivotal large and medium-sized SOEs12 was ascribed to

7 The Fifteenth CPC Central Committee (2008) Decisions on SOEs reform. http://cpc.people.com. cn/GB/64162/71380/71382/71386/4837883.html. Accessed 5 June 2008. In this Decision, the CPC Central Committee declared that administrative ranks should not be granted to SOEs and their leaders any more. This demonstrated that leaders of SOEs used to be state cadres. 8 The Twelfth CPC Central Committee (2008) The decision of the CPC Central Committee on the reform of the economic system. http://news.xinhuanet.com/ziliao/2005-02/07/content_2558000. htm. Accessed 7 June 2008. After this Decision was published in 1984, the slogan of “separation between the state ownership and the SOE management authority” and the phrase “legal person” become popular among Chinese. 9 See Clarke, “Corporate governance in China” (footnote 6, Chap. 1) pp 494–495. 10 See footnote 8 above. 11 The author learned “corporatization” from a journal paper authored by Professor Roman Tomasic and Professor Jian Fu. Tomasic R, Fu J (2006) Legal regulation and corporate governance in China’s top 100 listed companies. Company Lawyer 27:280. 12 See footnote 7 above.

2.1

Introduction

21

Mr. Xiaoping Deng who staunchly advocated the building of the market economy in China during his inspection tour to the south of China in 1992.13 In comparison with the immediately preceding contracting model, corporatization has been an advance of the reform to SOEs in a sense that a comprehensive western-style corporate governance system has been set up in these entities.14 However, the underlying motive of corporatization was still underpinned by the previous orientation to SOEs. It meant that the function of corporatized SOEs would remain a tool for implementing the policies of the state.15 Corporatization was only an effective approach which was envisaged by the CPC and the Chinese government to make SOEs profitable so as to better assume their duties.16 The influences of corporatization on SOEs which are relevant to the research of this book can be summarized in two aspects. On the one hand, some large SOEs have been listed on the Shanghai Stock Exchange and the Shenzhen Stock Exchange for the purpose of raising money from the public. They have played a backbone role in the stateowned economy.17 On the other hand, the state has firmly controlled these listed companies which are deemed to be their political tools by the CPC and the Chinese government through the institutions of corporate governance transplanted from developed western countries.18 Therefore, just as their name reflects, the corporate governance framework of state-controlled listed companies in China is a controlbased model.19 Following the brief historical retrospect of corporatization in China, the remaining part of the second section concentrates on the specific analysis of the control-based model through the aspects of the shareholder meeting, the board of directors and the supervisory committee which constitute the corporate governance structure of Chinese listed companies in accordance with the latest company law of China.20 With this analysis, this chapter reveals how the state has used the above governance institutions to achieve its grip on state-controlled listed companies in China. The last section of this chapter contains concluding remarks.

13 Deng X (2008) The comments made by Deng Xiaoping during his inspection tour to South China. http://cpc.people.com.cn/GB/33837/2535034.html. Accessed 23 June 2008. 14 Hawes C, Chiu T (2006) Flogging a dead horse? Why Western-style corporate governance reform will fail in China and what should be done instead. Aust J Corp Law 20:25. 15 Young A, Li G, Lau A (2007) Corporate governance in China: the role of the state and ideology in shaping reforms. Company Lawyer 28:208. 16 Clarke D (2008) Lost in translation? Corporate legal transplants in China. http://papers.ssrn.com/ sol3/papers.cfm?abstract_id=913784. Accessed 15 July 2008. 17 This fact will be demonstrated with data in Sect. 2.2 of this chapter. 18 See, Liu Q (2006) Corporate governance in China: current practices, economic effects and institutional determinants. CESifo Econ Stud 52:418 (footnote 6, Chap. 1). 19 Ibid., p 415. 20 The latest company law in China came into effect in 2006 after the previous one was revised by the NPC Standing Committee in 2005.

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The Status Quo of Corporate Governance of Chinese Listed Companies

A Historical Perspective: The State-Owned Enterprises

Before the economic reforms which started in 1978, SOEs occupied a near-total monopoly position over the means of production in China. Prior to the corporatization of SOEs after the first company law of the PRC was enacted in 1993, the governance systems of SOEs had evolved from a traditional model in which the state was the sole owner of all assets and managerial rights to a contracting model which conferred legal person status on SOEs and provided economic incentives for them.21 The salient features of the two models are described in order.

2.2.1

Traditional Model (1950–1984)

When the PRC was established in 1949, the dominating business organization in industrial and commercial sectors was private enterprises. In order to achieve socialism in the economic field, on the basis of the public ownership theory of Marxism and the socialist practice of the former Soviet Union, the new regime led by the CPC launched the movement to purchase private enterprises by the state and then convert them into SOEs at the very beginning of the 1950s. In 1956, the state successfully completed the transformative process of private enterprises and state ownership and SOEs obtained absolute monopolistic power in the industry and commerce of China.22 The rationale behind this economic metamorphosis was that state ownership represented the most advanced ownership form and correspondingly should be the only legal one in any socialist regime.23 The presence of SOEs and their monopolistic position provided justification for the CPC and Chinese government to adopt the centrally planned economy which was accepted by the former Soviet Union.24 Under this economic system, state planners required authorities to set production demands and distribute human and financial resources. Consequently, at that time, SOEs were not real business entities. They were just the affiliates of the state for the purpose of implementing its economic and social policies. Line departments of governments determined what products and how many an SOE was permitted to produce and how many resources it could acquire.25 In addition, SOE executives were also appointed and fired by government 21

With regard to the classification of governance models of SOEs and their respective valid periods in China, the author makes reference to the article authored by Cindy A. Schipani and Junhai Liu. See footnote 6 above. 22 Available at http://cpc.people.com.cn/BIG5/33837/2534775.html. Accessed 24 July 2008. 23 Wang J (2008) Reform on Chinese economic framework and the institutional innovation of SOEs. http://www.chuangxinzhe.com/show_hdr.php?xname=HSN9321&dname=MS28F21&xpo s=28. Accessed 24 July 2008. 24 Liu C (2007) Exploring the process from the centrally planned economy to the market economy in China. Econ Soc Dev 5:8. 25 See footnote 6 above, p 8.

2.2

A Historical Perspective: The State-Owned Enterprises

23

agencies. They were called “state cadres” whose duties were to fulfil the production demands assigned by government planners and guarantee the implementation of other state policies in their enterprises. These SOE managers were responsible to government agencies because they were also an integral layer of governmental hierarchy and “enjoyed the same economic and political treatments as government officials”.26 With their complete ownership and governance, the state not only deemed SOEs to be units for production activities, but also a tool to arrange employment and maintain social stability. In the age of a centrally planned economy, if a person was recruited by an SOE, it meant that he would obtain a so-called “ironclad bowl” which could be kept for his lifetime and insured his “salary, housing, medical treatment, and pension”.27 In a word, during the reign of the traditional model, the state firmly gripped governance power over SOEs. Unfortunately, “most SOEs were static and uncompetitive”.28

2.2.2

Transitional Model (1984–1993)

The transitional governance model of SOEs is referred to as the contracting model as well.29 With the long-term misleading nature of the centrally planned economy and devastating effects of the Cultural Revolution, most SOEs were on the brink of going bankrupt in the late 1970s.30 Under the circumstances, the reform to SOEs had been put on the agenda of the CPC and Chinese government since 1978.31 The strategy adopted by Chinese leaders was to change the rigid planned mechanism and allocate management rights to SOEs and their executives to a limited degree. At the initial stage of this reform, policy makers held a very cautious attitude and they only conducted pilot experiments in several carefully selected SOEs with this new tactic.32 Consequently, the contracting model did not become pervasive in the process of Chinese SOE reform until the 12th CPC Central Committee passed the breakthrough platform entitled “The Decision of the CPC Central Committee on the Reform of the Economic System” in 1984.33 With regard to the governance features of the contracting model, they were systematically introduced by the State-owned Industrial Enterprise Law of the PRC

26

Ibid. Ibid., p 9. 28 Ibid. 29 Gu S, Xie S (2002) Revisiting the reform process of SOEs. Econ Rev 9:2–3. 30 Ibid., p 2. 31 Xie H (2008) From the planned economy to the market economy – the transformation of the economic framework in China. Macroecon Manage 5:23. 32 See footnote 29 above, p 2. 33 See footnote 8 above. 27

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The Status Quo of Corporate Governance of Chinese Listed Companies

(SOEs Law) which was adopted in 1988 for the purpose of achieving the above reform objective. In the light of the SOEs Law, the state remained the ownership of all of SOEs’ property. SOEs were transformed into legal persons who were responsible for their own profits and losses. Instead of the CPC secretaries in the traditional model, the directors of SOEs occupied the central leadership in enterprises. They assumed the overall managerial responsibilities for those firms.34 The theory behind this reform was “separation between the state ownership and the SOE management rights”.35 Although the contracting model allocated some autonomous rights in the aspect of management to SOEs and their directors, it did not substantially reduce the state’s control of these entities and changed their nature of implementing policies. In other words, the transitional governance model was still operated on the basis of state control which could be proved by the following three pieces of evidence. First, in terms of the SOEs Law, the mandatory production plans required by governments were not completely eliminated from SOEs. They still had to finish a portion of bureaucratic production demands.36 In addition, even though the SOEs Law stipulated that SOEs should be responsible for their own profits and losses, in practice, they only retained their due profits and governments indemnified their losses with the so-called “soft budgets”.37 Therefore, governmental intervention in the production activities of SOEs was still substantial. Second, according to the SOEs Law, the competent departments of governments were responsible for the appointment of SOEs’ directors.38 Although the workers congresses of SOEs were entitled to recommend director candidates to governments,

34 Article 2 of the SOEs Law stated that “an industrial enterprise owned by the whole people shall be a socialist commodity production and operation unit which shall, in accordance with law, make its own managerial decisions, take full responsibility for its profits and losses and practice independent accounting. The property of the enterprise shall be owned by the whole people, and shall be operated and managed by the enterprise with the authorization of the state in line with the principle of the separation of ownership and managerial authority. The enterprise shall enjoy the rights to possess, utilize and dispose of, according to law, the property which the state has authorized it to operate and manage. The enterprise shall obtain the status of a legal person in accordance with law and bear civil liability with the property which the state has authorized it to operate and manage”. Article 45 of the SOEs Law stipulated that “the factory director shall be the legal representative of the enterprise. The enterprise shall establish a system of production, operation and management headed by the factory director. The factory director shall occupy the central position in the enterprise and assume overall responsibility for building up a materially developed and culturally and ideologically advanced enterprise”. 35 Ibid. 36 Article 35 of the SOEs Law declared that “the enterprise must fulfill the mandatory plans”. 37 See footnote 29 above, p 3. 38 Article 44 of the SOEs Law provided that “except as otherwise stipulated by the State Council, the selection of the factory director shall be made by the competent department of the government in the light of the specific conditions of the enterprise by one of the following methods: (1) appointment by the competent department of the government or choice of an applicant on a competitive basis by the same department; or (2) election by the staff and workers’ congress of the enterprise. With respect to the person to be appointed or the applicant to be chosen as factory director by the

2.3

Modern Corporate Model (1993 to Present)…

25

governments approved their recommendation in the form of official documents only if the CPC committees also appreciated these candidates.39 In other words, the CPC still made the final decisions on the personnel arrangements of SOEs as it determined state cadres. It guaranteed that the executives of SOEs were in line with the requirements of the state. Third, the SOEs Law provided that the local organizations of the CPC assured and supervised the implementation of the Party’s and the state’s guidelines and policies.40 That meant that SOEs were more policy-implementation tools than independent business entities. To sum up, the transitional governance model did not significantly diminish the power and intervention of the state in relation to SOEs. Even though its objective and slogan was “separation between the state ownership and the SOE management rights”,41 governmental acts and production activities still mingled with each other. Moreover, SOEs bore the heavy burden of carrying out different kinds of policies and did not concentrate on the maximization of profits. Therefore, the contracting model failed to provide much in the process of SOE reform.

2.3

Modern Corporate Model (1993 to Present): A Substantial Transformation of SOEs?

The failure of the contracting model induced the national debate on the transformation and diversification of public ownership of SOEs into different forms at the end of the 1980s.42 However, this move was halted by the Tiananmen Square protests in 1989. In the following 3 years after this demonstration, the speed of SOE reform was slowed down and the voice for a restoration of the centrally planned economy resurged.43 Confronted with the circumstances, Mr. Xiaoping Deng called for the

competent department of the government, the opinions of the staff and workers shall be solicited, with respect to the person elected as factory director by the staff and workers’ congress of the enterprise, his appointment shall be reported to the competent department of the government for approval. The removal or dismissal of the factory director appointed or chosen from applicants by the competent department of the government shall be decided upon by such department, while the opinions of representatives of the staff and workers shall be solicited; the recall of the factory director elected by the staff and workers’ congress of the enterprise shall be decided by such congress and reported to the competent department of the government for approval”. 39 Sun Z, Feng T, Zhao G (2008) The role of governments in the reform process of SOEs. Mod Bus 8:215. 40 Article 8 of the SOEs Law provided that “the local organization of the Chinese Communist Party shall guarantee and supervise the implementation of the guiding principles and policies of the Party and the state in the enterprise”. 41 See footnote 34 above. 42 See footnote 29 above, p 3. 43 See footnote 31 above, p 24.

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The Status Quo of Corporate Governance of Chinese Listed Companies

CPC and the whole nation to further emancipate their minds and put forward the economic reform with great courage during his inspection trip to South China in 1992.44 Under his theory, the market economy did not solely belong to capitalism and it was compatible with the needs of socialist economic division and productions.45 The support from Mr. Xiaoping Deng provided fresh political impetus to the transformation of SOEs in China. In late 1992, the 14th National Congress of the CPC put the establishment of the market economy into its charter.46 Soon afterwards, the 14th CPC Central Committee passed the “Decisions on the Establishment of the Socialist Market Economy” in 1993 in which the setting up of a modern corporate system in relation to SOEs was an urgent and important objective.47 A series of policy signals for the corporatization of SOEs from the CPC and its paramount leaders promoted the enactment of the first Company Law of the PRC at the end of 1993 (Company Law 1993). After that, on the legal foundation laid by the Company Law 1993, two new approaches were put into practice for the reform of SOEs. First, small and less important SOEs were privatized and diversified into other business forms. The overall amount of SOEs has drastically diminished.48 Second, recapitalization with the governance system of modern corporations was encouraged for big and key SOEs instead of total privatization.49 Some of them were listed on the emerging domestic stock market in order to raise as much money as possible.50 These listed companies whose predecessors were the traditional SOEs have constituted the cornerstone of the whole state-owned economy in China. Table 2.3 clearly shows the decreasing trend of state-owned industrial enterprises from 1993 to 2005. Given that this kind of enterprise represents a big part of SOEs in China, their drastic reduction can be used to demonstrate the descendent change of all SOEs.51 Table 2.4 displays the annual number of state-controlled listed companies on the Shanghai and the Shenzhen stock exchanges from 1993 to 2005. If the data in Table 2.4 are compared with that in Table 2.3, it is easy to see that state-controlled listed companies just account for a minority percentage of SOEs in the light of their respective amounts even if the latter has decreased significantly. However, if the limited data in Table 2.5 are paid attention to, it is clear that state-controlled listed

44

See footnote 13 above. Ibid. 46 Available at http://news.xinhuanet.com/ziliao/2003-01/20/content_697129.htm. Accessed 10 Aug 2008. 47 The Fourteenth CPC Central Committee (2008) Decisions on the establishment of the socialist market economy. http://www.people.com.cn/GB/shizheng/252/5089/5106/5179/20010430/456592.html. Accessed 10 Aug 2008. 48 Liang B (2008) The changing Chinese legal system, 1978-present-centralization of power and rationalization of the legal system. Routledge, New York, p 30. 49 Ibid. 50 These enterprises are generally called “state-controlled listed companies” in official documents and academic literature in China. 51 According to the definition provided by the National Bureau of Statistics of China, industry includes but is not limited to energy, steel, telecommunication, transportation, manufacture, textile, chemicals and public utilities. 45

2.3

Modern Corporate Model (1993 to Present)…

Table 2.3 Number of state-owned industrial enterprises (state-owned industrial enterprises include wholly state-owned ones and state-controlled ones)

Year 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

27 Number (unit: 10,000) 10.47 10.22 11.80 11.38 9.86 6.47 5.07 5.35 4.76 4.11 3.43 3.18 2.75

Source: The National Bureau of Statistics of China (2007) China statistic yearbook (1994–2006). China Statistics Press, Beijing

Table 2.4 Number of statecontrolled listed companies

Year 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Number 181 281 313 514 715 811 877 973 1,013 1,034 1,045 1,050 1,031

Sources: Liang B (2008) The changing Chinese legal system, 1978-present-centralization of power and rationalization of the legal system. Routledge, New York, p 30

Table 2.5 The ratio of the value of state-controlled listed companies to that of the state-owned assets Market capitalization of state-controlled listed Overall amount of state-owned companies (billion RMB) Percentage Year assets (billion RMB) 2004 7,498.55 3,266.196 43.56 2005 8,623.12 2,867.365 33.25 Sources: Li R (ed), China’s state-owned assets supervision and administration yearbook (2005–2006). China Economy Publishing House, Beijing; Chen B, Che J, Wang X, Lai J (2008) Positive research on Chinese private listed companies. http://www.szse.cn/main/files/2008/02/25/091811911155.pdf. Accessed 28 May 2008

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companies played a backbone role in the whole state-owned economy even in the 2 years when the Chinese domestic stock market reached its historical bottom.52 On the basis of the aforementioned empirical evidence and the traditional policyimplementation orientation to SOEs which has been analyzed in the above section, it is presumed that the state must tightly control these pivotal listed companies through the specific governance institutions which have been stipulated by the Company Law of the PRC.53 In other words, the corporate governance of statecontrolled listed companies in China is still the control-based model as traditional SOEs, which is the result of path dependence. Next, the remaining part of this chapter illustrates this model from the aspects of three principal corporate governance institutions applied in China – the shareholder meeting, the board of directors and the supervisory committee.

2.3.1

The Shareholder Meeting

In China, the shareholder meeting which is viewed as a supreme power organ of a corporation occupies the central position in corporate governance.54 In terms of the latest Company Law of the PRC which came into effect in 2006 (Company Law 2006), the shareholder meeting holds the following comprehensive decisionmaking powers: (1) to determine corporate operation guidelines and investment plans; (2) to elect and replace directors and shareholder supervisors and determine their remunerations; (3) to review and approve the reports submitted by the board of directors; (4) to review and approve the reports submitted by the supervisory committee; (5) to review and approve the corporate fiscal budgets and final account reports on an annual basis; (6) to review and approve the corporate plans regarding allocating profits and making up for losses; (7) to determine the increase and decrease of the corporation’s registered capital; (8) to determine the issuance of corporate bonds; (9) to make decisions regarding corporate mergers, divisions, dissolution and liquidation; and (10) to amend the Articles of Incorporation.55 By this enumeration, it is obvious that the shareholder meeting of a corporation in China keeps substantial managerial powers, some of which are reserved to the board

52

The author only had access to the data for the above 2 years. Even if it does not seem rich, the author thinks that it is persuasive to a large extent given that the 2 years happened to represent the bottom of the Chinese domestic stock market. 53 The Company Law 1993 was revised in 2005 and the latest Company Law came into effect in 2006. However, its overall structure with the three main sections of the shareholder meeting, the board of directors and the supervisory committee has remained in the new Company Law to which the author will make reference in the following analysis. 54 Ye L (2008) The distribution of corporate powers. http://www.civillaw.com.cn/article/default. asp?id=37502. Accessed 16 Aug 2008. 55 Article 38 of the Company Law 2006.

2.3

Modern Corporate Model (1993 to Present)…

29

Table 2.6 The biggest shareholders in the state-controlled listed companies in the sector of steel in China in 2001 Ratio to Amount of shares the total held by the biggest Name of the biggest shares (%) shareholder Corporation name shareholder Anyang Iron and Steel Anyang Iron and Steel Group 870,490,259 64.70 Incorporated Corporation Limited Baoshan Iron and Steel Bao Steel Group Corporation 10,635,000,000 85.00 Incorporated Guangzhou Iron and Guangzhou Iron and Steel 352,969,735 51.44 Steel Incorporated Group Corporation Limited Handan Iron and Steel Handan Iron and Steel Group 996,553,100 67.04 Incorporated Corporation Limited Hangzhou Iron and Steel Hang Steel Group Corporation 479,587,500 74.32 Incorporated Hongxing Iron and Steel Jiuquan Steel Group 515,000,000 70.74 Incorporated Corporation Limited Laiwu Iron and Steel Group 715,182,000 82.9 Laiwu Iron and Steel Incorporated Corporation Lingyuan Iron and Steel Lingyuan Group Corporation 178,500,000 57.58 Incorporated Ma Steel (Group) Holding 4,082,330,000 63.24 Ma Anshan Iron and Steel Incorporated Corporation Nanjing Iron and Steel Nanjing Iron and Steel Group 357,600,000 70.95 Incorporated Corporation Limited Tangshan Iron and Steel Group 915,772,382 67.64 Tangshan Iron and Steel Incorporated Corporation Limited Wuhan Iron and Steel Wuhan Steel Group 1,770,480,000 84.69 Incorporated Corporation Source: Zhu J, Yuan H, Liu G (2002) The analysis on the ownership structure of state-controlled listed companies in the sector of steel in China. Econ Rev 12:34

of directors in the USA and other western countries. This arrangement has given rise to the probability that the majority shareholder can control the operation of the corporation to considerable degrees through the governance institution of the shareholder meeting in China. As it was mentioned above, the current state-controlled listed companies in China are the transformative results of traditional SOEs. Even though they have privatized a portion of shares to the public during the process of corporatization, the ownership structure of these enterprises still characterizes the substantial concentration of the state shares. Given the limits of available data, it is not possible to show the ownership constitution of each state-controlled listed company in China to prove the above proposition. However, Table 2.6 provides the empirical evidence regarding the biggest shareholders of the state-controlled listed companies in the sector of steel. It is believed that these enterprises can be used as a sample to reflect the concentrated state shares in this kind of listed company in China to a large extent. In light of the data in Table 2.6, all of the biggest shareholders of the 12 listed companies

30

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The Status Quo of Corporate Governance of Chinese Listed Companies

producing steel and iron were state holding corporations which are solely held by the state.56 The appointments to the top-tier corporate leadership positions in these state holding corporations are made by state-owned asset management commissions and CPC committees.57 Moreover, almost all of the candidates for these positions have the background of working in related government agencies.58 Therefore, state holding corporation leaders are seldom held accountable for the economic performance of the enterprise and its subsidiaries as long as their performance does not deteriorate massively.59 Their obligations are to guarantee the implementation of state and local policies in those entities. With the level of state holding corporations as their biggest shareholders, the state has tightly gripped state-controlled listed companies through the shareholder meeting. Even though the equity division reform in 2005 made state shares tradable on the secondary market, it has not shaken the state’s position in state-controlled listed companies as the largest shareholders due to the hampering from political considerations and vested interests.60

2.3.2

The Board of Directors

According to the stipulation of the Company Law 2006, the board of directors plays the role as the executive branch of the shareholder meeting in a corporation. It is mainly responsible for the enforcement of the operation decisions made by the latter.61 The state has achieved its control over the board of directors by means of personnel arrangements. Generally speaking, the chairman and the vice chairman of the board of directors and the director who is concurrently the chief executive in a state-controlled listed company are actually determined by local CPC committees.62 After that, this decision is forwarded to local governments and their state-owned

56 McNally CA (2002) Strange bedfellows: communist party institutions and new governance mechanisms in Chinese state holding corporations. Bus Polit 4:97. 57 Yi C, Zhang Y (2007) Research on the corporate governance of wholly state-owned corporations. J Southwest Univ Nationalities (Hum Soc Sci) 7:89. 58 See footnote 56 above, p 104. 59 Ibid., p 102. 60 See footnote 54 above. 61 Article 47 of the Company Law 2006. 62 Liaoning Securities Supervisory Bureau (2008) Analysis on the behavioral changes of the majority shareholders and the de facto controllers of listed companies and the corresponding supervisory approaches after the equity division reform. http://www.csrc.gov.cn/n575458/ n870331/n10217417/10264959.html. Accessed 21 Aug 2008; People’s Daily Online (2008) Behind the dismissal of Qiao Hong: no contest for the successor of Maotai. http://finance.people. com.cn/GB/67815/71134/5870908.html. Accessed 21 Aug 2008. The appointment procedure is also applicable to the listed companies invested in by the central government which are the minority of all state-controlled listed companies.

2.3

Modern Corporate Model (1993 to Present)…

31

asset management commissions.63 Next, state-owned asset management commissions require state holding corporations who are the biggest shareholders to convene the shareholding meeting of state-controlled listed companies and appoint the candidates on the shortlist.64 Moreover, in terms of local government regulations, it is a prevalent requirement that the chairman of the board of directors should act as vice CPC secretary and then the vice chairman should act as CPC secretary in this sort of listed company.65 In addition, a large portion of directors in a state-controlled listed company are former officials in disbanded component government departments.66 With regard to the independent directors in state-controlled listed companies, they also represent the voice of the state. In the light of the “Guidelines on the Establishment of the Institution of Independent Directors in Listed Companies” (the Guidelines on Independent Directors 2001) issued by the CSRC in 2001, independent directors are elected by the shareholding meeting.67 Therefore, in state-controlled listed companies, the state is the largest shareholder, although the level of state holding corporations actually dominates the selection of their independent directors.68 Consequently, independent directors keep tight ties with governments and act on behalf of them.

2.3.3

The Supervisory Committee

In China, the principal function of the supervisory committee in a corporation is to monitor the behaviour of directors and managers in the interests of shareholders.69 The members of the supervisory committee in state-controlled listed companies tend to be drawn from two sources. First, state holding corporations as the largest shareholders select external shareholder supervisors through the shareholder meeting.70 Generally, these external shareholder supervisors are retired government officials, famous economists and accountants who have close relationships with the authorities.

63

Ibid. Ibid. 65 See footnote 56 above, p 105. In practice, it is also common that the chairman of the board of directors act as that corporation’s party secretary. 66 Xinhuanet (2008) Black record of Chinese listed companies in 2005. http://news.xinhuanet.com/ stock/2006-01/06/content_4015864.htm. Accessed 21 Aug 2008. 67 Article 4 of the Guidelines on Independent Directors 2001. 68 Su J, Yao Y, Su Y (2007) Analysis on the problems of independent directors in China. Finan Econ 14:79; Cao X (2008) Reasons for the dysfunction of independent directors in China. China National Conditions and Strength 1:47. 69 Article 54 of the Company Law 2006. 70 Zhao J (2003) Consideration on the improvements of the Supervisory Committee of Chinese Listed Companies. Chin Econ 11:113; Li J (2004) On the improvements of the Supervisory Committee of Chinese Listed Companies through the perspective of its relationship with independent directors. Law Sci 2:76. 64

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The Status Quo of Corporate Governance of Chinese Listed Companies

Second, within corporations, the secretaries of corporations’ disciplinary committees of the CPC and worker representatives constitute internal shareholder supervisors.71 The two sources clearly convey the two main purposes of the supervisory committees of state-controlled listed companies. First, the committee is applied to further internalize the oversight of competent government departments over how state-controlled listed companies are operated, thus assuring the maintenance and increase of state assets and the implementation of state policies.72 Second, the disciplinary committees of the CPC within corporations can play the traditional role as the primary organs of managerial discipline through their personnel overlap with the supervisory committees.73 Therefore, this corporate institution in charge of management supervision in state-controlled listed companies is also firmly held by the state. Even if it has not obviously taken effect in practice, it is another issue which is not essentially relevant to the analysis in this chapter.74

2.4

Conclusion

Just as Donald Clarke claimed, “China’s legal system cannot be understood apart from its history and that history – whether imperial or modern – is overwhelmingly a story of centrality of the state”.75 It is also applicable to the corporate governance of state-controlled listed companies. Through the retrospect to the governance structures of their predecessors, it is not difficult to understand why the corporate governance of state-controlled listed companies is a control-based model for the purpose of implementing state policies. In other words, without looking back to the historical path, it is not explicable that “the policy of corporatization does not involve a renunciation by the state of its ambition to remain the direct owner of enterprises in a number of sectors”76 because “this ambition makes no sense if profits are the only objective”.77 This control-based model has aligned the interests of the state with the listed companies controlled by them. Therefore, the state has the incentive to use its power to transfer as many resources as possible to these listed companies and to protect them from potential competition. In addition, the existing governance framework of state-controlled listed companies has also retained and continued the

71

Wang L (2008) The tragedy of the Supervisory Committee of Chinese Listed Companies: curious performance in the past eleven years. http://www.civillaw.com.cn/article/default. asp?id=25935. Accessed 21 Aug 2008. 72 See footnote 56 above, p 106. 73 Ibid. 74 Li K (2005) Brief analysis on the shortcomings and improvements of the Supervisory Committee of Chinese Listed Companies. Law Rev 130:123–127. 75 See footnote 16 above. 76 See Clarke DC (2003) Corporate governance in China: an overview. China Econ Rev 14:497. 77 Ibid.

2.4

Conclusion

33

inertia of the state’s active participation in the competitive industry featured in the age of the planned economy. Thus, when a new commercial field emerges, the state will be reluctant to just provide public goods. It will take part in this competition against private participants. Consequently, the interest-aligned effect and the state-entrepreneurism resulting from or maintained by this control-based model have significantly hindered the healthy development of Chinese domestic VCs, which are demonstrated in the remaining parts of this book.

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Chapter 3

The Difficulty of Fundraising Suffered by Chinese Domestic VCs

3.1

Introduction

The second chapter has systematically analyzed the corporate governance framework of state-controlled listed companies which have constituted the overwhelming majority of all listed companies in China, either from the aspect of their total number and capitalization or their substantial influences on the formation and change of law and other institutions. These efforts have provided the necessary institutional background for the following exploration on how the corporate governance of statecontrolled listed companies which is termed the control-based model by company law academics1 has hampered the healthy development and prosperity of Chinese domestic VCs. As it was mentioned in the first chapter, the examination of the negative impacts caused by the control-based model on Chinese domestic VCs would be conducted with the mirror of the successful template of American VCs which has been proved to be duplicable by other countries.2 On the basis of the abundant intellectual products about the institutional environment to guarantee an active VC market in the USA made by western legal and financial scholars, four indispensable elements have been isolated: the availability of large and independent funding, the application of organizational and contractual incentive mechanisms, the existence of efficient exit channels and the high-risk tolerance level of venture capitalists. This chapter aims to discuss how the control-based model has restrained the presence or the full functioning of the first institutional element in China. In other words, it is an attempt to establish the linkage between the control-based model and the difficulty of raising large and independent funds suffered by Chinese domestic VCs. This chapter comprises three sections. The first section briefly describes the successful

1 2

See Liu “Corporate Governance in China: Current Practices” (footnote 6, Chapter 1), p 415. See footnote 38, pp 1068–1103, Chapter 1.

L. Zhang, Venture Capital and the Corporate Governance of Chinese Listed Companies, DOI 10.1007/978-1-4614-1281-6_3, © Springer Science+Business Media, LLC 2012

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The Difficulty of Fundraising Suffered by Chinese Domestic VCs

operation of American VCs in the aspect of raising large and independent funds. With the American practice as the mirror, the second section analyzes how the control-based model has hindered the availability of large and independent funds for Chinese domestic VCs. The final section is a concluding remark.

3.2

The Profile of the Fundraising of American VCs

The nature of VCs in their provision of capital for high-risk, high-potential start-up companies determines that it is a financial sector featuring huge investments in projects.3 Generally speaking, a venture capitalist needs to infuse capital into a portfolio company during several rounds before he is able to incubate the potentially profitable technology invented by the company through the growth period and eventually market it to consumers in the form of mature products.4 The total staged capital infusions are usually up to millions of dollars. Therefore, not only does the VC industry mean high risks and high rewards, but also it requires large funds. An obvious reason for the vitality of the American VC market is that venture capitalists are able to obtain the sufficient influx of money, which enables them to satisfy the substantial pecuniary needs from their portfolio companies.5 However, by looking back at the history of the American VC industry, it is observed that its origin was not accompanied by massive monetary injection. In the USA, the first genuine venture capital organization was American Research and Development (ARD), set up in 1946 by former MIT President Karl Compton, General Georges F. Doriot who was a professor at Harvard Business School and some local commercial leaders.6 During its 26-year existence, ARD principally raised funds from individuals and seldom required the involvement of institutional investors due to regulatory barriers.7 The lack of capital led to the fact that the sizes of the entities invested in by ARD were generally small. For example, it only put up 70,000 US dollars for Digital Equipment Company which created almost half of ARD’s overall profits during its lifespan.8 At that time, the fundraising dilemma faced by ARD was not exceptional and was a miniature of the American VC industry at its early stage.

3

Gompers P, Lerner J (2004) The venture capital cycle, 2nd edn. MIT, Cambridge, MA, pp 6–7. Bartlett RP (2006) Venture capital, agency costs, and the false dichotomy of the corporation. UCLA Law Rev 54:53. 5 Gompers PA, Lerner J, Blair MM, Hellmann T (1998) What drives venture capital fundraising? Brookings Papers on Economic Activity-Microeconomics 149. 6 Gompers P, Lerner J (2001) The venture capital revolution. J Econ Perspect 15:146. In addition, “institutional investors” hereinbefore solely refer to non-financial institutions. At that time, financial institutions in America were not precluded from investing in VC firms, but few of them showed interest in this sector due to strong risk-aversion. 7 Ibid. 8 Ibid. 4

3.2 The Profile of the Fundraising of American VCs

37

The dramatic growth of commitments to the US VC industry occurred in the late 1970s.9 With regard to the forces that generated the striking movements in venture fundraising, American economic and legal scholars have conducted full discussions in their publications.10 Among all the positive factors which they have identified, the Department of Labor’s clarification of the “prudent man” rule in 1979 has played the most significant role in practice.11 Prior to that amendment, the Employee Retirement Income Security Act (ERISA) forbade pension funds to invest substantial amounts of money in VC or other high-risk financial instruments.12 The Department of Labor’s explication to the rule permitted pension fund managers to freely invest in high-risk assets, including venture capital. This change of regulatory requirement opened the floodgates to pension funds’ tremendous capital resources and considerably contributed to the increase of money flowing into the VC sector.13 Table 3.1 shows that pension funds became the single largest source of capital for American VCs and almost accounted for half of all contributions after 1978. Therefore, it is fair to say that pension funds have played the most salient part in the presence of the sizable fundraising of the American VC market. That is also why the capital volume of the VC industry in America has remained high during the past 20 years even if it went through several ebbs.14 Beyond the size of funds, the relationship between venture capitalists and their principal investors is also critical for the vitality of a venture capital market.15 Just as Curtis Milhaupt pointed out, “venture capitalists can be expected to behave differently – to have different investment and exit strategies and performance expectations – depending on their relationship with their principal investors”.16 If he is independent of major VC investors, the venture capitalist is allowed to focus on nurturing the most promising ventures and reaping the harvest of investment in the most profitable manner. In turn, the successful experience will induce successive capital injection from investors. In contrast, the venture capitalist is most likely to perform in a way which is divergent from the mission of maximizing the profits of investment if he is substantially affected by the intention of major investors.17

9

See footnote 33, p 881, Chapter 1. See Gompers P, Lerner J (1996) The use of covenants: an empirical analysis of venture partnership agreement. J Law Econ 39:463; Gompers P, Lerner J (1999) An analysis of compensation in the U.S. venture capital partnership. J Financ Econ 51:3; Poterba JM (1987) How burdensome are capital gains taxes? Evidence from the United States. J Public Econ 33:157–172. 11 Gompers P, Lerner J (1994) Venture capitalists and the decision to go public. J Financ Econ 35:293–295. 12 See footnote 6 above. 13 See footnote 11 above. 14 See footnote 5 above. 15 See footnote 33, p 880, Chapter 1. 16 Ibid., p 881. 17 Ivanov VI, Masulis RW (2008) Corporate venture capital, strategic alliances, and the governance of newly public firms. http://cei.ier.hit-u.ac.jp/Japanese/database/documents/WP2008-15.pdf. Accessed 11 Dec 2008. 10

Number Size Pension Corporations Individuals Endowments Year of funds ($ million) funds (%) (%) (%) (%) 1978 23 495 15 10 32 9 1979 27 560 31 17 23 10 1980 57 1,444 30 19 16 14 1981 81 1,984 23 17 23 12 1982 98 2,420 33 12 21 7 1983 147 6,319 31 12 21 8 1984 150 5,608 34 14 15 6 1985 99 4,856 33 12 13 8 1986 86 51 51 11 12 6 1987 112 6,232 39 10 12 10 1988 78 4,309 47 12 8 11 1989 88 4,007 36 20 6 12 1990 50 2,905 53 7 11 13 1991 34 1,771 42 4 12 24 1992 31 2,331 42 3 11 18 1993 54 2,949 59 8 7 11 1994 105 5,524 47 9 12 21 1995 72 5,283 38 2 17 22 1996 97 9,185 43 13 9 21 1997 136 12,676 40 30 13 9 1998 281 32,904 60 12 11 6 1999 421 62,053 43 14 10 17 2000 614 108,382 40 4 12 21 2001 299 40,648 42 3 9 22 2002 125 8,005 45 10 12 11 Source: Gompers P, Lerner J (2004) The venture capital cycle, 2nd edn. MIT, Cambridge, MA, pp 10–11

Table 3.1 Summary statistics for VC fundraising from 1978 to 2002 in the USA Insurance companies and banks (%) 16 4 13 15 14 12 13 11 10 15 9 13 9 6 14 11 9 18 5 1 10 16 23 25 16

Foreign investors and other (%) 18 15 8 10 13 16 18 23 11 14 13 13 7 12 11 4 2 3 8 7 N/A N/A N/A N/A 6

38 3 The Difficulty of Fundraising Suffered by Chinese Domestic VCs

3.2 The Profile of the Fundraising of American VCs

39

Consequently, it will negatively influence capital contribution both from the supply side and demand side. In America, pension funds as the single largest source of capital have guaranteed the independent status of venture capitalists. Pension fund managers invest in VC funds in order to seek returns and enhance diversification.18 Therefore, as per the pertinent analysis made by Curtis Milhaupt, “the pension manager’s investment decision reflects the calculation about the skill of the venture capitalist in ferreting out opportunities that promise a high rate of return”.19 Moreover, the importance of the independence of venture capitalists has also been evidenced by the failure of the Japanese VC industry whose venture capitalists are generally affiliated with the principal investors – large banks and securities firms.20 As for the capital of American VCs which operate in China, the overwhelming majority of them are raised within the territory of the USA. On the one hand, this fact has ensured that these American VCs possess adequate money throughout the whole process of investment.21 On the other hand, it also implicitly reflects the difficulties to pool RMB funds faced by foreign VCs. Although the Chinese authorities have approved several of them to directly or indirectly establish RMB funds, foreign VCs are still very cautious and passive with this choice, taking into account its high costs in China – the time-consuming approval procedure, the underdevelopment of limited partnerships, the limited sources of money and the uncertainty of liquidity through Chinese stock markets.22 Therefore, they are likely to rely on their compatriot VC investors rather than Chinese ones.

18

Lutsi JD (1995) Pensions turn to long-haul venture capital funds to raise returns. Corp Cashflow 16:36. 19 See footnote 33, pp 880–881, Chapter 1. 20 Sibbitt EC (1998) Law, venture capital, and entrepreneurism in Japan: a microeconomic perspective on the impact of law on the generation and financing of venture businesses. Conn J Int Law 13:85–105. 21 In China, the fundraising and exit of foreign VCs are usually carried out abroad. This model is called “two-end-outside” by Chinese venture capitalists. Recently, some commentators have argued that this model may be substantially changed by the ongoing financial crisis. However, as Nanpeng Shen, CEO of Sequoia Capital (China), pointed out in the 11th China VC Forum in June 2009, the “two-end-outside” had not been significantly altered even if several RMB funds had been established by foreign VCs. In addition, Shen’s statement also implies that the latest financial tsunami does not cause many difficulties for American VCs to raise money in the USA, which has been confirmed by Song Jin, Vice-chairman of Gotham Capital Management. The speech of Shen is available at http://money.163.com/09/0605/14/5B25BPQK00253DMT.html. Accessed on 23 June 2009; Xinhuanet (2009) Wall Street Journal: hedge funds and private equity in the context of financial crisis. http://news.xinhuanet.com/fortune/2009-03/30/content_11099567.htm. Accessed 23 June 2009. 22 ChinaReviewNews (2009) The environments for RMB funds are still immature. http://www. chinareviewnews.com/doc/1007/0/4/5/100704590.html?coluid=7&kindid=0&docid=100704590. Accessed 23 June 2009.

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The above successful story of the American VC industry in the aspect of fundraising presents us two valuable points from both the theoretical and practical views. First, pension funds can make great contributions to the capital growth of a VC market. If pension funds are not available, there must be alternative institutional investors of similar size and nature to take its place. Second, the independent status of venture capitalists plays a critical role in the presence of a vibrant VC industry. The combination of the two aspects has partly achieved the outstanding character of American VCs – the high-risk tolerance demonstrated by the preference to frontier high technologies and early stage investment.23

3.3

The Reflection of Chinese Domestic VCs’ Fundraising in the American Mirror

The above description of the successful practice of American VCs’ fundraising has provided a mirror to reflect the reasons for the failure of Chinese domestic VCs in this aspect. As the data illustrated in Chapter 1, the annual investment amounts made by foreign VCs in China were much larger than those by Chinese domestic VCs during the past several years. Given that American VCs constitute the majority of all foreign VCs actively operating in China, this situation indirectly shows that the ability of Chinese domestic VCs to pool capital and maintain their independent positions has substantially fallen behind their American competitors. The absence of both the real involvement of Chinese pension funds without alternative sources and the independent status of Chinese domestic venture capitalists, which are the two most critical factors guaranteeing the sizable fundraising of the American VC sector, can almost explain this difference. More importantly, their absence has been strongly linked to the corporate governance of Chinese state-controlled listed companies, which is the hypothesis of this chapter to be verified. Therefore, the remaining parts aim to prove this linkage in order.

3.3.1

The Absence of Pension Funds from Their Real Involvement in the Chinese VC Market

As it has been analyzed in Chapter 2, the corporate governance of state-controlled listed companies is termed as the control-based model by corporate law scholars. On the one hand, this model has ensured that the state is able to tightly control those pivotal entities of the Chinese state-owned economy. On the other hand, it has also aligned the interests of the state with those of its controlled listed companies.

23

See footnote 33, pp 892–894, Chapter 1.

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Therefore, the state has the incentive to use its power to transfer as many resources as possible to those listed companies by means of designing preferential laws and other institutions. Consequently, this partial behaviour has given rise to the difficulties for other economic participants to acquire sufficient capital for their own operations. Specifically to the fundraising of Chinese domestic VCs, pension funds, which should have been the principal contributor to the Chinese VC market, have been always absent from their real involvement in this sector because of the institutional barriers strongly related to the interest-aligned effect of the control-based model.24 In China, pension funds, together with unemployment insurance, work-related injury insurance, medical insurance and maternity insurance, are officially called “social security funds” which are in the charge of the National Council for Social Security Fund (SSF).25 Generally speaking, the SSF tends to put up social security funds as a whole for investment purposes. As Table 3.2 illustrates, pension funds accounted for the overwhelming majority of the total volume of social security funds. Therefore, I will consider “social security fund” to be an equivalent of “pension funds” in the Chinese context in this book. The current valid statute which regulates the investment of social security funds in China is the “Provisional Regulation of National Social Security Funds’ Investment” (Provisional Regulation) jointly promulgated by the Ministry of Finance (MOF) and the Ministry of Labour and Social Security in 2001. Article 28 of this regulation explicitly stipulates the financial instruments in which social security funds are permitted to invest and their respective receivable investment amounts. In terms of Article 28, the investment of social security funds in the form of bank deposits and national debts is not less than 50% of their overall volume; the investment of social security funds in the form of enterprise bonds and financial bonds is not more than 10% of their overall volume; the investment of social security funds in the form of mutual funds and stocks is not more than 40% of their overall volume.26 Apparently, VC is excluded from the investment categories permitted by Article 28. More importantly, the investment portfolio stipulated by Article 28 also reflects the underlying propensity of law makers to distribute as many resources as possible

24

Professor Xianping Lang disapproves of purchasing stocks with pension funds because he thinks that Chinese enterprises considerably lack the fiduciary duty. However, most Chinese economists do not agree with him on this issue. As Professor Jinglian Wu said, Lang’s assumption was that China was in the worst period of her history, which was very irresponsible. See FinanceQQ (2009) Xianping lang disapproves of investing pension funds into stock markets. http://finance.qq. com/a/20041206/000070.htm. Accessed 24 June 2009; People’s Daily Online (2009) Eliminating sentimental debate on reform. http://finance.people.com.cn/BIG5/42774/4180763.html. Accessed 24 June 2009. 25 Available at http://www.ssf.gov.cn/web/NewsInfo.asp?NewsId=42. Accessed 18 Dec 2008. 26 Article 28 of the Provisional Regulation.

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Table 3.2 Statistics of social security funds Total (RMB Pension Unemployment Medical Work injury Maternity Year 100 million) funds insurance insurance insurance insurance 1990 186.8 178.8 8.0 N/A N/A N/A 1991 225 215.7 9.3 N/A N/A N/A 1992 377.4 365.8 11.7 N/A N/A N/A 1993 526.1 503.5 17.9 1.4 2.4 0.8 1994 742 707.4 25.4 3.2 4.6 1.5 1995 1,006 950.1 35.3 9.7 8.1 2.9 2000 2,644.5 2,278.1 160.4 170.0 24.8 11.2 2001 3,101.9 2,489.0 187.3 383.6 28.3 13.7 2002 4,048.7 3,171.5 215.6 607.8 32.0 21.8 2003 4,882.9 3,680.0 249.5 890.0 37.6 25.8 2004 5,780.3 4,258.4 291.0 1140.5 58.3 32.1 Source: Department of Population and Employment Statistics of the National Bureau of Statistics and Department of Planning and Finance of Ministry of Labour and Social Security (2005) China Labour Statistical Yearbook. China Statistical Press, Beijing, p 575

to state-controlled listed companies, which in turn is partially linked to the interestaligned effect of the control-based model. To a large extent, the empirical evidence shown below is able to support this kind of linkage. First, with regard to deposits, the Industrial and Commercial Bank of China (ICBC), the Bank of China (BOC) and the Bank of Communications are collectively responsible for this business in terms of their own contracts, respectively, struck with the SSF.27 Stemming from their identities as state-owned financial institutions, the ICBC and the BOC have always acted as the vault for their “siblings” – state-owned enterprises. In other words, the ICBC and the BOC generally make loans, which are the conversion of their deposits, to SOEs.28 As for the Bank of Communications, its status was vague for quite a long time.29 However, in March 2008, the MOF of the PRC clarified that the Bank of Communications was a large state-controlled commercial bank and the percentage of its shares held by foreign investors must be within the limitation of 20%.30 Soon afterwards, the MOF increased its share holdings of this bank in order to strengthen its position as the largest shareholder.31 27

People’s Daily Online (2008) The ICBC has become the trustee of social security funds. http:// finance.people.com.cn/BIG5/5959441.html. Accessed 21 Dec 2008. 28 Dai Y (2008) The reform policies for Chinese state-owned commercial banks and their dilemmas. http://www.chinareviewnews.com/crn-webapp/cbspub/secDetail.jsp?bookid=14781&secid=14813. Accessed 21 Dec 2008. 29 People’s Daily Online (2008) The bank of communications has finished its preparation for the issuance of a shares within a short time and its IPO price will be above 10 yuan. http://finance. people.com.cn/GB/72020/74689/83016/5701297.html. Accessed 21 Dec 2008. 30 Ibid. HSBC as the strategic investor holds 19.9% of the total shares of the Bank of Communications. 31 The Bank of Communications (2008) An announcement on the transfer of shares. http://www. hkex.com.hk/csm/ShowNews.asp?mkt=hk&FileName=http://www.hkexnews.hk/listedco/listconews/SEHK/20080325/LTN20080325558_C.pdf. Accessed 21 Dec 2008.

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Table 3.3 The loan amounts made by the ICBC Loan amounts on 30 June Loan amounts 31 December Organizational forms 2007 (RMB million) 2006 (RMB million) State-held enterprises 1,489,436 1,395,412 Privately held enterprises 422,732 354,173 Foreign invested enterprises 277,120 257,437 Source: The Industrial and Commercial Bank of China (2008) 2007 Interim results announcement of the ICBC. http://www.hkexnews.hk/listedco/listconews/SEHK/20070924/01398_223914/C101. pdf. Accessed 21 Dec 2008

This change has symbolized the fact that the nature and functions of the Bank of Communications have been converging towards those of the other four state-owned commercial banks including the ICBC and the BOC. Table 3.3 shows the respective total loan amounts made by the ICBC by 31 December 2006 and by 30 June 2007. In terms of the data in Table 3.3, it is almost undoubted that SOEs have always enjoyed the preferential loan service offered by the ICBC. Even though the statistics of loans sorted out in the light of organizational forms by the BOC and the Bank of Communications are not had access to, there are plausible reasons to believe that they share the same affinity for SOEs with the ICBC because of their homogeneity. Furthermore, it is also undeniable that state-controlled listed companies which are the prop of the state-owned economy have definitely acquired the lion’s share of all the above loans accruing to SOEs. According to the gross statistics disseminated by the Xinhua News Agency, the total loan amount made by the Guangdong branch of the ICBC was up to RMB216.9 billion yuan from 2003 to 2007 and the overwhelming majority of that money was injected into the giant state-controlled listed companies in the sectors of energy, transportation or petroleum.32 Therefore, it is nearly reasonable to say that most of the social security funds deposited in the above three state-controlled commercial banks is channelled to state-controlled listed companies. As for national debts, their primary purpose is to promote the construction of infrastructure, such as railways, electrical grids or fresh water facilities for rural areas.33 These investment fields of national debts are almost naturally monopolized by gigantic state-controlled listed companies. Hence, it is presumed that the social security funds used for the purchase of national debts have been largely siphoned into state-controlled listed companies if not all. In the light of Article 28 of the Provisional Regulation, another major investment field of social security funds is to purchase stocks. Table 3.4 shows the investment

32

Xinhuanet (2008) The Guangdong branch of the ICBC has decided to loan RMB 30 billion to Guangdong Electric Power Development Company. http://big5.xinhuanet.com/gate/big5/gd.xinhuanet.com/newscenter/2008-09/05/content_14317974.htm. Accessed 23 Dec 2008. 33 National Debt Association of China (2008) The investment projects of national debts. http:// www.ndac.org.cn/specmemo.jsp?specid=investment. Accessed 26 Dec 2008.

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Table 3.4 Listed stocks held by social security funds by the end of the first half of 2008 Stock code Stock name Category of issuing company 000042 Shen Changcheng State-controlled 000089 Shenzhen Airport State-controlled 000429 Yue Expressway State-controlled 000513 Lizhu Pharmaceutical Group Privately held 000531 Sui Hengyun State-controlled 000539 Yue Electricity State-controlled 000559 Wanxiang Qianchao Privately held 000599 Qingdao Double Star State-controlled 000600 Jiantou Energy State-controlled 000650 Renhe Group Privately held 000667 Celebrities Real Estate Development Group State-controlled 000708 Daye Special Steel State-controlled 000785 Zhongshang Commercial Group State-controlled 000800 FAW Car State-controlled 000826 Eguard Resource Privately held 000848 Chengde Lulu Privately held 000882 Hualian Development Store State-controlled 000900 Xiandia Investment State-controlled 000951 China National Heavy Duty Truck Group State-controlled 000969 AT&M State-controlled 000970 Zhongke Sanhuan Privately held 002017 Eastcom Peace State-controlled 002018 Huaxing Chemical Industry Privately held 002038 Shuanglu Pharmaceutical Group Privately held 002039 Qianyuan Power State-controlled 002041 Denghai Seeds State-controlled 002056 DMEGC State-controlled 002065 DHC Digital Technology Privately held 002068 Black Cat Carbon State-controlled 002078 Sun Paper Privately held 002081 Gold Mantis Privately held 002106 Laibao Hi-tech State-controlled 002121 Clou Electronics Privately held 002204 Heavy Industry Steel Casting State-controlled 002205 Guotong Pipeline State-controlled Source: The interim reports of Chinese listed companies can be accessed at the China Stock Markets Web. http://www.hkex.com.hk/csm/homepage.asp?LangCode=tc. Accessed 30 Dec 2008

portfolio of social security funds on stock purchase by the end of the first half of 2008. From this table, it can be clearly observed that the number of state-controlled ones is 23 of the 35 listed companies. Therefore, to a large extent, this reflects the preference of the SSF for purchasing stocks issued by state-controlled listed companies with social security funds. With regard to buying the stocks issued by unlisted joint stock limited companies, till now, the SSF has only made investment

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in the ICBC, the BOC, the Bank of Communications and the Beijing–Shanghai Express Railway.34 Soon after the SSF purchased the shares of the three investee banks, they were successfully listed on the Hong Kong Stock Exchange. Hence, given the pre-IPO timing which the SSF chose, its behaviour could also display its strong interest in state-controlled listed companies. The fact that most social security funds have been channelled into state-controlled listed companies in accordance with the investment requirements of Article 28 of the Provisional Regulation has been proved. However, the significance of this verification is not limited to that aspect. The more important thing lies in the achievement that it has demonstrated the linkage between the control-based model and the propensity of law makers to choose institutional arrangements in favour of statecontrolled listed companies. Objectively speaking, without referring to the controlbased model, it would have been difficult for us to understand the partial behaviour of the authority in the process of designing laws and other institutions concerning the resource allocation among different market participants. Consequently, the interest-aligned effect of the control-based model has substantively prevented social security funds from being involved in the Chinese domestic VC market. Although the State Council recently approved the investing of social security funds in two private equity funds, respectively, established by the CDH Investment and the Hony Capital both of whom have strong governmental backgrounds,35 the two funds principally concentrate on the enterprises at their pre-IPO stages,36 especially those controlled and favoured by local governments, which is quite different from the function of the VC sector.37 Without the real involvement of social security funds in the Chinese VC industry, are there any institutional investors of similar size and nature taking its place? The

34

Xinhuanet (2008) Social security funds worth RMB50 billion yuan will be invested in private equity funds. http://big5.xinhuanet.com/gate/big5/news.xinhuanet.com/fortune/2008-05/07/content_8121071.htm. Accessed 31 Dec 2008. 35 Xinhuanet (2009) Social security funds have been approved of investing in private equity funds. http://news.xinhuanet.com/fortune/2008-06/06/content_8320154.htm. Accessed 2 Jan 2009; Xinhuanet (2009) The SSF have decided to invest in two private equity funds respectively established by the CDH Investment and the Hony Capital. Available at http://big5.xinhuanet.com/gate/ big5/news.xinhuanet.com/fortune/2008-06/11/content_8344332.htm. Accessed 2 Jan 2009. The Predecessor of the CDH Investment was the Private Equity Investment Department of China International Capital Corporation Limited (the CICC) affiliated with the China Investment Corporation; the Hony Capital is set up by Lenovo which was a state-owned enterprise. 36 The respective investment portfolios of the CDH and the Hony Capital are available at http:// www.cdhfund.com and http://www.honycapital.com. Accessed 2 Jan 2009. 37 In the terminology, venture capital is a type of private equity which focuses on high-risk and high-return start-ups. In addition, the author believes that some may argue that it is only a matter of time for Chinese social security funds to massively enter the VC industry. The author agrees that time has the power to let something happen. However, for academic research, one cannot completely leave problems to time. The right approach is to identify the institutional barriers which hinder the prompt solution to problems. If this kind of effort can eventually speed up the process of institutional changes, the significance of academic research is well achieved. In this book, the author assumes that this institutional barrier is the control-based model.

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answer is “No”. In the Chinese financial market, apart from social security funds, state-owned commercial banks, insurance companies and mutual funds also possess the ability to contribute huge amounts of money to the Chinese domestic VC sector.38 As it has been analyzed above, state-owned commercial banks have been basically excluded from this group as a result of the interest-aligned effect of the control-based model. Likewise, the remaining two members – insurance companies and mutual funds – are prohibited from participating in VC business as well. In terms of Article 106 of the Insurance Law of the People’s Republic of China and its implementing regulation, the use of the funds in the charge of insurance companies is confined to deposits, governmental or financial bonds, the stocks of non-GEM listed companies, mutual funds and real estate. In the meantime, in light of Article 58 of the Mutual Funds Law of the People’s Republic of China, mutual funds can only be used to purchase the stocks and bonds of listed companies. Consequently, none of them are allowed to enter the VC sector. Again, referring to their permissible usage and the above analysis, it can be easily observed that their massive money actually flows into state-controlled listed companies, which is the inevitable result caused by the control-based model.39 Here, it is believed that some must wonder who the principal investor in the Chinese domestic VC market is. Table 3.5 shows the sources of Chinese domestic VC funds from 1997 to 2002. It is obvious that governments accounted for more than half of the overall contributions. In addition, taking account of the fact that governments and their state-owned asset supervision and administration committees are actually in charge of material investment decisions of SOEs, it is justifiable to classify SOEs’ contribution to Chinese domestic VCs within the category of government. This fact also determines that the venture capital companies established by SOEs are just a variation of those directly set up by governments (GVC) and in turn they share a similar pattern of operation. As for the commitments made by financial institutions to Chinese domestic VCs, almost all of them were provided to the GVCs in the form of loans before 2007.40 Since 2007, some state-controlled commercial 38

By the end of 2005, the total value of mutual funds in China was RMB469.116 billion yuan; by the end of 2007, the overall amount of premiums in China was over RMB700 billion yuan. These two items of data are, respectively, available at http://finance.sina.com.cn/fund/jjpl/20060106/ 18342255619.shtml, accessed 25 June 2009, and http://big5.southcn.com/gate/big5/insurance. southcn.com/hyyw/content/2008-12/08/content_4753310.htm, accessed 25 June 2009. Recently, several leading brokers in China have been allowed by the CSRC to make direct investment in corporations. The investment cap is set at 15% of their net capital. This may have some positive impacts on the fundraising of Chinese domestic VCs. However, taking into account the limited capital sizes of those brokers, the author does not think that this kind of impact will be substantial. 39 By checking the ownership structures of leading mutual fund companies in China, it is discovered that most of them are state-controlled. Even if the statistics about the investment portfolios of their mutual funds cannot be obtained, there has reason to believe that they prefer stocks and bonds of state-controlled listed companies on the basis of the above fact. 40 Although there are no statistics available concerning the distribution of loans between GVCs and private domestic VCs, with massive research using the Internet, the author has found that almost all the news on commercial banks’ participation in the VC sector regarded their lending deals with the GVC. For example, China Development Bank made a loan worth RMB100 million yuan to Xi’an Venture Capital Limited Company which is in the charge of Xi’an Municipal Government, available at http://www.chinavalue.net/Article/Archive/2008/4/7/108068.html. Accessed 4 Jan 2009.

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Table 3.5 The breakdown of Chinese domestic VC funds from 1997 to 2002 State-owned Financial Year Government (%) enterprises (%) institutions (%) Others (%) 1997 69.8 12.7 16.7 0.8 1998 63 21.2 13.4 2.4 1999 57.7 30.9 8.21 3.19 2000 44.9 46.2 5.58 3.32 2001 43.9 47.4 5.25 3.45 2002 53.8 35.4 6.15 4.65 Source: Calculated from the Data in Wang S (2003) China venture capital development report (2003). Economics and Management Press, Beijing

banks have begun to lend to the Industry Guidance Funds (IGF) founded by local governments in addition to their direct loans for the GVCs.41 In comparison with the conventional GVCs, the IGF has been recently deemed a new form for the governments’ involvement in the VC sector,42 which is analyzed in detail in the next section of this chapter. Therefore, it is reasonable to add the capital raised by financial institutions for Chinese domestic VCs to that contributed by governments as well. Now a profile for Chinese domestic VCs has been pictured – the absolute dominance of governments. Therefore, the remaining parts of this chapter choose GVC as the sample for analysis and only concentrate on their operation. Even though the percentage of governmental investment decreased and the accurate numbers of SOEs’ investment were not available from 2005 to 2007 as Table 3.6 displays, it is virtually indisputable that the share of governmental inputs still amounted to two-thirds of the total domestic VC funds after a gross calculation. On the one hand, the strong figure of governments in the Chinese domestic VC segment has given rise to a cash shortage for the financing of projects because the budgets of governmental revenue and SOEs’ retained profits for the VC sector are quite limited.43 The aftermath of this kind of financial constraint is indicated in Table 3.7. Through Table 3.7, it is easy to assess that the investment strength of Chinese domestic VCs was just onefifth of that of foreign VCs in 2007. On the other hand, with the inertia of stateentrepreneurism which is mainly sustained by the control-based model, the highprofile of governments in the Chinese domestic VC market has also deprived venture capitalists of their independent status. The following part will be an attempt to prove the linkage between the control-based model and the absence of the independent status of venture capitalists.

41

People’s Daily Online (2009) A new movement on VC in Tianjin Binhai new area. http:// www.022net.com/2007/9-7/483342173097452.html. Accessed 4 Jan 2009. 42 Li C (2008) An industry guidance fund worth RMB1 billion yuan founded by the Hangzhou Municipal Government. Hangzhou S&H Magazine 2:60. 43 See footnote 48, Chapter 1.

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Table 3.6 The breakdown of Chinese domestic VC funds from 2005 to 2007 Financial Year Government (%) institutions (%) Enterprises (%) Individuals (%) Others (%) 2005 32 15 46 3 4 2006 33.6 7.88 44.9 5.7 2.7 2007 24.13 25.45 53.53 10.46 4 Source: China Venture Capital Research Institute Limited (2008) China venture capital yearbook (2008). Democracy and Construction Press, Beijing, p 249 Table 3.7 The difference of investment strength between domestic VCs and foreign VCs in China in 2007 Investment strength Domestic VC Foreign VC Average investment amount in a single project 23,885.6 122,470.4 (RMB1,000 yuan) Source: China Venture Capital Research Institute Limited (2008) China venture capital yearbook (2008). Democracy and Construction Press, Beijing, p 259

3.3.2

The Lack of Independence of Venture Capitalists in GVCs

In the information era, technological advancement is usually the main impetus for a country’s economic growth, which has become a consensus for most states in the world. The Chinese central government also realized the significance of enhancing China’s technological innovation ability in the early 1980s. In 1984, on the basis of their findings in the project named “the New Technology and China’s Countermeasures”, the National Centre of Science and Technology for Development put forth the suggestion that a venture capital system should be engineered in order to promote technological development in China.44 This proposal quickly drew the attention of the CPC Central Committee and the central government. In 1985, the CPC Central Committee promulgated “the Decision to Reform the Science and Technology System” in which the reigning party firstly recognized the supportive role of VC in developing high technologies.45 According to the successful experiences in other countries, the support in the form of both policies and seed funds from the authorities is indispensable at the initial development stage of a VC.46 Therefore, the CPC and the central government performed duly in their efforts to establish China’s VC market by 1985. However, the failing lessons of engineering VC markets in other countries have also underlined

44

See footnote 48, p 5, Chapter 1. The 12th CPC Central Committee (2009) The decision to reform the science and technology system. http://cpc.people.com.cn/BIG5/64162/134902/8092254.html. Accessed 4 Jan 2009. 46 Yigal E (2005) The successful experience of Israeli VC. Shenzhen Sci Technol 5:82–84. 45

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the caveat that the role of governments must be strictly limited to that scope.47 Otherwise, their intervention in the decision-making process of professional venture capitalists will definitely ruin the healthy development of the VC market.48 Unfortunately, China did not avoid this pitfall. In a country with the pervasiveness of its state-owned economy, both the Chinese central government and local ones have inevitably possessed the quality of state-entrepreneurism which means that they are used to actively participating in the competitive industry, especially in new commercial fields with potentially attractive benefits. Consequently, with the driving force of this affinity, the China New Technology Venture Investment Corporation as the first VC institution was established jointly by the State Science and Technology Committee and the MOF in 1986.49 It symbolized the beginning of the dual status of governments in Chinese domestic VCs – both principal investors and actual venture capitalists. In 1991, the State Council issued the “Notice on the Approval of National High-tech Zones and Its Relevant Policies” in which it permitted local governments to set up VC companies in their own high-tech parks.50 As a result, the GVC model was extended to the levels of province and city. The year 1998 witnessed the proliferation of GVCs in China. That year, the Central Committee of Chinese National Democratic Constructive Association presented the “Proposal for Developing China’s VC Industry” at the Ninth CPPCC.51 The motion represented the end of the pilot trial of VCs in China. As a result, the number of domestic VC companies and their investment scale grew rapidly afterwards.52 In the last section, it has been demonstrated that governments have always played the role of principal investor in the Chinese domestic VC market. Thus, the overwhelming majority of newly established domestic VC companies since 1998 are surely GVCs, which in turn has made them the dominant form in the Chinese domestic VC segment. Again, the change of GVCs from an experimental attempt to frequent practice is also a reflection of state-entrepreneurism. Moreover, in the context of the late 1990s, this character of Chinese governments was more directly maintained and strengthened by state-controlled listed companies and its controlbased model than by the pervasiveness of the state-owned economy in the centrally planned age because the reform to SOEs at that time has drastically decreased their numbers as the second chapter has illustrated. In other words, since the late 1990s, the inertia of state-entrepreneurism has been principally sustained by the controlbased model in that state-controlled listed companies have become the prop of the state-owned economy in China. Therefore, the control-based model is directly

47

See footnote 38, pp 1100–1103, Chapter 1. Ibid. 49 See footnote 48, p 5, Chapter 1. 50 The State Council (2009) Notice on the approval of National High-tech Zones and its relevant policies. http://news.xinhuanet.com/ziliao/2005-02/17/content_2587962.htm. Accessed 5 Jan 2009. 51 See footnote 48, p 6, Chapter 1. 52 Ibid. 48

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related to the boom of GVCs. Given that the biggest shortcoming of GVCs is the lack of independence of their venture capitalists which will be proved with the empirical evidence below, in turn, the control-based model is at least loosely linked to that aspect.

3.3.2.1

Piercing the Veil of GVCs: Empirical Evidence from the Interview

As the above analysis has referred to, in order to confirm the linkage between the control-based model and the lack of independent status of most Chinese venture capitalists, knowledge of the operation of GVCs which are the predominant form of Chinese domestic VCs is required. Perhaps, owing to the political sensitivity of this issue, there have existed few academic efforts to systemically and thoroughly generate an answer. Therefore, for the achievement of this purpose, the author conducted an interview with a venture capitalist of a provincial GVC to pierce its mysterious veil.53 The following analysis is based on the gains of this interview. Generally speaking, GVCs have dual functions. First, they are responsible for implementing the governmental policies of industry development. In other words, GVCs focus on supporting the enterprises in the sector which governments are eager to promote. Second, GVCs also have to ensure the maintenance and then the value-adding of the state-owned assets under their management. At first glance, the two goals of GVCs seem to perfectly match each other. However, on second thought, they are actually contradicted in practice. The aim of supporting relevant enterprises means that the selection of portfolio companies is more a job of governments than that of GVCs and their venture capitalists. All the things that venture capitalists can do are to provide so-called “suggestions” for the line departments of governments. The final investment decision is only up to a few senior government officials who are generally the laymen in the VC sector. In turn, this decisionmaking process makes the value-adding of state-owned assets an impossible task because the latter relies on the skills of professional venture capitalists to identify the projects with the potential of profit-maximization. Consequently, value-adding becomes a pure slogan and the selection of targets by inexperienced high-level officials is actually the frequent practice. In most cases, the good intention of venture capitalists of GVCs to invest in potentially profitable projects is usually softly rejected by the bureaucracy. In addition, the CEOs of GVCs also belong to state cadres. Hence, they possess a strong incentive to pander to senior governmental officials for the purpose of personal promotion in the future. Consequently, they try to keep in line with the authorities in the process of decision-making and tend to invest in the visible part of a project, such as premises, to satisfy their seniors.

53

For the sake of avoiding unnecessary trouble, the interviewee strictly forbade me to reveal both his name and his company’s name.

3.3 The Reflection of Chinese Domestic VCs’ Fundraising in the American Mirror

51

Up to now, some scholars may point out that the control-based model is not able to explain the exclusion of GVCs from being invested in by pension funds and other institutional investors since both state-controlled listed companies and GVCs seem to fall into its category. For this book, this question is difficult but not unanswerable. Combining the analysis of the second chapter with that of the third chapter, the reason for the state to transfer as many resources as possible to state-controlled listed companies is because such enterprises are the cornerstones of the state-owned economy, which results from the control-based model. Therefore, a simple logic is that the control-based model is the root of the interest-aligned effect which is typically reflected by the transferring of the lion’s share of limited resources to state-controlled listed companies. In other words, just relying on the control-based model, one can reasonably explain the exclusion of GVCs as well as Chinese private domestic VCs from substantively approaching the related institutional investors mentioned above.

3.3.2.2

Evidence from the Case of the China New Technology Venture Investment Corporation

The interview as the primary source has sketched out the operation of GVCs. As it has been mentioned above, the evidence from secondary sources to explore the internal decision-making of GVCs is fairly limited. Even so, a piece of useful evidence has been tracked down – the case of the China New Technology Venture Investment Corporation to support the interview findings.54 The China New Technology Venture Investment Corporation as the first VC institution in China was established jointly by the State Science and Technology Committee and the MOF in 1986. In its initial several years, the China New Technology Venture Investment Corporation concentrated on cultivating hightechnology start-ups. However, its investment in high-technology products suffered from big losses because they were selected by government officials instead of seasoned venture capitalists. After the high-technology nightmare, its bureaucratic shareholders were daunted and immediately changed their business lines from VC to real estate, securities and credits. Unfortunately, with the parentalism of bureaucracy, it did not make a fortune from this transformation as well. Ultimately, the first Chinese VC company ended in insolvency in 1998. Through the brief introduction to the failure of the China New Technology Venture Investment Corporation, it is believed that the interview findings that venture capitalists in GVCs are not independent can be basically confirmed. Consequently, the lack of independence of venture capitalists in GVCs has led to the failure of most of their invested projects. Further, it may ruin the confidence of Chinese private participants to join VC because they are more likely to refer to the

54

Southcn (2009) What have we learnt from the failure of the China new technology venture investment corporation? http://www.southcn.com/tech/special/fxtz/case/200403150917.htm. Accessed 27 June 2009.

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The Difficulty of Fundraising Suffered by Chinese Domestic VCs

performance of GVCs which are the representative of Chinese domestic VCs before they determine whether to participate in this field.55 Up to this point, it is fair to say that this chapter has proved the linkage between the control-based model and the absence of independent status of venture capitalists of GVCs.56 However, a new form for governments’ involvement in the VC sector which is called the Industry Guidance Funds has emerged recently in China. It is commented that the IGF can get rid of the above drawback of the conventional GVCs. Have governments already jumped out of the niche of state-entrepreneurism and undue intervention? The last part of this section is an anatomy of this problem.

3.3.2.3

The IGF: Has an Upheaval Really Occurred?

The reason for the emerging of the IGF was the successful listing of a Chinese multimedia chips manufacturer named the Vimicro Corporation (Vimicro) on the Nasdaq in 2005.57 Before its IPO, Vimicro received a capital injection of RMB10 million yuan from an offshore investment company called InfoTech who was the trustee of the Ministry of Information Industry of the PRC (MII) for that money.58 After Vimicro was successfully floated in the USA, the investment approach of the MII was viewed as a new model for the government’s involvement in the VC sector as opposed to the traditional GVCs by the authorities.59 However, if the case is carefully considered, it is clear that InfoTech only finished the investment in its own name for the MII. The target company was still selected by the MII rather than by InfoTech. Therefore, there was no essential difference from the GVC. The success of Vimicro was mainly attributed to its ambitious and intelligent management and research teams, most members of which held advanced degrees from overseas universities.60 Unfortunately, this simple story was exaggerated by the Chinese central government. In 2007, the National Development and Reform Commission (NDRC) and

55

In addition to spoiling the climate of domestic VCs, GVCs also have a squeeze-out effect on private domestic VCs. By contrast, foreign VCs have obtained many preferential policies and opportunities from governments. This difference is mainly ascribed to the standard used by Chinese authorities to judge political achievements. See Xinhuanet (2009) The development of private enterprises should have the priority over foreign ones. http://news.xinhuanet.com/comments/2007-01/29/content_5657623.htm. Accessed 27 June 2009. 56 Actually, in Chinese private domestic VCs which are the minority compared with GVCs, venture capitalists also lack independence. As it is illustrated in the fourth chapter, it is also attributed to the control-based model to some extent. 57 Wang Y (2007) A new model for government’s involvement into VC. China Electron Market 3:76. 58 Ibid. 59 Ibid. 60 Available at http://www.vimicro.com.cn/milestone3.htm. Accessed 5 Jan 2009.

3.4

Conclusion

53

the MOF collectively issued “The Provisional Regulation on the Industry Guidance Funds under the Management of VCs” in which they duplicated the MII model.61 According to this regulation, the investment projects are principally recommended by local NDRCs. Although the trustee VCs can also commend some to the NDRC, the final decision power is tightly in the hands of the latter.62 At the level of provinces and cities, local governments have made some modifications to the MII model. According to their approach, the IGF raised by governments are not directly entrusted to large and seasoned private VCs for management. Instead, they are still in the charge of their own GVCs. Then, GVCs as the majority shareholders establish a new VC company with other private VCs for the purpose of managing the IGF.63 Here, it is clear that the modification to the MII model is just a tactic used by local governments to elicit money from private VCs for their control. In 2008, the NDRC, the MOF and the Ministry of Commerce (MOC) recognized this approach with the regulation entitled “The Guideline on the Establishment and Operation of the Industry Guidance Funds”.64 To sum up, the IGF is just a variation of conventional GVCs. With the lasting support from the control-based model for state-entrepreneurism, it is unrealistic to expect governments to play the role of passive investor in the VC sector. The empirical evidence above has also proved that governments’ intervention is inevitable when they actively participate in a competitive business field.

3.4

Conclusion

With regard to the phase of fundraising, the American VC template presents two valuable points for China – the great contribution of pension funds and the independent status of venture capitalists. Unfortunately, with both the interest-aligned effect and the state-entrepreneurism resulting from or maintained by the control-based model of state-controlled listed companies, the above two factors are actually still absent from Chinese domestic VCs without alternative mechanisms. However, the negative impacts of this model are never only confined to the first stage of the cycle of Chinese domestic VCs. It is just the beginning of the whole story.

61

The National Development and Reform Commission and the Ministry of Finance (2009) The provisional regulation on the industry guidance funds under the management of VCs. http://gjss. ndrc.gov.cn/xgfj/t20080523_212913.htm. Accessed 5 Jan 2009. 62 Article 2 of “The Provisional Regulation on the Industry Guidance Funds under the Management of VCs”. 63 Yu N, Qiao X (2009) A new wave of domestic private equity. http://www.caijing.com.cn/200711-14/100037821.html. Accessed 5 Jan 2009. 64 The National Development and Reform Commission, the Ministry of Finance and the Ministry of Commerce (2009) The guideline on the establishment and operation of the industry guidance funds. http://www.gov.cn/zwgk/2008-10/22/content_1127977.htm. Accessed 5 Jan 2009.

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Chapter 4

The Underdevelopment of Incentives in the Operation of Chinese Domestic VCs

4.1

Introduction

Chapter 3 has outlined that Chinese domestic VCs have fallen behind their American rivals in the first phase of the whole cycle of VC – the fundraising, due to the institutional barriers resulting from the corporate governance of Chinese state-controlled listed companies. This chapter moves forward to the second stage of the operation trajectory of VC – the section regarding injecting venture funds into selected startups.1 For the sake of the success of the joint venture invested in by both venture capitalists and entrepreneurs, three aspects must be well-devised in the above period.2 First, venture capitalists must determine with what type of organization they plunge venture funds into targeted enterprises. Under the condition that they are allowed to participate in the VC sector, investors who are rational persons will show a different extent of willingness to make investments in this industry when they face different organizations adopted by venture capitalists to structure venture funds.3 In turn, the different magnitude of investment made by investors has substantial influences on the sufficiency of money supply for entrepreneurs. Obviously, the selection of venture capital organizations can be placed in Chapter 3 if we consider this aspect through the perspective of fundraising. However, in this book, it is preferably viewed as the outset and incentive mechanism of the investment process of VC and is discussed thoroughly in this chapter. Second, in order to persuade themselves to contribute money to start-up firms which are associated with high uncertainty and great information asymmetry,4 venture capitalists must work out the contractual mechanisms which they will apply to their portfolio companies for

1

See footnote 3, Chapter 3. See footnote 33, p 885, Chapter 1. 3 Liu C, Yan Y (2009) The analysis on the organizational forms of venture capital. http://www.islaw.com/OurDocuments/VC0002BE.pdf. Accessed 12 Apr 2009. 4 Triantis GG (2001) Financial contract design in the world of venture capital. Univ Chic Law Rev 68:305–322. 2

L. Zhang, Venture Capital and the Corporate Governance of Chinese Listed Companies, DOI 10.1007/978-1-4614-1281-6_4, © Springer Science+Business Media, LLC 2012

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the purpose of minimizing risks and accomplishing harvests of investment. Third, venture capitalists must ensure that the management of start-ups has incentives to perform their best for the success of the venture and to accept the reduced control over the entity in return for the pecuniary and non-pecuniary support from VC.5 Essentially, the three aforementioned issues collectively refer to the selection and application of organizational and contractual incentives in the operation of VC. In this regard, the successful practice of American VCs as a mirror to reflect the corresponding deficiencies besetting their Chinese counterparts will be still used. More importantly, it will be demonstrated that the absence and underdevelopment of incentive structures in Chinese domestic VCs are at least loosely linked to the control-based model of Chinese state-controlled listed companies. Here, it is to be noted that some popular incentive mechanisms with American VCs were once absent for quite a long time in China as a result of legal prohibition. This kind of unavailability was applicable not only to Chinese domestic VCs but also to the Chinese operation of American VCs. Therefore, with the equal impossibility to rely on those variables, the Chinese triumph of American VCs was largely ascribed to their advantages of other parts over their Chinese competitors. However, now that Chinese legislature has legitimated them by revising laws, those incentive tools ought to be seen as valid variables to be analyzed by this book because American VCs have swiftly integrated them into their Chinese practice but Chinese domestic VCs have always held an indifferent attitude towards them and even have adversely deformed them owing to the institutional obstacles set up by the control-based model. In addition, some of the incentive mechanisms analyzed below, such as staged financing, board representation, convertible preferred stocks and stock options, usually belong to commercial secrets between VCs and their portfolio companies. Therefore, it is unrealistic to directly acquire related statistics and the contracts and agreements which stipulate such issues as evidence. In this case, only indirect proof regarding those incentive tools through carrying out interviews and retrieving secondary qualitative sources can be sought. Even so, in certain aspects of Chinese domestic VCs, only the operation of GVCs has been acquired. Consequently, in several places below, this chapter uses GVCs as the sample to conduct the analysis for Chinese domestic VCs. On the one hand, GVCs can basically represent Chinese domestic VCs taking into account their dominant position described in Chapter 3. On the other hand, the unavailability to complete information also reflects the fact that every research has its own limitation. This chapter consists of three sections. The first section briefly introduces the successful incentive structure of American VCs. The second section proves the linkage between the underdevelopment of incentives in the operation of Chinese domestic VCs and the control-based model with the American mirror. The final section is concluding remark.

5

Oehler GG (2005) The wider implications of ‘implicit’ contracts in venture capital partnerships. NYU J Law Bus 1:492–493.

4.2 The Answers Provided by the American Model

4.2

57

The Answers Provided by the American Model

With regard to the above three questions, the practice of American VCs has presented persuasive answers to them. As for the selection of organizational forms, most American VC funds are structured as limited partnerships.6 Under this structure, venture investors serve as limited partners.7 In terms of the legal rules governing limited partnerships in America, limited partners enjoy limited liability if they can abstain from exercising control over the critical elements of venture funds’ business.8 Correspondingly, the virtually complete management power over venture capital is granted to venture capitalists who serve as general partners.9 On the one hand, the allocation of control between limited partners and general partners shows the fact that investors need to rely on the skills and expertise of venture capitalists to make investments.10 On the other hand, it also ensures that venture capitalists possess sufficient discretion to maximize investors’ benefits with their knowledge and experience.11 For the sake of minimizing agency costs resulting from control allocation, limited partnerships use compensation to guarantee the interests of general partners in line with those of limited partners. The bulk of general partners’ compensation comes from the fixed share of ultimately realized profits of limited partnerships.12 As a result, this compensation scheme creates incentives for venture capitalists to maximize investment returns of venture funds. In addition, limited partnerships have limited lives, typically 10 years, after which the partnerships must be dissolved and their assets must be returned to investors.13 Apparently, the fixed termination provides a mechanism to estimate the abilities of venture capitalists in their overall performance by the time of liquidation for prospective investors.14 Therefore, in order to keep staying in the VC sector, venture capitalists have incentives to lead the venture funds at hand to success before their dissolution. As to the tax deduction, in contrast with the dual taxation applicable to corporations, limited partnership income is not subject to

6

Rosenberg D (2003) The two ‘cycles’ of venture capital. J Corp Law 28:421. Gulinello C (2006) Venture capital funds, organizational law, and passive investors. Albany Law Rev 70:304. 8 See footnote 6 above. The limited partnership agreements stricken by venture capitalists and venture investors are typically subject to Delaware law. Pursuant to Article 17-303(a) of Limited Partnerships of Delaware, “a limited partner is not liable for the obligations of a limited partnership unless he or she is also a general partner or, in addition to the exercise of the rights and powers of a limited partner, he or she participates in the control of the business”. http://delcode.delaware.gov/ title6/c017/sc03/index.shtml. Accessed 22 Apr 2009. 9 See footnote 7 above. 10 See footnote 38, p 1089, Chapter 1. 11 Ibid. 12 Rosenberg D (2002) Venture capital limited partnerships: a study in freedom of contract. Columbia Bus Law Rev 2002:365. 13 Gilson RJ (2004) Globalizing corporate governance: convergence of form or function. In: Gordon JN, Roe MJ (eds) Convergence and persistence in corporate governance. Cambridge University Press, Cambridge, p 148. 14 Ibid. 7

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taxation at the entity level.15 The integration of the above features into limited partnerships makes them best boost the investment willingness of venture investors in comparison with alternative organizational forms. In 1980, 42.5% of the investments made by venture capital in America were from the ones structured as limited partnerships. This number substantially increased to 81.2% in 1995.16 Concerning the organizational form of American venture funds operating in China, almost all of them are limited partnerships because they are mainly raised in the territory of the USA.17 To minimize the high risk and agency costs concomitant with start-up firms which they invest in, American venture capitalists commonly rely on staged financing, board representation, stock options and convertible preferred stocks.18 Staged financing refers to the fact that the initial VC investment is generally not sufficient to satisfy the monetary needs of a portfolio firm’s entire business plan.19 The subsequent injection of funds will occur only if some landmarks which are spelled out in the business plan are achieved.20 Obviously, the mechanism of staged financing guarantees that venture capitalists can be efficiently responsive to the high risk and high uncertainty associated with start-up companies by granting them the right to withdraw.21 In the meantime, their option to abandon also gives negative signals to potential investors to avoid the losses from investing in “black hole” projects.22 Although staged financing shifts the decision on the continuation of the venture project from entrepreneurs to venture capitalists, it cannot solve the daily monitoring of the conduct of portfolio firm managers.23 In response to this kind of shortcoming, venture capitalists are usually given the disproportionate representation or even control of the portfolio company’s board of directors.24 With this power, venture capitalists are able to effectively monitor the day-to-day exercising of discretion by managers who are delegated this privilege due to the incompleteness of contracts.25 Stock options as the principal part of managers’ compensation are also a means used by American venture capitalists to address agency costs.26 It is undoubted

15

See footnote 12 above, p 377. The Research Centre of the People’s University of China on the Development of Venture Capital (2003) China venture capital yearbook (2002). Democracy and Construction Press, Beijing, p 69. 17 People’s Daily Online (2009) Foreign VCs have begun to focus on RMB funds and their whole cycles will be finished in China. http://finance.people.com.cn/BIG5/8215/115194/6831527.html. Accessed 22 Apr 2009. 18 See footnote 33, pp 885–887, Chapter 1. 19 See footnote 38, p 1074, Chapter 1. 20 Ibid. 21 Ibid., p 1079. 22 Ibid., p 1080. 23 Wang J (2002) The legal institution construction for the development of Chinese venture capital industry. In Cheng S (ed) The strategic thinking on the formation and development of Chinese venture capital industry. Democracy and Construction Press, Beijing, p 242. 24 Bratton WB (2002) Venture capital on the downside: preferred stock and corporate control. Michigan Law Rev 100:897. 25 Williamson O (1984) Corporate governance. Yale Law J 93:1197–1230. 26 See footnote 38, p 1084, Chapter 1. 16

4.2 The Answers Provided by the American Model

59

that entrepreneurs have strong incentives to strengthen the performance of portfolio companies and to increase the value of shares which they own. Likewise, by accepting low cash salaries in return for stock options, other management members also make their earnings largely dependent on the performance of the portfolio company which they collectively operate with entrepreneurs.27 In addition to tying managerial compensation to the success of the venture, stock options can maintain the continued commitment of the management team to the firm as well because their equity stake will be forfeited if they quit prior to specific dates.28 The last tool on which American venture capitalists principally rely is convertible preferred stocks. With the VC investment made as a purchase of this type of securities, venture capitalists profit from the sale of the potential common stocks when their investment is fruitful, and they bear disproportionately less risk than that stood by entrepreneurs when the projects turn out to be failures.29 Moreover, convertible preferred stocks also include the terms of liquidation preference, redemption rights and anti-dilution protection.30 The liquidation preference provides priority to venture capitalists in the process of allocating liquidated assets when the venture goes bust;31 the redemption right reinforces the liquidity of venture capitalists in the event of barely passable performance by the portfolio company;32 and the anti-dilution protection ensures that venture capitalists can protect their interests against the subsequent contingencies with value-dilutive effects.33 Specifically referring to those American VCs which do business in China, they always apply the mechanisms of staged financing and board representation to their Chinese portfolio firms since this kind of practice is not forbidden by laws and regulations.34 As to stock options and convertible preferred stocks, they were inaccessible to both domestic and foreign VCs in China for quite a long time due to legal prohibitions. Therefore, during the period of their absence, they were not valid variables to explain the success of American VCs in China. Now that they have been permitted by Chinese statutes and then swiftly put into practice by American VCs in recent years,35 it is reasonable to subsume them in the discussion in this chapter.

27

Ibid. See footnote 33, p 887, Chapter 1. 29 Schmidt KM (2003) Convertible securities and venture capital finance. J Finance 58:1139. 30 See footnote 33, p 887, Chapter 1. 31 Ibid. 32 Ibid. 33 Klein WA, Coffee JC Jr (2004) Business organization and finance: legal and economic principles, 9th edn. Foundation Press, New York, pp 290–291. 34 See footnote 23 above. 35 This is from the interview with the venture capitalist of the provincial GVC cited in Chapter 3. Currently, there does not exist the issuance of convertible preferred stocks in mainland China. However, after the amendment of the Company Law in 2005, American VCs prefer to design clauses on the priority rights attached to their shares in the contract entered into with their Chinese portfolio companies. Per se, this kind of clause is the content of convertible preferred stocks. See People’s Daily Online (2009) The legal framework of convertible preferred stocks in the investment made by private equity. http://www.022net.com/2007/7-6/476931162855568.html. Accessed 27 July 2009. 28

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Finally, American venture capitalists resort to a combination of stock options and exit mechanisms for the purpose of stimulating the management’s willingness to perform their best for the success of the venture and to accept reduced control over the entity in return for the monetary and non-monetary support from VC.36 Given the exit of VC is also the ending section of its circle, it will be elaborated on in the next chapter. As opposed to their prevalence in the operation of American VCs, those incentive mechanisms are fairly underdeveloped in Chinese domestic VCs. The following section is an attempt to prove that this underdevelopment is largely ascribed to the control-based model.

4.3

The Underdevelopment of Incentive Mechanisms in Chinese Domestic VCs: The Shadow of the Control-Based Model

At first glance, the underdevelopment of incentive mechanisms in Chinese domestic VCs seems to be mostly attributed to the long-term lack of legal provisions in China. However, on second thought, an informed and curious youngster might wonder why the Chinese legislature did not revise the relevant laws to legitimize the application of those incentive measures for such a long time and at the same time why some legally permissible incentive tools, such as staged financing, did not positively function as well. More notably, since the Chinese legislature has filled the legal loopholes in recent years, why have Chinese domestic VCs still been reluctant to apply those incentives to their operation? For these questions, it is believed that certain domestic venture capitalists may argue that they need time to get familiar with the above mechanisms. But in the information era featured with the quick sharing of knowledge, the time of familiarity simply sounds like a lame excuse. Therefore, the underlying factors which have given rise to this sort of underdevelopment must be explored. The following part aims to prove that the control-based model covered in this book is one among those factors.

4.3.1

Limited Partnership

As to the proposals in favour of the establishment of a limited partnership by legislation in China, they had been put forward by a group of Chinese scholars and progressive government officials since the 1990s.37 In a lecture addressing the audience

36

See footnote 38, p 1086, Chapter 1. Jiang P (2009) The contemplation around limited partnership. http://www.civillaw.com.cn/article/default.asp?id=8085. Accessed 12 May 2009. 37

4.3 The Underdevelopment of Incentive Mechanisms in Chinese Domestic VCs…

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of the People’s University of China, Professor Ping Jiang, former Principal of the China University of Political Science and Law, confirmed that the drafting team indeed thoroughly designed the chapter entitled “Limited Partnership” when they drew up the Partnership Enterprise Law of the PRC (Partnership Law) in 1997.38 However, this chapter was deleted after the final draft of the Partnership Law was presented to the Standing Committee of the National People’s Congress (NPC) for final approval.39 According to the explanation from a senior member of the NPC, the reason for relegating that chapter was the inexistence of limited partnership in Chinese commercial practice at that time.40 Then, he said that the legislature would consider adding limited partnership into the Partnership Law if this organization was applied by practitioners afterwards.41 On the basis of the above statement from the authorities, Professor Jiang commented that it was impossible to expect the real appearance and survival of limited partnership in business practice if it was not stipulated by laws beforehand because China stringently complied with the principle of legality in the area of enterprise law.42 Professor Jiang’s remark is correct and pertinent in that it has been verified by the following empirical evidence – the case of Sinotrust.43 Sinotrust as a VC fund came into existence on the 12 July 2001 in Beijing, which was collectively established by Beijing Sinotrust Limited Liability Company (Sinotrust Ltd.), General Company of Xinjiang Shi Hezi Economic and Technological Development Area (General Company) and Xinjiang Tianye Group (Tianye). In terms of the contract entered into by the three investors, Sinotrust adopted the organizational form of limited partnership pursuant to the Regulatory Measures on Limited Partnership in Zhong Guancun Technological Park enacted by Beijing Municipal People’s Government. General Company and Tianye served as limited partners, who were obligated to contribute 99% capital and enjoined 80% profits. Sinotrust Ltd. served as the general partner, who was obligated to contribute 1% capital and reaped 20% profits. In addition, Sinotrust Ltd. was also responsible for the operation of Sinotrust. With regard to their respective exposure to debts, the risk of the two limited partners was limited to their capital contribution and the general partner was liable with all of its assets. Up to this point, Sinotrust seemed to be a classic story of limited partnership. Given that it was the first domestic VC in the form of limited partnership in China, Sinotrust was regarded to be the pioneer by the media. However, beyond everyone’s prediction, Tianye as the biggest investor of Sinotrust announced unilateral withdrawal less than half a year after its establishment. This piece of bad news so heavily hit Sinotrust that it had got to halt its operation. So, why did Tianye suddenly withdraw from Sinotrust? It was because the CSRC

38

Ibid. Ibid. 40 Ibid. 41 Ibid. 42 Ibid. 43 Securities Daily Online (2009) 2007: the first year of Chinese LP. http://zqrb.ccstock.cc/ html/2007-11/18/content_5314.htm. Accessed 12 May 2009. 39

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required it to do so. According to the CSRC’s explanation, they thought that it would bring intolerant risks to Tianye’s shareholders if it acted as a general partner. However, as it has been mentioned above, Tianye served as a limited partner in Sinotrust. Hence, did the CSRC make a mistake? The answer is “No”. The reason for this disparity was that Zhong Guancun Technological Park was not authorized to issue business licences to limited partnerships even if it recognized this organizational form within its borders. Consequently, Sinotrust must file the application for the business licence with the Beijing Administration for Industry and Commerce (BAIC). However, the BAIC reviewed its application only in accordance with the Partnership Law rather than the Regulatory Measures on Limited Partnership in Zhong Guancun Technological Park which is only a local regulation. Since limited partnership was not permitted by the Partnership Law at that time, the BAIC just issued a business licence of general partnership for Sinotrust. Thus, although Tianye was a limited partnership de facto, it was a general partner de jure. Meanwhile, the standard adopted by the CSRC to judge the status of Tianye was also to find out its business licence type. As a result, Tianye was forced to depart from Sinotrust now that it was officially deemed a general partner. It is clear that the Sinotrust case is consistent with Professor Jiang’s judgment. Then, a question arises: couldn’t the members of the NPC foresee the result which Professor Jiang predicted? It is obviously unfair to suspect the capability of the Chinese legislature in this manner. Hence, another question arises: how do we perceive the paradox made by the senior member of the NPC about the deletion of the “Limited Partnership” section? As far as the research of this book is concerned, his explanation is preferably interpreted as an attitude rather than an answer. This attitude implicated that the authorities were indifferent to limited partnership and further to VC and high potential start-ups. Also, it is not difficult to understand this sort of nonchalance because the state’s focus was inevitably on the giant enterprises under its control of which the state-controlled listed companies were typical. Given the unavailability of limited partnerships prior to the revision of the Partnership Law in 2006, corporations became the absolutely dominant organization for Chinese domestic VCs to structure VC funds during that period.44 Incident to the adoption of corporations, those VC funds had to withstand dual taxation.45 In addition, corporations also provided large room for VC investors to interfere with the specific operation of the funds which ought to be solely the charge of venture capitalists.46

44

See footnote 48, p 12, Chapter 1. Article 1 of the Enterprise Income Tax Law of the People’s Republic of China. It says “the enterprises and other organizations which have incomes (hereinafter referred to as the enterprises) within the territory of the People’s Republic of China shall be payers of the enterprise income tax and shall pay their enterprise income tax according to the present law. The sole individual proprietorship enterprises and partnership enterprises are not governed by the present law”. 46 Refer to the analysis of the operation of GVCs in Chapter 3. Also see People’s Daily Online (2009) The national development and reform commission fully supports corporations: the debate over the patterns of private equity. http://www.022net.com/2008/5-27/424960372650604.html. Accessed 6 June 2009. 45

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At the beginning of 2006, the CPC Central Committee and the State Council made the strategic decision on the establishment of an innovative society.47 In order to cater to this political slogan, the Standing Committee of the NPC amended the Partnership Law by adding the provisions of limited partnerships.48 This change seemed to be progress. However, due to the inertia of their serving the state’s need to control SOEs, especially state-controlled listed companies, the legislature eroded the freedom of limited partnership contracts. Pursuant to Article 61 of the Revised Partnership Law, the number of limited partners is limited to 49.49 This mandatory cap has significantly restricted the fundraising capability of this organizational form in China.50 In addition, even though limited partnerships have been in place, the Chinese authorities have stated that corporations ought to continue to be the dominant organization for GVCs to structure VC funds.51 Through the perspective of the control-based model, it is easy to understand this statement as the reflection of state entrepreneurism because the status of shareholders is much more convenient for them to directly intervene in the running of VC funds than the identity of limited partners. Consequently, given the fact that GVCs constitute the overwhelming majority of Chinese domestic VCs, limited partnerships are almost excluded from Chinese VC practice. As for minority private domestic VCs in China, they are actually entitled to take advantage of limited partnerships. However, as it has been analyzed above, due to the effect of attention diversion of the control-based model, limited partnerships were put on hold for quite a long time by the Chinese legislature. Instead, corporations became the dominant organization applied by Chinese domestic VCs to structure VC funds. One of the main shortcomings concomitant with corporations is the high probability for VC investors to interfere with the concrete operation of VC funds for which venture capitalists ought to be solely responsible. Therefore, after years of this sort of inappropriate behaviour, VC investors have naturally applied this ritual to limited partnerships when the novel organizational instrument became suddenly available to them. Consequently, the substance of limited partnerships has been distorted by Chinese private domestic VCs. The following case of East Sea VC can empirically prove this proposition.52

47

Hu J (2009) The speech in the national scientific and technological meeting. http://politics.people.com.cn/BIG5/1024/4011536.html. Accessed 5 June 2009. 48 Yan Y (2009) The explanation to ‘the partnership enterprise law of the People’s Republic of China (draft for revise)’. http://vip.chinalawinfo.com/newlaw2002/SLC/SLC.asp?Db=lfbj&Gid= 1090520821. Accessed 6 June 2009. 49 Article 61 of the Revised Partnership Enterprise Law of the People’s Republic of China. It says “a limited partnership enterprise shall be established by not less than 2 but not more than 50 partners, unless it is otherwise provided by law. A limited partnership enterprise shall have at least one general partner”. 50 Liu J (2009) It is necessary to establish limited partnership. http://www.civillaw.com.cn/article/ default.asp?id=8800. Accessed 6 June 2009. 51 See footnote 46 above. 52 Online Z (2009) The investigation into the suspension of the East Sea VC. http://biz.zjol.com. cn/05zjman/system/2008/04/22/009445487.shtml. Accessed 6 June 2009.

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In August 2007, East Sea VC (East Sea) was jointly founded by James & Hina Capital Management Limited Company (James), seven privately held enterprises and a natural person in Wenzhou. Pursuant to the Revised Partnership Law, East Sea adopted limited partnership as its organizational form. This movement made it the second domestic VC fund in the form of limited partnership in China since the amendment of the Partnership Law.53 James served as the general partner and all the other investors played the role of limited partner. From its inception, the media and Chinese VC sector placed a lot of emphasis on East Sea and hoped to witness its miracle in the short run. However, almost out of everyone’s expectation, East Sea only existed for 7 months before it came to an end. Based on the comments from the participants of East Sea, the main reason for its failure was the disagreement concerning the investment judgments between the limited partners and the general partner. As it has been described above, in a limited partnership, general partners are responsible for making investment decisions and limited partners only wait to recoup their capital and harvesting profits. However, East Sea changed this mode with a so-called “joint meeting” consisting of the limited partners as the supreme authority.54 This meant that the general partner must obtain the approval from the joint meeting before it could invest in a project. Consequently, fundamental discrepancies in some projects occurred between the general partner and the joint meeting, which ultimately led to the dissolution of East Sea in its early stage. After its termination, in an interview with a local newspaper, Xucang Hu, Chairman of the joint meeting of East Sea, said that limited partnership also needed to fit into the local practice so that VC investors in Wenzhou collectively shared the power to make investment decisions. Even though East Sea is only an individual case in Wenzhou, it also represents a miniature of the Chinese domestic VC industry. The long-term absence of limited partnership in China largely owing to the negative effects of the control-based model has given rise to the undue intervention of limited partners in the specific operation of VC funds and in turn has deformed the practice of limited partnership, which has been typically reflected by the statement of Xucang Hu. Therefore, to a large degree, the case of East Sea has proved the hypothesis that the erroneous practice of limited partnership is linked to the control-based model. To sum up, with the empirical evidence subsumed in this section, the connection between the underdevelopment of limited partnership in the Chinese domestic VC industry and the control-based model has been established. The immediate next section of this chapter focuses on the linkages between the control-based model and the staged financing and board representation of Chinese domestic VCs.

53

The first VC fund in the form of a limited partnership after the revision of the Partnership Law was the South Sea VC. Detailed information on its operation is not available yet. 54 Jinrongstreet Online (2009) The mystery of the suspension of the East Sea VC. http://www.jinrongstreet.com/show.asp?id=1239. Accessed 6 June 2009.

4.3 The Underdevelopment of Incentive Mechanisms in Chinese Domestic VCs…

4.3.2

65

Staged Financing and Board Representation

The evidence on the use of staged financing in Chinese domestic VCs emanates from the interview with the venture capitalist of the provincial GVC. In terms of his explanation, staged financing is a common tool applied by GVCs to their portfolio companies. However, he adds that it is more of a formality than a utility because most projects invested in by GVCs are actually determined by senior government officials, which means that GVCs must continuously inject money into “lucky dogs” for the purpose of pandering to their seniors’ vanity even if the portfolio companies do not fulfil the milestones necessary for the next round of financing. As it has been analyzed in Chapter 3, the root of the inappropriate intervention in the operation of GVCs by government officials is the inertia of state entrepreneurialism which has been principally maintained through the control-based model. Therefore, the substantive malfunction of staged financing in GVCs can be linked to the control-based model in this sense. Although the proof about the use of staged financing in private domestic VCs is not available to the author, the case of GVCs can basically reflect the profile of this mechanism in the Chinese domestic VC industry taking into account their dominant role in the aspect of amount. With regard to board representation, the interviewee confirms that GVCs always insist on acquiring board membership of portfolio companies. However, he says that the implication of board representation is more about satisfying the psychic demand of governmental officials for the status of decision makers than obtaining information from the funded firms and monitoring their performance. It is not difficult to understand his statement on the basis of the above analysis. On the one hand, the government official’s psychology of being centred in a business is the inevitable by-product of state entrepreneurism. On the other hand, it is predictable that few venture capitalists in GVCs would like to really perform the surveillance duty in those “guanxi” firms with the dread of displeasing their seniors. As it has been explicated above, to a large extent, the twofold cases are ascribed to the influence of the control-based model. Also, by and large, the situation of board representation in GVCs can represent its status quo in the whole Chinese domestic VC industry because of GVCs’ majority position.

4.3.3

Convertible Preferred Stocks

In Chapter 2, it has been illustrated that the Company Law 1993 was promulgated for the purpose of the corporatization of traditional SOEs.55 Through corporatization, the CPC and Chinese central government intended to privatize small and medium-sized

55

Wang B (2009) It is important to understand the spirit of the new company law. http://www.civillaw.com.cn/article/default.asp?id=24654. Accessed 13 June 2009.

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SOEs and to reform and keep control of big and key ones with the institutions of modern corporate governance. This objective determined that the Company Law 1993 included plenty of mandatory provisions which should have been discretionary ones in terms of the spirit of modern company law.56 Given that gigantic SOEs are the predecessors of most state-controlled listed companies, their control-oriented governance framework is actually the equivalent of the successive control-based model. Therefore, in this sense, the control-based model is connected with the rigid character of the Company Law 1993. One aspect of the rigidity of the Company Law 1993 was its provision regarding the distribution of profits among shareholders. In accordance with its Articles 33 and 177, profits were only divided pro rata among shareholders on the basis of their shareholdings. As a result, this stipulation denied the existence of convertible preferred stocks because the owners of this type of securities receive a fixed-rate dividend which is not set in terms of their shareholdings. In the next decade prior to the revision of the Company Law 1993 in 2005, a group of progressive government officials and scholars appealed to the Chinese legislature to amend the above two articles and add some new ones for the purpose of legalizing the use of preferred stocks.57 However, the target of all the proposals was the common shares held by the state in state-controlled listed companies, which meant that they suggested substituting preferred stocks for the common ones.58 Consequently, their petition did not obtain a positive response from the authorities because decision makers thought that preferred stocks which are featured with restricted voting rights would undermine the state’s control over state-controlled listed companies in comparison with common stocks. Therefore, before the latest amendments of the Company Law 1993 became effective in 2006, common stocks naturally became the predominant investment means of Chinese domestic VCs if not the only. With the rapid development of China’s market economy and the increasing weight of privately held enterprises in the whole of society, more and more interested groups criticized the Company Law 1993 for its stiffness.59 Ultimately, after two minor revamps separately in 1999 and 2004, the NPC overhauled it in 2005 to satisfy the needs of other participants in the economy.60 On the aspect of profit distribution, pursuant to Articles 35 and 167 of the Company Law 2006, the way of

56

Liu J (2009) Institutional innovations of the new company law. http://www.civillaw.com.cn/ article/default.asp?id=25323. Accessed 13 June 2009; Easterbrook FH, Fischel DR (1991) The economic structure of corporate law. Harvard University Press, Cambridge. 57 Liu F (1998) Preferred stocks – an alternative of the state’s ownership. Reform Econ Syst 3:88– 91; Hu Z (1996) A feasibility research on the change of state-owned stock to the priority stock. Jianghan Trib 3:60–62; Feng X, Wang H (2001) Brief research on the application of preferred stocks in the reduction of state-held shares. Res Econ Manag 6:43–45; Wang C (2002) The conversion of state-held stocks to preferred stocks – a new way for the reform of SOEs Coal Econ Res 11:22–23. 58 Ibid. 59 See footnote 56 above. 60 Ibid.

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dividing profits among shareholders is not only on the basis of shareholdings. Other means permitted by articles of incorporation are also accepted by the new company law. This change has laid the legal ground for the use of convertible preferred stocks. Immediately after this modification, echoing the encouragement of innovation from the CPC and the central government,61 ten ministries and committees of the State Council jointly enacted a regulation entitled “Interim Measures for the Administration of Startup Investment Enterprises”.62 In this regulation, VCs are eventually allowed to take advantage of convertible preferred stocks.63 This should have been a boost for Chinese domestic VCs. Unfortunately, due to the effect of path dependence on common stocks, they have not shown much interest in this issue as opposed to their foreign counterparts. According to the interview with the venture capitalist of the provincial GVC, he admits that domestic VCs, including both GVCs and private ones, prefer common equity to convertible preferred stocks because it has been the common practice for them all the way. Therefore, through his statement, we can clearly see the continuous influence of path dependence. Some may argue that Chinese domestic VCs are likely to gradually adopt convertible preferred stocks since the law and regulation have been in place. It is just a matter of time. In the opinion of the author, the function of convertible preferred stocks will be largely discounted at least with GVCs even if they broadly apply this kind of security to their investment in the future. The prediction is built on the fact called “soft budget constraints” related to SOEs, especially giant state-controlled listed companies.64 Soft budget constraints means that managers of state-controlled listed companies are expected to receive additional financial support from governments in case of big losses because their enterprises are under the control of the state.65 In turn, this kind of implicit contract provides insurance for the management to behave without due diligence.66 In GVCs, the phenomenon of soft budget constraints also pervasively exists. An executive officer of a GVC explained the non-avoidance of soft budgets in GVCs by saying that: All of our shareholders are governments or government-tied, so most of the time our work is to support their policies. But testing policies is risky, and it’s costly, right? So it is reasonable that we get compensation (refinancing) for the cost.67

61

Guo X, Liu J (2006) Interpreting ‘interim measures for the administration of startup investment enterprises’. Securit Market Herald 3:12. 62 http://www.ndrc.gov.cn/zcfb/zcfbl/zcfbl2005/t20051115_49928.htm. Accessed 13 June 2009. 63 Article 15 of the Interim Measures for the Administration of Startup Investment Enterprises says “VCs may make investments by the way of stocks, preferred stocks and convertible preferred stocks on the basis of the agreement with venture enterprises”. 64 Chen D, Zhang T, Li X. Implicit contract without law – empirical evidence from china capital market. On file with the author. 65 Ibid. 66 Ibid. 67 See footnote 48, p 13, Chapter 1.

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Consequently, the existence of soft budget constraints inevitably lowers GVCs’ level of risk aversion. Therefore, even if convertible preferred stocks are widely applied by them, it is doubted if they can carefully design the clauses of stock purchase agreements for the purpose of making this security fully function in venture enterprises. The connection between the control-based model and the underdevelopment of convertible preferred stocks in Chinese domestic VCs has been set up. The following section turns to the last mechanism – stock options.

4.3.4

Stock Options

As it has been analyzed in the last section, rigidity was the character of the Company Law 1993 as a result of the control-based model. Therefore, stock options as an incentive mechanism were not stipulated by it. In addition, its Article 149 prohibited companies from purchasing their own stocks except for reducing registered capital or merging with other companies which held their shares. Consequently, this provision made it impossible for companies to reserve stocks for the purpose of stock options. With the deep development of SOEs’ reform, the CPC and the Chinese central government realized that it was necessary to introduce stock options as an incentive mechanism to supplement the governance institutions featured with control.68 In 1999, the 15th CPC Central Committee passed the document entitled “Decisions on SOEs Reform”.69 In this document, the CPC Central Committee cautiously permitted the pilot trial of stock options in SOEs.70 Since then, some attempts were carried out mainly in state-controlled listed companies located in several big cities.71 However, because of the above legal barrier and the governments’ affinity to control, this endeavour was not successful.72 Here, the “Wuhan model” is taken as an example for illustration.73 In this model, if a state-controlled listed company decided to award “stock options” to a manager, the Wuhan State-owned Assets Administration Company would purchase the company’s stocks from the secondary market with the manager’s salaries. After that, this amount of stocks would not be awarded to the manager in a lump sum. Instead, within a fixed return period, the stocks would be granted to the manager on a yearly basis. If the performance of the manager was not satisfactory in a certain year within the return period, the due stock amount in that year would be expropriated by the Wuhan State-owned Assets Administration Company.

68

Gan P (2002) The legal analysis of manager stock options. J China Univ Polit Sci Law 20:49. See footnote 7, Chapter 2. 70 Ibid. 71 See footnote 68 above. 72 Ibid. 73 Ibid. 69

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From the Wuhan model, we can clearly figure out that its so-called “stock options” were far different from the real ones. It was more of a penalty and restriction on managers than an incentive. Hence, it inevitably ended in failure. The unsuccessful trial of stock options in state-controlled listed companies made governments daunted. This passive attitude also negatively influenced the homogeneous enterprises of state-controlled listed companies – GVCs. The evidence on this assumption mainly comes from Zhong Guancun Technological Park. In 2000, the Standing Committee of the 11th Beijing People’s Council passed the local regulation entitled “The Regulation of Zhong Guancun Technological Park”.74 In this regulation, enterprises in Zhong Guancun Technological Park are allowed to use stock options.75 Traditionally, Zhong Guancun Technological Park is the turf of GVCs. Therefore, regardless of the legal barriers and the specific design of its provisions, if GVCs hold an active attitude towards stock options, this mechanism must have been a common practice in this area. However, till 2005, the first dispute on stock options just happened in Zhong Guancun Technological Park.76 Especially, the defendant enterprise did not have the background of GVCs’ support. Thus, to a large extent, it is believed that the first case did not show the so perfect design of stock options by GVCs that there was not a dispute related to them in Zhong Guancun Technological Park within 5 years since it was available, but did show the rare use of this tool by them. Other proof about the underdevelopment of stock options in GVCs comes from their venture capitalists’ salaries. Table 4.1 shows the salaries of senior managers in a Beijing GVC in 2002. From this table, it is clear to see that stock options were not an element of their salaries. Since internal incentives are not adopted by GVCs, it is almost unrealistic to expect them to use stock options as an incentive for outsiders. Even though the Company Law 2006 has permitted the use of stock options, the Chinese authorities are still very cautious about this incentive tool. In 2008, the State-owned Assets Supervision and Administration Commission (SASAC) even suspended all the schemes of stock options in state-controlled listed companies in order to strengthen its control.77 This passive attitude of governments towards stock options inevitably has had an impact on GVCs. Just as the interviewee – the venture capitalist of the provincial GVC – says, they seldom use stock options in their investment because their seniors who are quasi government officials are reluctant to do so.

74

http://www.bjdch.gov.cn/n1569/n2458434/n2462161/2573918.html. Accessed 14 June 2009. See its Article 12. 76 ChinaByte (2009) Former employees have filed a lawsuit against ZOL. http://www.chinabyte. com/net/217581260803932160/20050226/1915458.shtml. Accessed 14 June 2009. 77 Some state-controlled listed companies carried out stock options without obtaining approval from the SASAC in advance. The SASAC thought that its control over those enterprises had been challenged. Therefore, it took a tough action to suspend all the schemes of stock options in statecontrolled listed companies. See Caijing Online (2009) The China mobile and the China Unicom challenge the SASAC in the aspect of stock options. http://www.caijing.com.cn/2009-0204/110052821.html. Accessed 14 June 2009. 75

Table 4.1 Salaries of senior managers in a Beijing GVC in 2002. Unit: RMB yuan Chairman of the Investment Senior project Position board of directors CEO Vice CEO manager manager Project manager Total salary 129,500 119,448 115,668 103,156 85,488 66,688 Fixed allowance 36,000 32,400 32,400 28,800 21,276 18,000 Floating allowance 24,000 21,600 21,600 19,200 14,400 12,000 Basic salary 24,444 24,048 20,988 17,676 19,116 9,600 Bonus 1 440 440 240 440 440 360 Bonus 2 728 752 360 272 368 408 Housing allowance 3,120 2,880 2,880 2,640 2,160 1,920 Snack allowance 3,600 3,600 3,600 3,600 3,600 3,600 Dining allowance 2,640 2,640 2,640 2,640 2,640 2,640 Laundry allowance 2,400 2,160 2,160 2,160 2,160 2,160 Sole child allowance NA NA 60 60 NA 60 Nursery allowance NA NA NA NA NA 480 Source: Ouyang C (2009) Study on contracts of venture capital in China. http://cjn.lib.hku.hk/kns50/detail.aspx?QueryID=3&CurRec=1. Accessed 14 June 2009

70 4 The Underdevelopment of Incentives in the Operation of Chinese Domestic VCs

4.4

Conclusion

71

To sum up, the linkage between the control-based model and the underdevelopment of stock options in GVCs really exists. Again, given their dominant position in China, GVCs can basically reflect the case of stocks options in the overall Chinese domestic VCs.

4.4

Conclusion

With the proofs offered by this chapter, the underdevelopment of incentive mechanisms in the specific investment stage of Chinese domestic VCs has been linked to the institutional hamper of the control-based model. However, this is still not the end of the story. The negative impact of the control-based model has also spread to the exit phase of Chinese domestic VCs, which is explored in the next chapter.

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Chapter 5

The Lack of Efficient Exit Channels for Chinese Domestic VCs

5.1

Introduction

Chapter 4 has analyzed the shortage of incentive mechanisms in the operation of Chinese domestic VCs in comparison with their American competitors. More importantly, on the basis of this analysis, the hypothesis that the underdevelopment of incentive suffered by Chinese domestic VCs is closely linked to the institutional barriers imposed by the control-based model of Chinese state-controlled listed companies has been demonstrated. Following Chapter 4, this chapter explores the last section of the whole cycle of VC – its exit from successful portfolio companies.1 Prior to making a performance comparison between American VCs and their Chinese counterparts in this aspect, it is essential to answer two relevant questions. First, why does a VC need to exit from successful venture enterprises? Second, what is the optimal exit channel for the principal participants of successful ventures? As for the first question, Bernard Black and Ronald Gilson have made a plausible explanation through the two dimensions below.2 First of all, the economies of scope between financial contributions and non-financial ones supplied by VCs for portfolio companies require its exit.3 Practically, venture capitalists provide both capital and non-capital inputs for their portfolio companies.4 The non-capital inputs, such as management assistance and reputational capital, are especially valuable to start-up companies.5 As the early stage companies gradually become mature, the

1

The reason for the author’s focus on successful ventures is that they can add value to the entire VC industry as opposed to the value-loss effect of failed ones. 2 See footnote 39, pp 252–257, Chapter 1. 3 Ibid., p 255. 4 Barry CB (1994) New direction in research on venture capital finance. J Financ Manag 23:3–15. 5 Ibid. L. Zhang, Venture Capital and the Corporate Governance of Chinese Listed Companies, DOI 10.1007/978-1-4614-1281-6_5, © Springer Science+Business Media, LLC 2012

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relative value of non-pecuniary contributions decreases.6 Therefore, by the time of the success of portfolio companies, the transfer of non-financial contributions to new start-up companies is more efficient and beneficial for VCs.7 But because non-financial contributions are linked to financial ones, redeploying the former inevitably requires the simultaneous redeployment of the latter – the exit of VCs.8 Second, the relationship between VC investors and venture capitalists also requires the exit of VCs.9As capital contributors, VC investors need to rely on a benchmark to estimate the capability of venture capitalists who act as their agents.10 Exit with the payment of capital proceeds for VC investors just provides such a criterion for the purpose of measuring venture capitalists’ skills.11 In addition, by means of successful exit, venture capitalists accumulate valuable track records for their future fundraising as well.12 The explanation to exit through the perspective of the relationship between VC investors and venture capitalists also includes a standard to guide us to answer the second question – the optimal exit channel. In the light of the above analysis, the profitable exit is desired by both VC investors and venture capitalists. Naturally, one characteristic of the optimal exit channel ought to be the highest level of profitability compared with the other available approaches. However, the standard of profitability itself is not enough to help us identify the most efficient exit approach without combining with entrepreneurs’ recouping of control over venture enterprises. As existing statistics have indicated, the likelihood of failure for hightechnology start-ups is fairly high.13 Thus, many entrepreneurs may not quit their decent jobs to start such a venture if they do not put a large private value on control.14 Even though entrepreneurs highly desire control, they generally have to hand it to venture capitalists as an incentive mechanism when they seek financial inputs.15 But at the time that venture capitalists choose to exit as start-up companies turn out to be successful, handing over the control to entrepreneurs is more efficient than other choices because those entrepreneurs have proved their managerial skills and have been more familiar with those entities.16 In addition, the opportunity to regain control also provides an incentive for them to make great efforts which are necessary

6

See footnote 39, p 255, Chapter 1. Ibid. 8 Ibid. 9 Ibid. 10 Ibid. 11 Ibid. 12 See footnote 38, p 1092, Chapter 1. 13 Salhman WA (1990) The structure and governance of venture capital organizations. J Financ Econ 27:473–522. In this article, Salhman pointed out that one-third of venture capital investment ends in losses. 14 See footnote 39, p 259, Chapter 1. 15 Hellmann T (1998) The allocation of control rights in venture capital contracts. Rand J Econ 29:57–76. 16 See footnote 39, p 259, Chapter 1. 7

5.1

Introduction

75

for success.17 Thus, besides mere profitability, the most efficient exit channel must guarantee the reversion of control to entrepreneurs as well. The standards of profitability and control-reversion provide the grounds for us to identify the optimal one among the available exit approaches. Generally speaking, venture capitalists take advantage of four means to achieve the liquidity of capital and non-capital contributions. Those means include bankruptcy, buyback, acquisition and IPOs.18 Bankruptcy is the only way for venture capitalists to exit from portfolio companies when they fail.19 But for the successful ventures which are concerned by this chapter, it is obviously not a suitable exit channel from the standards of profitability and control-reversion. Buyback is usually resorted to when the performance of venture enterprises is really mediocre.20 By requiring entrepreneurs to buy them out, venture capitalists can transfer their resources to more promising entities. Therefore, this arrangement acts as a protection mechanism for venture capitalists while it also enables entrepreneurs to recoup the control over enterprises. However, when the venture is successful, entrepreneurs need to have huge amounts of cash for the purpose of purchasing the equity held by venture capitalists.21 But few of them have the ability to achieve this mission.22 Consequently, in this case, buyback lacks the feasibility for VC to fulfil profitable exits. Acquisition frequently means that entrepreneurs lose control of their enterprises.23 As it has been illustrated above, this fact is fairly difficult for them to accept. In addition, the profitability of acquisition is much lower than that of IPOs.24 According to the survey subsumed in “China venture capital yearbook 2007”, the percentage of VC-backed projects exiting by means of IPOs with profitability above 100% in China was 57.14 in 2006.25 But that number was just 10.87 for VC-backed projects exiting in the form of acquisition in the same year.26 Three exit approaches with the criteria of profitability and control-reversion have been examined. The result is that none of them are completely consistent with the characteristics of the optimal exit channel for successful ventures. Apart from them, the last exit means which has not been analyzed is IPOs. In terms of the existing academic findings, IPOs have been viewed as the most efficient

17

Ibid. Yu G (2002) The policy implication of comparative studies on venture capital markets. Jurists Rev 4:14. 19 Ibid. 20 See footnote 33, p 887, Chapter 1. 21 See footnote 18 above. 22 Ibid. 23 See footnote 18 above, p 15. 24 Ibid. 25 See China Venture Capital Research Institute Limited (2007) China venture capital yearbook (2007). Democracy and Construction Press, Beijing, p 263. 26 Ibid. 18

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choice for venture capitalists to exit from successful portfolio companies.27 On the one hand, they provide the highest returns for venture capitalists, VC investors and entrepreneurs.28 On the other hand, after IPOs, an implicit contract will be automatically enforced between venture capitalists and entrepreneurs for the purpose of handing over the control rights of enterprises from the former to the latter.29 Therefore, IPOs entirely conform to the two standards regarding identifying the optimal exit channel. Now that IPOs can help venture capitalists accomplish a golden exit from successful portfolio companies, the existence of a suitable stock market becomes fairly essential. As it will be illustrated below, American VCs have its striking advantages in this aspect. More importantly, this advantage also provides a mirror for us to reflect the defects of Chinese domestic VCs at the point of exit. Further, on the basis of the comparison, this chapter will aim to prove that this kind of disadvantage of Chinese domestic VCs is closely linked to the institutional barriers imposed by the control-based model. This chapter comprises three parts. The first part briefly introduces the availability of tailor-made stock markets to American VCs to achieve exit by means of IPOs. The second part indicates that Chinese domestic VCs face difficulties when exiting through IPOs. Moreover, this sort of difficulty is caused by the control-based model to a large degree. The last part is conclusions.

5.2

The Availability of Tailor-Made Stock Markets to American VCs

In the history of American VCs, the National Association of Securities Dealers Automated Quotations (NASDAQ) undoubtedly played a vital role in their exit through IPOs.30 As it has been mentioned above, American venture funds are generally structured as limited partnerships with a life span of around 10 years.31 This life limitation provides a benchmark for VC investors to estimate the skills of venture capitalists.32 Therefore, in order to accumulate valuable track records for their future fundraising, venture capitalists have to achieve exit from successful portfolio companies before the deadline. This fact determines that successful venture enterprises are still too young and small-scale to satisfy the listing rules of American main boards when VCs plan to opt out. Hence, for the sake of VCs’ withdrawal from them by means of IPOs, it is necessary to establish a stock market with listing rules

27

See footnote 18 above, p 15. Ibid. 29 See footnote 39, pp 257–264, Chapter 1. 30 Xin S (2008) NASDAQ: the model of growth enterprise markets. Shenzhen Stock Exchange 1:62. 31 See footnote 6, Chapter 4. 32 See footnote 13, Chapter 4. 28

5.2

The Availability of Tailor-Made Stock Markets to American VCs

77

which can match the relatively low level of success of those entities. NASDAQ just fulfilled this sort of necessity. In terms of the initial listing requirements of the NASDAQ Capital Market,33 applicant companies are eligible for being listed only if they meet one of its three standards – equity standard, market value of listed securities standard or net income standard.34 All of the three standards adopt relatively low and loose criteria to measure potential listed companies. Taking the equity standard as an example, its main indicators include: (1) stockholders’ equity of 5 million US dollars, (2) market value of publicly held shares of 15 million US dollars, (3) publicly held shares of 1 million US dollars and (4) operating history of 2 years.35 There is no requirement of net income from continuing operations. Ultimately, together with the rapid procedure of listing approval adopted by the Securities and Exchange Commission (SEC),36 this kind of lower listing requirement enables American VCs to smoothly exit from successful portfolio companies through IPOs. According to statistics, from 1992 to 2002, the number of IPOs of VC-backed companies on NASDAQ was 1,721 and the amount of money which they raised was 107.24 billion US dollars.37 One may question the praise for the NASDAQ with the severe slumping of its index after the bursting of the “dot-com bubble” in 2000.38 Fairly speaking, this kind of argument regarding the demise of the NASDAQ legend is unreasonable. Undeniably, the NASDAQ Composite Index went through a drastic falling in the dot-com disaster.39 But it is unfair to estimate the contribution of a stock market only on the basis of its temporary fluctuation. The objective attitude towards the NASDAQ ought to be a focus on its past and future. Historically, the NASDAQ played a critical role in the development of American VCs. To a large extent, without the NASDAQ, the vibrant VC sector in America may not have appeared. In the future, with improving its regulation for the continuous listing plus restoring investors’ confidence,40 the NASDAQ will still support the success of American VCs by providing an efficient exit channel.

33

Currently, the NASDAQ consists of the NASDAQ Global Select Market, the NASDAQ Global Market and the NASDAQ Capital Market. The NASDAQ Capital Market aims to provide listing services for small- and medium-sized enterprises, especially those in the high-technology field. http://www.nasdaq.com/about/nasdaq_listing_req_fees.pdf. Accessed 13 Oct 2009. 34 Ibid. Even though they are updated from time to time by the NASDAQ, those rules always match the features of small-scale enterprises. 35 Ibid. 36 Pursuant to the Securities Exchange Act of 1934, “if the exchange authorities certify to the Commission (the SEC) that the security has been approved by the exchange for listing and registration, the registration shall become effective 30 days after the receipt of such certification by the Commission (the SEC) or within such shorter period of time as the Commission may determine”. 37 See footnote 30 above. 38 http://en.wikipedia.org/wiki/Dot-com_bubble. Accessed 14 Oct 2009. 39 Ibid. 40 From the author’s point of view, the dot-com bubble reflected the shortcomings of continuous listing regulation by the NASDAQ.

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As for American VCs which make investments in China, they currently seldom take advantage of Chinese domestic stock markets for the purpose of exiting from their successful portfolio companies because of China’s stringent foreign currency policy.41 However, this reality has not caused fundamental impediments for them to accomplish liquidity through IPOs because they have access to overseas GEMs, such as the NASDAQ, as alternative channels. Generally speaking, in order to circumvent the approval from the CSRC,42 American VCs and their Chinese portfolio companies rely on special purpose vehicles (SPVs) to achieve indirect listings on overseas GEMs.43 SPVs are usually incorporated in offshore jurisdictions, such as British Virgin Islands (BVI), Cayman Islands or Bermuda Islands, by the controlling shareholders of the aforementioned Chinese companies backed by American VCs.44 After their incorporation, SPVs purchase all the outstanding shares of VC-sponsored companies with their own stocks.45 Then they file applications with one of the overseas GEMs to be floated.46 If their requests are approved by GEMs, American VCs as their shareholders can fulfil exit through IPOs. In 2006,the MOC, the SASAC, the CSRC, the State Administration of Taxation (SAT), the State Administration for Industry and Commerce (SAIC) and the State Administration of Foreign Currency (SAFE) collectively enacted a regulation entitled “Interim Provisions on the Takeover of Domestic Enterprises by Foreign Investors”.47 In this regulation, SPVs are required to obtain the approval from the MOC before they purchase the shares of affiliated domestic companies.48 Apparently, this requirement has added extra costs into the traditional SPV model for the exit of

41

As analyzed in Chapter 3, the funds of American VCs operating in China are principally in the form of US dollars. Therefore, after harvesting, American VCs must provide returns to their VC investors in the form of US dollars as well. If their portfolio companies are listed on Chinese stock markets, American VCs can only obtain RMB by selling their shares in the secondary market. Then, they need to convert RMB to US dollars and transfer it to their VC investors outside China. However, China always adopts stringent policies regarding foreign currency exchange and transfer. Hence, in order to avoid the potential hassles caused by Chinese foreign currency policy, American VCs generally choose to list their successful portfolio companies on overseas GEMs located in jurisdictions with free and flexible policies concerning foreign currency exchange and transfer. See China Venture Capital Research Institute Limited (2006) China venture capital yearbook (2006). Democracy and Construction Press, Beijing, p 371. 42 Without using SPVs, Chinese domestic companies must file an application to be listed on overseas stock markets with the CSRC. See “Notice regarding the overseas listings of Chinese domestic enterprises” promulgated by the CSRC on the 14th April 1999. http://vip.chinalawinfo.com/ NewLaw2002/SLC/slc.asp?db=chl&gid=23191. Accessed 8 Nov 2009. 43 For an overview of the SPV model used by American VCs in China, please visit http://finance. sina.com.cn/stock/blank/hcsscq.shtml. Accessed 8 Nov 2009. 44 Ibid. 45 Ibid. 46 Ibid. 47 http://news.xinhuanet.com/fortune/2006-08/10/content_4944032.htm. Accessed 8 Nov 2009. 48 Ibid., the Article 11.

5.2

The Availability of Tailor-Made Stock Markets to American VCs

79

American VCs because the administrative approval is time-consuming and uncertain.49 But it never means that for American VC practitioners in China, the SPV approach has reached a dead end. As Article 2 of the regulation defines, “domestic companies” refer to all the other companies incorporated in the jurisdiction of China except foreign-invested ones.50 Therefore, in order to avoid the approval requirement when relying on SPVs to fulfil exit, American VCs just need to convert their Chinese portfolio companies to foreign-invested companies.51 This practice has already been implicitly recognized by the MOC after the company named “Zhongwang” was successfully listed on the Hong Kong GEM with this conversion.52 In contrast with American ones, Chinese domestic VCs face much more barriers to use overseas GEMs for the sake of exiting from successful portfolio companies. As it has been described above, about two-thirds of Chinese domestic VCs are GVCs. This fact determines that the choice of listing location of GVC-backed companies is inevitably influenced by governments. For municipal governments, in order to echo the State Council’s requirement to promote the development of Chinese domestic stock markets, they usually strongly encourage GVCs to have their portfolio companies listed on the Shanghai Stock Exchange or the Shenzhen Stock Exchange.53 As for overseas GEMs, local governments just think of them as supplementary choices.54 In addition, for Chinese domestic VCs which have not earned a reputation in the global financial markets, they are also reluctant to depend on overseas GEMs as their liquidity channels because their portfolio companies lack the attraction to foreign investors in comparison with those backed by American VCs which are already prestigious worldwide.55 Consequently, mainly based on the above two reasons, the exit of Chinese domestic VCs is tightly connected to Chinese domestic stock markets. However, Chinese domestic stock markets have not functioned well in this aspect. According to the statement made by Shouren Wang who is the general secretary of the Shenzhen VC Association, one of the biggest bottlenecks for the development of Chinese domestic VCs was the lack of efficient IPO

49

Wu L (2007) A primary analysis on the red chip model. Hebei Enterprises 2:56. See footnote 47 above. 51 See footnote 49 above, pp 55–56. In practice, the approval of the incorporation of foreigninvested companies is a routine administrative issue for Chinese governments. So, it is much easier than the approval of the takeover by SPVs from the Ministry of Commerce. 52 Sino-manager Online (2009) The mystery of Zhongwang’s IPO. http://www.sino-manager. com/200987_7517.html. Accessed 8 Nov 2009. 53 Interview with the venture capitalist of the provincial GVC. In 2004, the State Council promulgated the document entitled “Suggestion on the reform and development of domestic financial markets”. http://www1.peopledaily.com.cn/GB/jingji/1037/2314920.html. Accessed 10 Nov 2009. 54 Interview with the venture capitalist of the provincial GVC. For example, Putian municipal government explicitly holds this view in its document entitled “Suggestion of Putian municipal government on fully taking advantage of capital markets to boost the development of economy”. http://big5.putian.gov.cn/a/20081113/10871.html. Accessed 10 Nov 2009. 55 Interview with the venture capitalist of the provincial GVC. 50

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channels.56 He estimated that the percentage of IPOs was less than 30 among all the exits achieved by Chinese domestic VCs from their successful investments.57 The next section will try to prove that this kind of malfunction results from the controlbased model to a large degree.

5.3

The Exit of Chinese Domestic VCs Through Chinese Domestic Stock Markets: An Uneven Road

Currently, Chinese domestic stock markets comprise three parts: the main boards, the SME Board and the newly established GEM. In terms of official statements, the presence of the three parts has made China to achieve the mission of establishing a multi-tier domestic stock market.58 Next, the three boards will be analyzed one by one in order to verify that none of them have assumed the duty to provide a smooth exit channel for Chinese domestic VCs. In turn, this analysis will contribute evidence to prove that this kind of inability of Chinese domestic stock markets is largely ascribed to the influences of the control-based model.

5.3.1

Main Boards

Generally speaking, the main board of a stock market aims to provide a financing channel for well-established companies. Therefore, it usually maintains a set of high listing standards which are difficult to be satisfied by successful VC-backed companies when such VCs are prepared to exit from them. Consequently, this fact determines that per se the main board is not specially designed for the fundraising of small-sized and medium-sized companies as well as for the exit of VCs from these firms. However, in some cases, when VCs are planning to exit, their portfolio companies have been so fully feathered that they have reached the listing criteria of main boards. Hence, the VCs and their collaborative entrepreneurs may prefer to list their companies directly on main boards in order to raise more money and reap more profits. When it happens, an efficient and fair main board should be able to satisfy such a demand. In other words, a well-devised main board can present equal opportunities for potential qualified companies, including VC-backed ones, to be

56

Financial Times (2009) Chinese domestic VCs are hopefully catching up with the GEM. http:// cnstock.xinhuanet.com/08zhongguorz/2009-04/29/content_4251328_3.htm. Accessed 10 Nov 2009. 57 Ibid. 58 People’s Daily (2009) GEM: promoting innovation and serving economic development. http:// big5.xinhuanet.com/gate/big5/news.xinhuanet.com/fortune/2009-10/23/content_12304608.htm. Accessed 4 Dec 2009.

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floated. But because of the control-based model, the quality of equal-opportunity is still absent from the main boards of Chinese domestic stock markets. As illustrated above, the underlying intention of the CPC and the State Council to establish the Shanghai Stock Exchange and the Shenzhen Stock Exchange was to facilitate the fundraising of moribund SOEs.59 But the authorities could not express this intention in a straightforward manner because they had to nominally accommodate the interests of privately held enterprises under the pressure of fairness and equality.60 Therefore, in order to ensure that as many SOEs could be listed as possible, the authorities put the power of listing approval in their hands from the beginning.61 From the inception of the Chinese stock markets to 2000, the Chinese central government implemented a dual-control policy regarding the listing of enterprises on the Shanghai Stock Exchange or the Shenzhen Stock Exchange.62 Under this policy, the related units of the State Council determined a listing volume cap and a listing number cap every year.63 Then, in terms of the two caps, each provincial government was assigned a quota for choosing enterprises to be listed.64 Thus, in this listing approval system, provincial governments were the actual decision makers and they inevitably preferred to select the SOEs located in their areas as the listed candidates.65 On the one hand, the dual-control policy created the first batch of state-controlled listed companies and their control-based model, which in turn deepens on the incentive of the authorities to continuously grip the power of listing approval to preferentially enlarge the category of state-controlled listed companies.66 On the other hand, the selection of listed companies through an administrative approach determined that the quality of those enterprises was usually paid inadequate attention by decision makers.67 Therefore, for the sake of the sustainable development of the Chinese stock markets, it was necessary to reform the dualcontrol policy.

59

See footnote 1, Chapter 2. In 1988, the amendment of the Constitution of the PRC officially recognized the legitimate status of private-owned economies. 61 Theoretically, listing standards should also have been discussed here as a tactic to protect the interests of SOEs like listing approval policies. But in practice, for the sake of superficial equality, the listing standards of the Chinese main boards are not able to play that role. Therefore, the author ignores it in this chapter. 62 Sun R (2009) Thinking about the Chinese stock issuance system. Internet Fortune 4:58. 63 Ibid. 64 Ibid. 65 Geng Z (2007) The internal mechanism underlying the evolution of Chinese stock issuance systems. J ZhengZhou Univ 40:76. 66 Here, the incentives resulting from the control-based model include but are not limited to the better implementation of government policies, the increase of political achievements and the satisfaction of private interests. 67 See footnote 65 above. 60

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From 2001 to 2003, the Chinese central government and the CSRC replaced the dual-control policy with the dual-recommendation policy.68 According to this policy, provincial governments and qualified securities companies were responsible for selecting candidate enterprises to be listed on the Shanghai Stock Exchange or the Shenzhen Stock Exchange.69 Simply speaking, provincial governments were authorized to decide the shortlist of potential listing companies.70 Then, those companies struck contracts with qualified securities companies for pre-listing assistance.71 Finally, those qualified securities companies recommended the companies whose performance was satisfactory during the assistance period to the CSRC for ultimate approval.72 From the brief description, in comparison to the dual-control policy, the dual-recommendation policy was more concerned with the quality of listed companies by involving security companies which have expert knowledge to help the candidate enterprises reach the listing standards. However, because of the SOE-oriented nature of the Chinese stock markets and the various interests resulting from the control-based model,73 provincial governments maintained the power to decide the shortlists of enterprises to be listed in accordance with the dual-recommendation policy. In addition, securities companies were also incentivized to actively recommend the enterprises favoured by local governments to the CSRC in order to acquire more underwriting opportunities from local governments in the future. Consequently, under the dual-recommendation system, SOEs still possessed considerable advantages in the process of listing competition. Since 2004, for the purpose of further improving the quality of listed companies, the CSRC has made security companies liable for their recommendation acts if the recommended companies are identified to be inconsistent with the listing standards afterwards.74 But the change did not fundamentally affect the power of listing selection held by local governments because both the vested interests and potential ones from the control-based model present incentives for local governments to lobby the central government to keep this power.75 Hence, the main boards of Chinese stock markets are still in favour of SOEs. The introduction to the evolution of Chinese listing approval policies reveals the fact that the control-based model maintains and deepens the SOE-oriented nature of

68

Dai G (2008) Exploring the approval systems of stock issuance. Spec Zone Econ 8:36. Ibid. 70 Ibid. 71 Ibid. 72 Ibid. 73 See footnote 62 above. 74 See footnote 68 above. 75 See footnote 66 above. After the CSRC receives the requisite documents from candidate companies, it needs to solicit the advice from provincial governments where those companies are located. Thus, to a large degree, this procedure indirectly maintains the practice that local governments select listed companies. http://www.csrc.gov.cn/n575458/n870705/n1333591/11360537.html. Accessed 4 Dec 2009. 69

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83

the Chinese main boards to a large degree. This proposition has also been empirically verified by the data regarding the dominant position of state-controlled listed companies in the Chinese main boards in Chapter 2.76 Consequently, the two main boards in China are not able to provide a smooth and fair exit channel for Chinese domestic VCs even if their portfolio companies reach the listing standards. Just as the venture capitalist from the provincial GVC argued, VCs hardly have the opportunity to approach Chinese main boards which were the traditional turf of giant SOEs.77 Perhaps that may explain why only two companies were VC-backed ones among 120 newly listed companies on the main boards of the Shanghai Stock Exchange or the Shenzhen Stock Exchange in 2007.78

5.3.2

The SME Board

The SME Board which belongs to the Shenzhen Stock Exchange was launched by the State Council in May 2005. The SME Board was viewed as the interim form of the GEM by the Chinese authorities.79 The mission of it is to provide an exit channel for Chinese domestic VCs and to establish a convenient fundraising environment for SMEs, especially for high-technology ones.80 Objectively speaking, the presence of the SME Board has alleviated the financing difficulties confronted by SMEs to some degree.81 However, it also inevitably diverts a portion of capital which should have flowed into the main boards and in turn threatens the vested interests of state-controlled listed companies. Chinese governments are not willing to ignore the competition from SMEs, most of which are privately held against state-controlled listed companies in the Chinese stock markets because the control-based model has aligned their interests with those of state-controlled listed companies.82 Consequently, in order to weaken the effect of capital diversion of the SME Board, the Chinese central government completely transplanted the listing standards, the listing approval procedure and even the policy of equity division of the Chinese main boards to the

76

See Table 2.1. Interview with the venture capitalist of the GVC. 78 See China Venture Capital Research Institute Limited (2007) China venture capital yearbook (2007). Democracy and Construction Press, Beijing, p 274; Ceocio Online (2009) The sports meeting of listing. http://www.ceocio.com.cn/12/93/124/312/24512.html. Accessed 4 Dec 2009. 79 Shenzhen Stock Exchange (2009) The implementation plan of the Shenzhen stock exchange regarding the establishment of the SME Board. http://www.szse.cn/main/sme/sczy/ ywgz/200405255828.shtml. Accessed 15 Dec 2009. 80 See footnote 53 above. 81 More than 80% of listed companies on the SME Board are privately held ones. See China Venture Capital Research Institute Limited (2008) China venture capital yearbook (2008). Democracy and Construction Press, Beijing, p 362. 82 Ibid. 77

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SME Board.83 Therefore, this fact has determined that the real function of the SME Board is unlikely to be consistent with its missions mentioned above. Now that this chapter only focuses on the exit of Chinese domestic VCs, it will principally analyze how the transplantation has disabled the SME Board from normally functioning in this aspect in the remaining part of this section. The listing standards of the SME Board include several key accounting indicators for candidate firms. First, the pre-listing shares of the candidate firm must be above RMB30 million yuan.84 Second, each of the net profits of the candidate company in the past 3 accounting years must be positive and their overall amount must be above RMB30 million yuan.85 Third, the overall cash flow of the candidate company in the past 3 accounting years must be above RMB50 million yuan or its overall revenue in the past 3 accounting years must be above RMB0.3 billion yuan.86 Fourth, at the end of the last quarter of the immediately previous accounting year, the ratio of the candidate company’s intangible assets to its net assets must not be above 20% and it does not have losses without compensation.87 The aggregation of these accounting criteria determines that only the capital-concentrated SMEs which are usually from the manufacturing industry possess the scale and capability to satisfy the high listing requirements. Numerous high-technology SMEs, the feature of which is technology-concentrated barely reach the threshold of the SME Board. Consequently, for the exit of Chinese domestic VCs through the SME Board, the impact of the prohibitive listing standards is twofold. First, Chinese domestic VCs can rarely achieve the exit from the high-technology companies backed by them via the SME Board. Second, if Chinese domestic VCs hope to rely on the SME Board for the purpose of exit, they must invest in companies in the manufacturing industry. Taking into account the fact that VCs are not willing to become massively involved in traditional industry, the ratio of VC-backed listed companies on the SME Board is low. The existing empirical evidence has confirmed the judgments. According to the data in Table 5.1, it is clear that the overwhelming majority of VC-backed listed companies on the SME Board came from the manufacturing industry from 2004 to 2007. Meanwhile, in terms of Table 5.2, the average percentage of VC-backed listed companies among all the listed companies on the SME Board was only 26.2 in the above 4 years. In addition to the listing standards, the listing approval procedure of the SME Board which features administrative selection, as described in the immediately previous part, can also filter out a portion of VC-backed candidates of high quality and then extend the listing opportunities to establish SOEs which do not acquire the listing quotas on the main boards. Last year, one of the author’s relatives

83

Ibid., p 377. Article 33 of “Provisional administration method regarding listing stocks by means of initial public offerings”. http://www.gov.cn/ziliao/flfg/2006-05/18/content_283660.htm. Accessed 15 Dec 2009. 85 Ibid. 86 Ibid. 87 Ibid. 84

Non-VC-backed 2 0 28 0 3 0 4 1 0 0 2 0 1 41

2006 VC-backed 0 0 8 0 0 0 3 0 0 0 0 0 0 11

0 30

0 4 0

0 0

4

2007 VC-backed 0 1 20 0 1 0

0 70

2 2 1

1 1

4

Non-VC-backed 1 1 56 0 1 0

Source: China Venture Capital Research Institute Limited (2008) China venture capital yearbook (2008). Democracy and Construction Press, Beijing, p 367. Here, it is believed that some scholars may argue that the number of VC-backed listed companies on the SME Board is acceptable given the short history of the Chinese domestic VC industry. As an academic product, this book opposes this kind of attitude which over-simply attributes everything to time. Certainly, time can explain some things. However, as a research project, this book must also try to find out the more complicated institutional factors which determine the malfunction of the SME Board against the smooth exit of Chinese domestic VCs

Table 5.1 The industry spectrum of listed companies on the SME Board 2004 2005 Industry VC-backed Non-VC-backed VC-backed Non-VC-backed Agriculture 0 0 1 0 Mining 0 0 0 0 Manufacture 9 25 2 7 Public utilities 0 0 0 1 Construction 0 0 0 0 Transportation 0 1 0 1 and storage Information 0 1 0 0 technology Sales and retails 0 1 0 0 Finance and 0 0 0 0 insurance Real estate 0 0 0 0 Social services 0 1 0 0 Media and 0 0 0 0 entertainment Others 0 0 0 0 Total 9 29 3 9

5.3 The Exit of Chinese Domestic VCs Through Chinese… 85

86

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The Lack of Efficient Exit Channels for Chinese Domestic VCs

Table 5.2 Numbers of listed companies on the SME Board Numbers of IPOs VC-backed Non-VC-backed Total IPOs Year Numbers Percentage Numbers Percentage Numbers Percentage 2004 9 24.32 28 75.68 37 100 2005 3 25 9 75 12 100 2006 11 21.15 41 78.85 52 100 2007 30 30 70 70 100 100 Total 53 26.2 149 73.8 202 100 Source: China Venture Capital Research Institute Limited (2008) China venture capital yearbook (2008). Democracy and Construction Press, Beijing, p 364

who was vice mayor of a county in China told me that a large-scale state-owned steel company located in her county had obtained approval from the provincial government and CSRC to be listed on the SME Board after it failed to lobby for the entrance ticket of the main boards. As for the policy of equity division, it once made the exit of Chinese domestic VCs through the SME Board impossible. In accordance with the requirements of the policy, shares held by the state and legal persons were prohibited to be traded on the secondary market. As it has been explicated, most Chinese domestic VCs are structured as companies which are deemed legal persons by the relevant PRC laws.88 Therefore, the policy of equity division meant that Chinese domestic VCs were not able to achieve exit via the SME Board even if their portfolio companies had been successfully listed on it. In 2005, in order to rescue the Chinese main boards from the brink of collapse, the CSRC launched the reform of the policy of equity division.89 Benefiting from this reform, shares held by legal persons are allowed to be traded on the SME Board.90 Objectively speaking, the abolishment of the equity division policy has promoted the exit of Chinese domestic VCs through the SME Board. However, it also reflects that the Chinese stock markets are still SOE-oriented because of the control-based model and Chinese domestic VCs are at most the “free riders” of the policies in favour of state-controlled listed companies. Thus, without resetting the mission of the Chinese stock markets, the effects of any reforms at the technical level are inevitably limited. To sum up, with the interest-aligned effect of the control-based model, the Chinese SME Board has almost completely duplicated the Chinese main boards. Consequently, it cannot assume the duty to provide a smooth exit channel for Chinese domestic VCs.

88

Article 2 of the Company Law 2006. The CSRC (2009) Notice regarding the pilot reform of equity division. http://big5.csrc.gov.cn/ SuniT/www.csrc.gov.cn/n575458/n776436/n804935/n2466682/2652975.html. Accessed 15 Dec 2009. 90 Ibid. 89

5.3 The Exit of Chinese Domestic VCs Through Chinese…

5.3.3

87

The GEM

After 10 years’ discussion and waiting, the Chinese GEM was eventually launched by the Chinese central government in May 2009. In comparison with the main boards and the SME Board, the listing standards and listing approval procedure of the GEM are more suitable for the reality of high-technology venture enterprises. For example, in the aspect of accounting conditions, the GEM only requires that candidate enterprises are continuously profitable in the past 2 years before listing; the net profits in the period must be above RMB10 million yuan; the trend of profitability is lasting and the net assets must be above RMB20 million yuan at the end of the last quarter of the immediately previous accounting year.91 In addition, in the aspect of listing approval, the pre-approval of provincial governments is excluded.92 Therefore, the GEM is theoretically an ideal exit channel for Chinese domestic VCs. However, due to the negative effect of the control-based model, this function of the Chinese GEM has not been fully made use of yet. This proposition will be proved below. As it is known, the main boards of stock markets play the role of providing a fundraising platform for established companies. Different from the main boards, the GEM is principally responsible for the exit of VCs from their successful portfolio firms and the fundraising of companies is just the “side product” of this kind of exit. The rationale underlying the orientation to the GEM is that the potential of the VC industry for financing SMEs is much higher than that of the GEM. Therefore, by acting as the exit channel of VCs, the GEM can stimulate potentially huge capital flow into the VC industry and the adequate fundraising of VCs can in turn satisfy the financing demands from thousands of SMEs.93 Unfortunately, this rationale has not been fully realized by the Chinese authorities because they always focus on the financing function of the Chinese main boards as a result of the control-based model. Consequently, this inertia has made them label the GEM a market of financing as well. It means that the Chinese authorities do not pay much attention to the exit of Chinese domestic VCs via the GEM and instead they care more about listing as many enterprises as possible. Even though it is rather limited at the moment because of the very short history of the Chinese GEM, the existing empirical evidence can basically prove the above analysis. By checking the 10 biggest shareholders of the first 28 listed companies on the GEM, it is discovered that the 10 biggest shareholders of 10 companies among the 28 listed companies do not include VCs. In addition, some VC institutions, most of which are GVCs, invested in 11 out of the 18 VC-backed companies right before their listing for the purpose of being “free riders”.94 Just as Zhongting Wu who is the CEO of Beijing Huaqi Information Digital Technology 91

See footnote 84 above. http://finance.sina.com.cn/stock/opengem/index.shtml. Accessed 15 Dec 2009. 93 See footnote 23, p 210, Chapter 4. 94 http://www.nbd.com.cn/newshtml/20091030/20091030024557388.html. Accessed 15 Dec 2009. 92

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Corporation said, there were few VCs which actively got in touch with her before her company applied for being listed on the GEM. But after it filed the application, many VCs had approached her for investments.95 Therefore, among the 28 listed companies, the authentic exit of Chinese domestic VCs from their successful portfolio firms at most accounts for 25%.96 To summarize, on the basis of the limited empirical evidence, the Chinese authorities put too much emphasis on the financing function of the GEM and pay inadequate attention to its role as the exit channel for Chinese domestic VCs. Again, this kind of shortcoming is closely linked to the control-based model.

5.4

Conclusion

In the aspect of liquidity, American VCs are able to achieve efficient exit from their successful portfolio companies through tailor-made stock markets, such as the NASDAQ. In comparison with their American counterparts, Chinese domestic VCs cannot achieve smooth exit via either domestic or foreign stock markets at the moment. More importantly, the lack of efficient exit channels for Chinese domestic VCs is largely attributed to the control-based model.

95

Beijing Newspaper (2009) Many VCs hastily approached Huaqi digital right after its application for being listed on the GEM. http://it.people.com.cn/GB/9335395.html. Accessed 15 Dec 2009. 96 Although the accurate number of VC-backed companies which are eligible for listing on the GEM cannot be obtained, there is enough reason to believe that this number must be larger than seven. Therefore, many authentic VC-backed companies which are qualified for being floated on the GEM have not obtained this kind of opportunity.

Chapter 6

The Lower Level of Risk Tolerance of Chinese Domestic Venture Capitalists

6.1

Introduction

Collectively, Chapters 3, 4 and 5 analyzed the defects in the entire cycle of Chinese domestic VCs with the practice template of American ones. More significantly, on the basis of this analysis, the assumption that those disadvantages of Chinese domestic VCs are at least loosely ascribed to the institutional impediments imposed by the control-based model of Chinese state-controlled listed companies has been proved. This chapter attempts to explain their different performance through the perspective of risk tolerance. As it has been repeatedly indicated in this book, the investment targets of VCs ought to be the high-technology start-ups with high risks as well as high returns. Therefore, high risk tolerance should be an essential quality of real venture capitalists. Correspondingly, it should also be a valid factor which affects the performance of the VC sector. In this aspect, the existing research has already established the linkage between the prosperity of the American VC industry and the more remarkable risk tolerance of American venture capitalists.1 Thus, in order to more thoroughly assess the reasons for the distance between American VCs and Chinese domestic ones, it is meaningful to make a comparison of the risk tolerance of their respective venture capitalists based on the empirical evidence. More importantly, this comparison provides clues to explore whether or not the control-based model has passive influences on this quality of Chinese domestic venture capitalists. This chapter comprises three parts. The first part compares the risk tolerance of American venture capitalists with that of their Chinese competitors in the light of the empirical evidence. Through this comparison, it is discovered that the risk tolerance of Chinese domestic venture capitalists is lower. The second part aims to verify the connections between the lower risk tolerance of Chinese domestic venture capitalists and the negative effects of the control-based model. The last part is conclusions.

1

See footnote 33, pp 892–893, Chapter 1.

L. Zhang, Venture Capital and the Corporate Governance of Chinese Listed Companies, DOI 10.1007/978-1-4614-1281-6_6, © Springer Science+Business Media, LLC 2012

89

90

6.2

6 The Lower Level of Risk Tolerance of Chinese Domestic Venture Capitalists

The Comparison of Risk Tolerance: Findings from Empirical Studies

As defined in Chapter 1, VC refers to “investment by specialized venture capital organizations in high-growth, high-risk, often high-technology firms that need capital to finance product development or growth and must, by the nature of their business, obtain this capital largely in the form of equity rather than debt”.2 On the basis of the definition, it is clear that VC features two dimensions. One dimension is related to its affinity for investing in the early stage of firms as described by “to finance product development or growth”.3 The other dimension refers to its preference for investing in the high-technology industry. On the basis of the two dimensions, two indicators have been extracted – financing stages and technological intensity, which will be used to measure the risk tolerance levels of Chinese domestic venture capitalists and their American counterparts in this chapter. As for financing stages, it is principally concerned with the investment magnitudes of Chinese domestic VCs and American ones in the start-up stage. In the VC sector, the development of a company is usually divided into four stages – the seed stage, the start-up stage, the expansion stage and the pre-IPO stage.4 The seed stage refers to the situation in which entrepreneurs only generate their ideas and are yet to convert those ideas into products.5 The start-up stage determines that trial production and early marketing have been carried out.6 The expansion stage means that products have been recognized by consumers and have achieved a major share of the market.7 The pre-IPO stage implicates that the VC-backed company is mature and possesses the scale to raise funds in the stock markets.8 VCs, as the common practice, very rarely invest at the seed stage.9 Instead, at this stage, entrepreneurs whose companies just have good ideas usually acquire equity investment from a group of wealthy individuals who are commonly called “angel investors”.10 Except the seed stage, VCs are willing to be involved in the other three stages. However, this kind of investment portfolio does not simply mean that the other three stages are equally important in the eyes of VCs. Theoretically, VCs ought to be much more interested in the start-up stage because the returns from investing at this stage are fairly higher than those from investing at the expansion stage or the pre-IPO stage.

2

See footnote 39, Chapter 1. Ibid. 4 http://en.wikipedia.org/wiki/Venture_capital. Accessed 15 Jan 2010. 5 Ibid. 6 Ibid. 7 Ibid. 8 Ibid. 9 Heyming H (2010) Where venture capital fits. http://www.kciinvesting.com/articles/9958/1/ Where-Venture-Capital-Fits-Part-2/Page1.html. Accessed 15 Jan 2010. 10 Ibid. 3

6.2

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But along with large profits, the risks in the start-up stage are also much higher than those in the later two stages. Therefore, in order to disperse risks, VCs also put some money into enterprises at their expansion stages or pre-IPO stages, which are more secure than investing in early stage ones. From this analysis, two points are intended to convey. First, only the investment in the early stage can validly reflect the risk tolerance of venture capitalists. Maybe the expansion stage and the preIPO stage represent different risk levels. But both of them are means adopted by VCs to offset the high risks stemming from the early stage. In this sense, they are not directly related to the risk-neutrality character of VCs. Second, since the early stage represents a variable to measure the risk tolerance of venture capitalists, it is possible to compare the risk tolerance of venture capitalists in different VCs by calculating the different weights of new investment in this stage by those VCs during a certain period. Technology intensity is related to the fact that the risk levels of different high technologies are never identical although all of them are usually associated with high uncertainty and high risks. Theoretically, the determinant factor of the risk magnitudes of different high-technology sectors is their different technology intensity.11 The higher the technology intensity, the higher the risks a high-technology sector has. Therefore, it is feasible to measure the degrees of risk tolerance of different venture capitalists if the technology intensity of various high-technology sectors and the distribution of new investment among such sectors by the subject venture capitalists during a certain period are known. In the aspect of investing in start-up companies, the empirical evidence does not show any substantial differences between Chinese domestic venture capitalists and their American rivals. According to the data regarding the respective new investments by Chinese domestic VCs and foreign ones in China in 2005, among a total of 187 projects financed by Chinese domestic VCs, 80 were at the start-up stage with a percentage of 42.8;12 likewise, among 102 projects financed by foreign VCs, 44 were at the start-up stage with a percentage of 43.1.13 From this comparison, it is basically concluded that no obvious divergence exists between Chinese domestic venture capitalists and their foreign counterparts concerning their preference for start-up companies. Even though this set of data did not specially measure the performance of American venture capitalists in this aspect, the performance of foreign venture capitalists can be virtually applied to American ones because the latter plays a dominant role among all the members of the former in China.14 Thus, “American venture capitalists” will be used in the following similar quotations instead of “foreign venture capitalists”. Another piece of supplementary empirical proof to support the findings comes from the research collectively carried out by Rob Dixon,

11

See footnote 48, Chapter 1. See Zhang X, et al. (2006) China high-tech industry development almanac. Beijing Institute of Technology Press, Beijing, p 277. 13 Ibid. 14 See Chapter 1. 12

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John Ritchie and Di Guo.15 In their research, the three authors statistically compared the propensity of Chinese domestic venture capitalists and American ones to opt for different stages of companies in terms of their investment from 2002 to 2003 in China.16 Finally, Dixon, Ritchie and Guo found that there was not a statistically significant difference between American venture capitalists and Chinese domestic ones in their preference to invest in projects at the start-up stage.17 On the basis of the above two pieces of empirical evidence, the risk tolerance of Chinese domestic venture capitalists and American ones toward start-up companies is tight. The explanation for this phenomenon is that Chinese domestic VCs as learners have imitated the practice of seasoned American ones in the aspect of choosing investment stages. As Jianbiao Xiang who was the founder of the Holding VC said, our standards of selecting projects were mainly transplanted from those of IDG which is a famous American VC.18 In addition, the interviewee from the provincial GVC also held the same position on this matter.19 In the aspect of choosing high-technology sectors, the empirical evidence indicates that there are clear differences between Chinese domestic venture capitalists and American ones. In 2006, 20.3% newly invested projects with a monetary injection of RMB812 million yuan by Chinese domestic VCs were in the fields of new energy and new materials.20 Both of the data ranked No. 1 among all the projects financed by Chinese domestic VCs that year.21 By contrast, in the same year, 51% newly invested Chinese projects with a monetary injection of RMB5,669 million yuan by American VCs were in the fields of IT.22 Likewise, both of the data also ranked No. 1 among all the Chinese projects financed by American VCs that year.23 From this comparison, Chinese domestic venture capitalists are more interested in new energy and new materials while American venture capitalists focus more on IT. At this point, the finding is supported by the above-mentioned research of Dixon, Ritchie and Guo as well. In their research, the three authors concluded that there was a statistically significant difference between American venture capitalists and Chinese domestic ones in their preference for high-technology sectors – the former concentrated on IT-related technologies and the latter was attracted to new energy and new materials.24 The explanation for American venture capitalists’ favouring

15

See footnote 48, Chapter 1. Ibid. 17 Ibid. 18 CEO & CIO Magazine (2010) The pain of Chinese private domestic VCs. http://tech.163. com/09/0722/10/5EQOCTER000915BF.html. Accessed 15 Jan 2010. 19 Interview with the venture capitalist from the provincial GVC. 20 See China Venture Capital Research Institute Limited (2007) China venture capital yearbook (2007). Democracy and Construction Press, Beijing, p 236. 21 Ibid. 22 Ibid. 23 Ibid. 24 See footnote 48, Chapter 1. 16

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IT is that IT is their traditional advantage and they have accumulated rich experiences about making their fortune in this sector from their past successes and failures. Especially, many senior members of American VCs directly come from IT companies, which is why they are more willing to invest in their formerly specialized area.25 The reasons for Chinese domestic venture capitalists’ inclination towards new energy and new materials can be divided into two cases. For GVCs, this kind of inclination mainly results from the environmental policy of the State Council. In 2002, the State Council issued “The National Report of Sustainable Development” in which new energy and new materials were deemed the urgent fields for development.26 In order to echo the calling from the central government, local governments subsequently made their own plans for rapidly developing the two fields.27 In those plans, one common method is to finance the start-up companies with the technologies related to new energy and new materials.28 Therefore, GVCs which are affiliated to local governments inevitably play the role of investor for those companies. For private domestic VCs, their partiality for new energy and new materials principally stems from the backgrounds of their VC investors. As Jiaqing Li who is the CEO of the Legend Capital Limited said, almost all VC investors of private domestic VCs in China are privately held companies in the manufacturing industry.29 With the increasing prices of traditional energy and the more stringent environmental responsibilities, entrepreneurs of those privately held companies had realized that the profit room for their enterprises had been significantly narrowed.30 Therefore, they put part of the retained profits of their companies into the VC industry in order to earn more money.31 From Mr. Li’s explanation, one of the direct reasons for the participation of privately held enterprises in the VC industry is the pressure caused by the state policy of protecting traditional energy and the environment. Given their sufferings from this kind of pressure as well as the political advocacy from the Chinese central government, there is enough reason to believe that the entrepreneurs of those companies can definitely identify the big market potential of new energy and new materials in China, which means that they have more incentive to participate in the two fields. In addition, different from VC investors in America, they always require the status of decision makers as described in the East Sea case above, which implicates that they possess the discretion to select their preferred areas.

25

IT Time Weekly (2010) IT experts jump into the VC sector. http://news.zero2ipo.com.cn/n/200911-14/20091114114800.shtml. Accessed 16 Jan 2010. 26 The State Council (2002) The national report of sustainable development. China Environmental Science Press, Beijing. 27 It is easy to find that almost every province has issued its plan for developing new energy and new materials if we search for them through Google or Baidu. 28 Ibid. 29 First Financial Daily (2010) The temperature of private domestic VC needs to be cooled. http:// www.china-cbn.com/s/n/000002/20080722/020000084359.shtml. Accessed 16 Jan 2010. 30 Ibid. 31 Ibid.

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Thus, the combination of the two factors explains why private domestic VCs also show a preference for new energy and new materials. Related to the technology intensity of different high-technology sectors, little quantitative research has been conducted so far. In all likelihood, this inadequacy is attributed to the potential huge and complicated task of designing measurable indicators and collecting data across sectors and even across nations. Therefore, the technology intensity of the high-technology sectors respectively preferred by American venture capitalists and Chinese domestic ones can only be qualitatively measured by conducting an interview. From the viewpoint of the interviewee from the provincial GVC, IT is more technological intense and riskier than new energy and new materials.32 As he explained, the profits of IT projects mainly come from attracting and maintaining a huge number of users.33 However, from an initial IT product to a widely accepted one, this process usually takes several years during which almost all of the work is technology-based because most IT products are intangible.34 The longer growth period of IT products resulting from technologyintensity commonly means that they are not able to create money before maturing.35 Moreover, nobody could guarantee that they can definitely build a huge client base within a few years’ time.36 Therefore, the uncertainty is fairly great.37 By contrast, investing in technologies with tangible products, such as new energy and new materials, is less technologically intense and risky because they are able to generate profits with a mature product in a much shorter period.38 The interviewee’s opinion has been supported by Qifa Liu who is the investment manager of the Fitch Crown Venture Capital Management Company. In a VC forum organized by the Net Ease Company, Mr. Li expressed the same position regarding the technology intensity and risks of IT, new energy and new materials.39 In addition, in their research, Dixon, Ritchie and Guo mentioned that their interviewee who was a domestic venture capitalist also confirmed that IT was more technological intense and riskier than new energy and new materials.40 In terms of the aforementioned empirical evidence, the conclusion that the risk tolerance of American venture capitalists is higher than that of Chinese domestic venture capitalists can be basically arrived at. However, as analyzed above, venture capitalists in GVCs and private domestic VCs are not independent decision makers in the process of choosing investment projects.41 And passive selection cannot

32

Interview with the venture capitalists from the provincial GVC. Ibid. 34 Ibid. 35 Ibid. 36 Ibid. 37 Ibid. 38 Ibid. 39 The Net Ease (2010) Chinese domestic VCs stay away with IT in the three years ahead. http:// tech.163.com/08/0117/00/42CCME3K000922QC.html. Accessed 16 Jan 2010. 40 See footnote 48, Chapter 1. 41 See Chapters 3 and 4. 33

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authentically represent the risk tolerance of venture capitalists. Therefore, in order to truly reflect the risk tolerance of Chinese domestic venture capitalists, it is necessary to assess whether or not they would have been willing to catch up with or even overtake their American rivals in this aspect if it is assumed that everything is the same except that they are able to independently make decisions. For venture capitalists in GVCs, their answers to the above question are “No”. In the interview with the venture capitalist in the provincial GVC, he expressed the view that even if they obtained the sufficient autonomy to make investment decisions, venture capitalists in GVCs were inclined to choose the projects favoured by governments, such as start-up companies developing new energy or new materials.42 As he explained, on the one hand, they could get rescued by governments when they are in trouble with the projects recommended by the authorities; on the other hand, they cannot earn more because of the fixed income system in GVCs but must be blamed for losses if they independently choose riskier projects like IT start-ups.43 The interviewee’s opinion has also been supported by the interview conducted by Dixon, Ritchie and Guo in their quoted research.44 Therefore, in comparison with American venture capitalists, a lower level of risk tolerance of venture capitalists in GVCs can be ascribed to the effects of risk absorption and incentive inadequacy. For venture capitalists in private domestic VCs, their answer to the above question is “No” as well. As explicated before, the main funding source for private domestic VCs is the limited retained profits of privately held enterprises. Therefore, without alternative large funds, the failure of investment for a private domestic VC generally means that it has to leave the VC industry. Consequently, in order to survive, there is enough reason to believe that venture capitalists in private domestic venture capitalists do not invest in the areas riskier than those currently invested in by them if they have the discretion to select projects. The analysis has been testified by Fenglin Chen who is the vice CEO of the privately held Shanghai Huile Investment and Management Corporation. According to Mr. Chen’s illustration, foreign VCs generally hold billions of dollars for investment.45 If they fail in a project, they can also get compensated by other successful ones.46 But for private domestic VCs, their funds are quite limited.47 If they fail in a project, it usually means that all is lost.48 Therefore, private domestic VCs pay more attention to risks while foreign VCs are more concerned with profits.49 In addition, the interviewee in the GVC also agreed with my reasoning on this matter. As he said, even though neither GVCs nor private

42

Interview with the venture capitalist from the provincial GVC. Ibid. 44 See footnote 48, Chapter 1. 45 The CVCRI Online (2010) The differences between Chinese domestic VCs and foreign ones. http://bbs.chinavcpe.com/topic.action?topicId=7004. Accessed 17 Jan 2010. 46 Ibid. 47 Ibid. 48 Ibid. 49 Ibid. 43

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domestic VCs have as much money as American ones, the budgets of GVCs are much softer than that of private domestic VCs.50 Hence, for private domestic VCs, project failure is almost the equivalent of their bankruptcy.51 Consequently, they are more cautious in relation to risks.52 From the above analysis, the lower level of risk tolerance of private domestic venture capitalists can be attributed to their shortage of funds. To sum up, the empirical evidence has shown that the risk tolerance of American venture capitalists is higher than that of Chinese domestic venture capitalists. For GVCs, the difference is because of the effects of risk absorption and incentive inadequacy. For private domestic VCs, the difference results from their more limited fund sources. The next section tries to prove that these reasons are linked to the control-based model.

6.3

The Lower Risk Tolerance of Chinese Domestic Venture Capitalists: What the Control-Based Model Explains

According to the empirical findings from the preceding section, in order to prove the linkage between the control-based model and the lower risk tolerance of Chinese domestic venture capitalists, the following two propositions in this section must be testified: (1) the effects of risk absorption and incentive inadequacy faced by GVCs largely result from the control-based model; (2) the more severe funding shortage suffered by private domestic VCs is mainly attributed to the control-based model as well. Next, they will be verified in sequence.

6.3.1

Risk Absorption and Incentive Inadequacy: The Reflection of Parentalism

Chapter 2 points out that the control-based model has aligned the interests of governments with those of their controlled listed companies. Consequently, this kind of alignment has maintained the parentalism of governments which pervasively existed in traditional SOEs before their corporatization. With the parentalism, on the one hand, governments have the incentive to transfer as many resources as possible to state-controlled listed companies, which has been proved with empirical evidence in Chapter 3; on the other hand, they are also willing to absorb any risks which threaten the operation and vested interests of those companies. As a result, when GVCs emerged since the end of the 1990s,53 the behavioural inertia inevitably made 50

Interview with the venture capitalists from the provincial GVC. Ibid. 52 Ibid. 53 See footnote 48, Chapter 1. 51

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governments apply the risk-absorption aspect of parentalism to this new type of firm which is homogeneous with state-controlled listed companies. Naturally, when GVCs experience trouble after investing in projects recommended by governments, the authorities will try to bail them out by providing more money. Here, it is believed that some may argue that the bailout of governments should have the effect of increasing the risk tolerance of venture capitalists in GVCs. Thus, is it inconsistent with its role as the reason to lower the risk tolerance level of venture capitalists of GVCs? The answer is “No”. As the existing academic research has identified, the two factors that measure the risk tolerance level of venture capitalists are financing stages and technology preference as adopted in this chapter. The ability or willingness of venture capitalists to use risk-controlling mechanisms can only influence their risk tolerance at each level but cannot upgrade or downgrade their levels. For example, Professor Curtis Milhaupt once compared the risk tolerance levels of American venture capitalists and Japanese ones through the above two indicators.54 Even though he also found that Japanese venture capitalists seldom made use of convertible securities or stock options, it did not change their lower risk tolerance level in comparison with their American rivals because they generally focus on latestage financing and traditional industries.55 Therefore, based on this reasoning, it is understood that the bailout of governments lowers the risk tolerance level of venture capitalists in GVCs as the empirical evidence shows but may increase their risk tolerance at this lower level. On the basis of the above analysis, what ought to be done next is to prove that the practice of risk absorption maintained by the control-based model really exists in the state-controlled listed companies. In order to achieve this, the interaction between the control-based model and the risk absorption of governments in three situations which cause risks to the state-controlled listed companies will be explored. The three situations are fraudulent information disclosure, hostile takeovers and bankruptcy. Next, they will be analyzed one by one.

6.3.1.1

Fraudulent Information Disclosure

Pursuant to the Securities Law of the PRC, when the fraudulent information disclosed by a state-controlled listed company is spotted by the CSRC, the company will suffer administrative fines and warnings.56 In addition, according to the judicial interpretation entitled “Notice regarding Dealing with the Disputes Resulting from Fraudulent Information Disclosure” which was made by the Supreme Court of the PRC in 2002, the shareholders which fall victim are also entitled to file lawsuits against the company for compensation after the administrative penalty from the

54

See footnote 33, p 894, Chapter 1. Ibid., p 889. 56 Article 193 of the Securities Law of the PRC. 55

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CSRC is imposed.57 Therefore, for state-controlled listed companies, fraudulent information disclosure theoretically means the loss of money and confidence from public investors. With the risks of heavy punishments from the regulatory body, courts and market, state-controlled listed companies should be dissuaded from issuing fraudulent information. But in reality, false information disclosed by them has been rampant in the Chinese stock markets. Professor Peixin Luo from the East China University of Political Science and Law once conducted an interview with a government official who was responsible for investigating securities crimes.58 In this interview, the official admitted that it was common practice for state-controlled listed companies to issue fraudulent information, but only a few of them had been punished by the CSRC or courts.59 Likewise, Professor Liufang Fang from the China University of Political Science and Law also expressed the same opinion in an interview with an influential newspaper in China.60 During this interview, Professor Fang even commented that the information frauds of state-controlled listed companies had made accounting firms forget how to provide true auditing reports.61 Facing the divergence between the punishment risks and the flooding of false information from state-controlled listed companies, some may wonder why it happens. Among others, the main reason is because governments absorb most risks from disclosing fraudulent information for state-controlled listed companies, which was implicitly revealed by the official in his or her interview with Professor Luo.62 As it has been analyzed in Chapter 2, the underlying purpose of the control-based model is to ensure that state-controlled listed companies are able to faithfully implement the policies of the CPC and governments. This fact determines that the administrative penalty made by the CSRC against the behaviour of information frauds of state-controlled listed companies definitely impairs the interests of local governments or the SASAC. Therefore, when the fraudulent information from statecontrolled listed companies is identified by the CSRC, local governments and the SASAC inevitably wade in and prevent the CSRC from taking any punitive action. Moreover, this kind of intervention also deprives victim shareholders from the right to approach courts for remedies because the penalty decisions of the CSRC are the prerequisite for filing lawsuits in terms of the “Notice regarding Dealing with the Disputes Resulting from Fraudulent Information Disclosure”. Consequently, the risks from issuing false information for state-controlled listed companies have been substantially absorbed by governments. Even though it is impossible to know how many state-controlled listed companies’ governments have helped escape the administrative penalties after disclosing

57

http://policy.mofcom.gov.cn/section/claw!fetch.html?id=g100000723. Accessed 19 Jan 2010. Luo P (2005) The establishment of legal system for the harmonized ecology of Chinese securities markets. China Legal Sci 4:101–102. 59 Ibid. 60 See footnote 28, Chapter 1. 61 Ibid. 62 See footnote 58 above. 58

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fraudulent information, it is still possible to indirectly identify this kind of practice from some cases investigated and announced by the CSRC. Next, in order to further demonstrate the claim in this section, the Hongguang case will be chosen as an example.63 Chengdu Hongguang Industrial Corporation (Hongguang) was a television manufacturer which was in the charge of Chengdu Municipal Government. In June 1997, upon the recommendation of Sichuan Provincial Government and the approval of the CSRC, Hongguang was listed on the Shanghai Stock Exchange. In its prospectus, Hongguang predicted that it could achieve profits of RMB70.55 million yuan by the end of 1997. However, according to its annual report of 1997, Hongguang eventually suffered net losses of RMB203 million yuan. Consequently, it became the first company to report losses in its listing year in China. The tremendous difference between the prospectus and the annual report aroused the intensified criticism and scepticism among the media and public investors. Under this kind of pressure, the CSRC announced its intention to investigate Hongguang at the beginning of 1998. At the end of that year, the CSRC reported its investigation results to the public. According to the results, Hongguang provided fraudulent accounting information in its prospectus for the purpose of acquiring the listing quota. For example, in terms of its prospectus, Hongguang was continuously profitable from 1994 to 1996. But in fact, till 1996, it had suffered losses of RMB103 million yuan. From this brief description of the Hongguang case, three points are intended to convey. First, as the SOE was located in its area and enjoyed its subsidy, Chengdu Municipal Government had no reason to say that they did not know about the losses of Hongguang before its listing. But they never declared any objection to the false financial data included in the prospectus when Hongguang sought to be listed. Therefore, it just means that the local government allowed the fraudulent practice of its enterprise. Second, ex ante conniving must be associated with ex post harbouring. From the almost 1-year investigation, there is enough reason to imagine how much resistance from the local governments the CSRC went through. Hence, if Hongguang did not generate such huge negative influences in China, it may have escaped the punishments of the CSRC. Finally, the combination of the above two points can basically prove the risk absorption of governments for state-controlled listed companies after they issue false information. More importantly, it is largely ascribed to the control-based model.

6.3.1.2

Hostile Takeovers

Hostile takeovers are an important and effective external governance mechanism to discipline the performance of the management of a listed company.64 Along with the

63

Zhang Y (2010) The red and black of Chinese stock markets. http://www.guosen.com.cn/webd/ eBook/redandblack/hongguan.html. Accessed 21 Jan 2010. 64 Gilson RJ (1992) The political ecology of takeovers: thoughts on harmonizing the European corporate governance environment. Fordham Law Rev 61:169–171.

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success of a hostile takeover, the controlling power of the target company will be transferred to the bidder; its incumbent managers will be probably replaced and its overall operation strategies will usually be changed. Therefore, for a listed company, hostile takeovers threaten the vested interests of the controlling shareholders and the management, and the established tactics of operation. However, the prerequisite for the survival of hostile takeovers is the dispersed ownership structure of listed companies. In the case of concentrated ownership, a bidder can only negotiate in a friendly way with the controlling shareholders and the management if it intends to acquire the target company. Thus, with the controlbased model, governments as the majority shareholders, not only guarantee the implementation of their policies in state-controlled listed companies, but also discourage any hostile takeover attempts against those companies. In this sense, governments absorb the risks from hostile takeovers for state-controlled listed companies. Actually, in addition to hostile takeovers, friendly negotiations usually mean that a bidder is not able to ultimately control the target state-controlled listed companies as well. According to the “Provisional Administration Regulation regarding the Transferring of State-owned Shares of Listed Companies” jointly enacted by the SASAC and the CSRC in 2007, the selling of state-owned shares of listed companies must obtain the approval of the SASAC or provincial governments.65 Given the vested interests from the control-based model, in most cases, those authorities are reluctant to hand over their identities as controlling shareholders to friendly bidders. Ultimately, such bidders at most become minority shareholders of the target state-controlled listed company. On this point, the Tsingtao Beer case has provided persuasive empirical evidence.66 Although this case occurred before the enactment of the “Provisional Administration Regulation regarding the Transferring of Stateowned Shares of Listed Companies”, governments also possessed the power to transfer state-owned shares of listed companies at that time. Therefore, time is not a factor to weaken the illustration ability of this case. Next, it will be briefly analyzed so as to support the position in this section. The Tsingtao Brewery Corporation (Tsingtao Beer) is a listed company which is controlled by Tsingtao Municipal Government. Given the popularity of Tsingtao Beer among Chinese consumers, the Anheuser-Busch Company (AB) which is the largest beer producer in the USA once negotiated with Tsingtao Municipal Government to acquire the controlling shares of Tsingtao Beer at the very beginning of the 1990s. But Tsingtao Municipal Government refused its request. In 1993, Tsingtao Beer was listed on the Hong Kong Stock Exchange. Since then, it had begun to take over small beer producers in China. Till 2001, this kind of takeover movement made Tsingtao Beer heavily burdened with debts. In order to enhance its financial liquidity, with the support and involvement of Shandong Provincial

65

Article 7 of “Provisional administration regulation regarding the transferring of state-owned shares of listed companies”. 66 China Business Newspaper (2010) The takeover defense of the Tsingtao beer in the past sixteen years. http://finance.aweb.com.cn/2009/5/19/22520090519082155840.html. Accessed 21 Jan 2010.

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Government and Tsingtao Municipal Government, Tsingtao Beer approached AB with regard to equity investment. After almost 1 year of negotiations regarding the controlling power, Tsingtao Beer and AB eventually reached an agreement in 2002. According to the agreement, Tsingtao Beer issued 1.4 billion HK dollars worth of convertible bonds to AB, which meant that AB would hold 27% of the shares of Tsingtao Beer after the complete conversion of those bonds and the percentage owned by Tsingtao Municipal Government would be diluted from around 40 to 31 by then. In order to stabilize the status of Tsingtao Municipal Government as the controlling shareholder, the agreement also stipulated that AB only held the voting rights of 20% of the shares of Tsingtao Beer even though it actually owned 27%. The voting rights of the extra 7% shares had to be transferred to Tsingtao Municipal Government. With the Tsingtao Beer case, the assumption that governments are reluctant to hand over their controlling power of state-controlled listed companies to outside bidders in friendly takeovers has been empirically proved. In turn, it indirectly supports the fact that with the protection of governments through ownership concentration, hostile takeovers are more impossible to cause risks to state-controlled listed companies. Again, the root of the protection can be found in the control-based model as explicated above.

6.3.1.3

Bankruptcy

For a listed company, bankruptcy represents its demise as a legal person. With the completion of the bankruptcy procedures, the company does not legally and physically exist any longer. Therefore, in comparison with fraudulent information disclosure and hostile takeovers, the risks from bankruptcy look more severe. Specifically referring to state-controlled listed companies, as repeatedly mentioned above, they are the tools for governments to implement their policies. Thus, if they are announced to be bankrupt by courts, the vested interests of governments must be jeopardized. Consequently, this interest chain built by the control-based model determines that governments have the incentive to bail out state-controlled listed companies which face the risk of bankruptcy. In reality, the frequently used bail-out method by governments is to provide extra financial subsidies for those state-controlled listed companies which are in trouble. This method is commonly called “soft budget constraints” as quoted in Chapter 4.67 Even though there are no statistics regarding the magnitude of “soft budget constraints” in state-controlled listed companies, it is still easy to find many cases involving this sort of practice from the mainstream media.68 To some extent, it is fair to say that we can always find the figures of governments when state-controlled

67 68

See footnote 64, Chapter 4. Such as the “Houwang” case, http://web.cenet.org.cn/upfile/4992.doc. Accessed 20 Jan 2010.

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listed companies are on the brink of bankruptcy. Next, the Zheng Baiwen case will be used to further justify this point.69 Zhengzhou Baiwen Corporation (Zheng Baiwen) was listed on the Shanghai Stock Exchange in 1996. At that time, the biggest shareholder was Zhengzhou Baiwen Group Corporation which was wholly held by Zhengzhou Municipal Government. Therefore, Zhengzhou Municipal Government was the actual biggest shareholder of Zheng Baiwen. Because of bad operations, in 2000, Zheng Baiwen owed China Cinda Asset Management Corporation (Cinda) RMB2.1 billion yuan. Given Zheng Baiwen’s inability to repay the debt, in the same year, Cinda filed a bankruptcy lawsuit against it. However, under the pressure of Zhengzhou Municipal Government and Henan Provincial Government, Zhengzhou Intermediate People’s Court dismissed the application by Cinda. After that, in order to salvage Zheng Baiwen, Zhengzhou Municipal Government and Henan Provincial Government persuaded Shandong Sanlian Corporation which is a large SOE in Shandong province to restructure this moribund listed company with equity investment. In addition, with their efforts, Cinda which was wholly owned by the MOF also agreed to cancel Zheng Baiwen’s debt worth 1.2 billion yuan out of the total 2.1 billion yuan payable to it. For the remaining 0.8 billion yuan debt, 0.3 billion was repaid by Shandong Sanlian Corporation and 0.5 billion was repaid by Zheng Baiwen Group Corporation with a guarantee from Zhengzhou Municipal Government. Finally, with the series of arrangements above, Zheng Baiwen successfully escaped the consequence of bankruptcy. Through this brief introduction to the Zheng Baiwen case, the efforts made by governments to save the state-controlled listed companies on the brink of bankruptcy are clear. Thus, it empirically proves the existence of the soft budget constraints in reality. The proposition that the risk absorption of governments really exists in statecontrolled listed companies due to the control-based model has been proved. In turn, the effect of risk absorption resulting from the control-based model inevitably leads to incentive inadequacy. As it is known, incentive mechanisms are generally associated with discretion and risks.70 Hence, it is not difficult to understand that incentive is not paid much attention to in an environment featuring control and protection. The long-term lack of a well-devised and regular system of stock options in both state-controlled listed companies and GVCs is just a persuasive piece of evidence.71 To sum up, this section has demonstrated that the risk absorption and incentive inadequacy faced by GVCs are the outcomes of the parentalism of governments. The culture of parentalism is in turn largely cultivated and maintained by the

69

Chen Y (2001) Innovation or illegality? Modern Econ Sci 23:57–58. For example, stock options as an incentive mechanism connect the income of managers to their independent management performance. It is typically the combination of autonomy and risks. 71 In Chapter 4, it is illustrated that stock options are not prevalent in state-controlled listed companies and Chinese domestic VCs. 70

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control-based model. Finally, on the basis of this correlation, the linkage between the lower risk tolerance of venture capitalists working for GVCs and the controlbased model has been verified.

6.3.2

Severe Funding Shortage: An Old Problem

Chapter 3 illustrated that GVCs and private domestic VCs are commonly confronted with the problem of funding shortage because the control-based model hinders the huge amount of money held by various institutional investors flooding into the VC sector. However, in terms of the empirical evidence in this chapter, it is clear that the shortage suffered by private domestic VCs is much more pressing than that of GVCs in that it has become the main factor affecting the risk tolerance of venture capitalists in private domestic VCs. Therefore, more accurately speaking, the more severe funding shortage determines the lower risk tolerance of venture capitalists working for private domestic VCs. The reason for the badly funding insufficiency plaguing private domestic VCs is principally that privately held enterprises as their main VC investors lack financing channels in China. The fundraising difficulties of privately held enterprises are not a new problem. As explicated in Chapter 3, it is largely ascribed to the interestaligned effect of originating from the control-based model. Consequently, the cash flows of privately held enterprises are very easy to dry up. Therefore, when they participate in the VC industry, they just put up a small amount of retained profits in order not to endanger the financial liquidity of their main business. For example, the biggest VC investor of Shunli VC which is a private domestic one in Foshan City only contributed RMB3.6 million yuan.72 According to Zhiqiang Ouyang who is the CEO of Shunli VC, their VC investors were all privately held enterprises with limited fundraising sources.73 Thus, for them, investing with small amounts of money would not risk their operations.74 Next, in order to further illustrate the severe financing difficulties of privately held enterprises, the Sun Dawu case will be analyzed.75 Hebei Dawu Farming and Husbandry Group (Dawu Group) was established by Sun Dawu in 1985. Under the excellent management of Sun Dawu, Dawu Group developed very fast during its first 10 years. By 1995, Dawu group was among the 500 biggest privately held enterprises in China. However, the expansion of enterprises is usually associated with the larger demand for cash. In order to enhance its cash flow, Dawu Group made loan applications with banks many times before 1996.

72

Guangzhou Newspaper (2010) VCs in Foshan have appeared. http://www.ezcap.cn/News/ 200815330.html. Accessed 22 Jan 2010. 73 Ibid. 74 Ibid. 75 Faren Magazine (2010) Sun Dawu fell before the regulation of Chinese financial market. http:// finance.sina.com.cn/leadership/crz/20080305/14364583433.shtml. Accessed 23 Jan 2010.

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6 The Lower Level of Risk Tolerance of Chinese Domestic Venture Capitalists

But the banks almost refused all of those attempts because only SOEs were their traditional clients in this aspect. Under such circumstances, Sun Dawu decided to let Dawu Group take deposits from its employees and the residents living nearby. From 1996 to 2003, this kind of fundraising which is deemed a crime by the Criminal Law of the PRC significantly improved the financial liquidity of Dawu Group.76 In addition, during the period, Dawu Group did not default on any borrowings. In 2003, Sun Dawu was arrested by the police with the charge of illegally taking deposits and then was sentenced to 3 years in prison by judges. With reference to the Sun Dawu case, it does not mean to discuss whether or not the action of Sun Dawu is lawful per se but to reflect the tough financing ecology of Chinese privately held enterprises under the gloom of the control-based model. In turn, this kind of negative effect of the control-based model has given rise to the lower risk tolerance of venture capitalists in private domestic VCs as the empirical evidence has shown above.

6.4

Conclusion

The risk tolerance of venture capitalists directly influences the returns of VC investment.77 With the existing empirical evidence, it has been discovered that the risk tolerance of Chinese domestic venture capitalists is lower than that of their American counterparts. For GVCs, the reason for this disadvantage is because of risk absorption and incentive inadequacy; for private domestic VCs, the reason is because of severe funding shortage. Further, on the basis of the empirical findings, it has been proved that those reasons are all linked to the negative effects of the control-based model.

76 77

Article 176 of the Criminal Law of the PRC. See footnote 33, p 894, Chapter 1.

Chapter 7

Conclusion

With the mirror of the practice of American VCs, this book has demonstrated that the corporate governance of Chinese state-controlled listed companies has badly hampered the healthy development of Chinese domestic VCs. Overall speaking, under the negative effects of the control-based model, the majority of Chinese domestic VCs are GVCs and private domestic VCs only represent the minority. As for GVCs, because of the lack of the involvement of institutional investors, the amounts of their funds are much smaller than those of their American competitors. Meanwhile, confronted with the intervention of governments, venture capitalists in GVCs feature a lower risk tolerance level and the deprivation of independence. In addition, various incentive mechanisms are also not able to function well in the investment of GVCs. Finally, even if their invested projects are successful, GVCs cannot smoothly and efficiently achieve exits through IPOs. As a result, the array of defects of GVCs which is largely linked to the control-based model determines that their investment is generally associated with small scales and low success and return rates. With regard to private domestic VCs, the shortage of their fund sources is more severe than GVCs, which has substantially weakened the risk tolerance level of venture capitalists working for them. Moreover, VC investors of private domestic VCs are usually not able to remain passive. Consequently, the intervention of VC investors has replaced the autonomy of private domestic VCs in the process of selecting projects. In the aspect of exits, similar to GVCs, the IPO road of private domestic VCs is still uneven. Therefore, the combination of the above disadvantages of private domestic VCs which are closely ascribed to the control-based model has led to the fact that their investment scale is small and their return rate is low. Even though empirical evidence to analyze the influence of the control-based model on the application of incentive mechanisms in the investment of private domestic VCs could not be collected, this limitation just reflects the basic fact of academic research but does not substantively affect the verification of the hypothesis of this book because private domestic VCs only belong to the minority of the aggregation of Chinese domestic VCs. Through demonstrating the impediment of the control-based model to the soundness and development of Chinese domestic VCs, this book aims to reveal that the L. Zhang, Venture Capital and the Corporate Governance of Chinese Listed Companies, DOI 10.1007/978-1-4614-1281-6_7, © Springer Science+Business Media, LLC 2012

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7 Conclusion

corporate governance of Chinese state-controlled listed companies has refrained and decreased the adaptive efficiency of Chinese society.1 In turn, this finding provides a benchmark for us to revisit the current proposals for reforming the corporate governance of Chinese state-controlled listed companies. In the light of this standard which is termed the harmonization principle, the efficient reform proposal ought to accommodate both agency costs and adaptive efficiency. Here, it never means to extend the purpose of corporate governance by adding in facilitating adaptive efficiency. According to the academic consensus, the purpose of corporate governance is to minimize agency costs. However, the problem is that when it fulfils its purpose, corporate governance cannot hamper the enhancement of adaptive efficiency of society. In other words, we need to make sure that our corporate governance system must at least be neutral to adaptive efficiency. This is its institutional efficacy or manner but not its purpose. The significance of this research for the improvement of the corporate governance of Chinese state-controlled listed companies has been explicated. The remaining part plans to briefly analyze the latest reform steps in this area with the harmonization principle. According to the political theory which was put forth by Professor Mark Roe, the ultimate determinant of corporate governance is politics.2 On this point, the formation and maintenance of the control-based model has provided persuasive proof. Therefore, when observing the reform measures for the corporate governance of Chinese state-controlled listed companies, this kind of observation naturally includes two aspects: political reform and corporate governance reform. The remaining part will firstly introduce the latest movements related to the two aspects and then explore whether or not those movements are consistent with the harmonization principle.

7.1

Chinese Political Reform: The Establishment of a Public Servant Government

Along with China’s economic reform at the end of the 1970s, the senior leaders of the CPC, like Mr. Xiaoping Deng, also started political reform in China.3 But before the 1990s, China’s political reform mainly focused on eliminating the influ-

1

From the viewpoint of transaction cost economics, the success of the American VC template lies in the fact that it significantly reduces the transaction costs among the related parties in the whole cycle of VC so as to reinforce innovation and the adaptive efficiency of America. In contrast, due to the barriers imposed by the control-based model, Chinese domestic VCs feature high transaction costs in each section of its cycle, which ultimately undermines the cultivation of innovation and the increase of adaptive efficiency of Chinese society. 2 Roe MJ (2003) Political determinants of corporate governance: political context, corporate impact. Oxford University Press, Oxford. 3 Bao X (2009) China’s political reform: historical experiences and current choices. Shandong Soc Sci 161:19–20.

7.1 Chinese Political Reform: The Establishment of a Public Servant Government

107

ences of Maoism and decentralizing power down to local governments.4 During that period, the transformation of the role of governments in the economic area was only slightly carried out by adopting the contracting model in some SOEs.5 In 1992, the CPC firstly proposed the mission of establishing the market economy within the socialist regime in its 14th National Delegate Conference.6 Soon thereafter, a corporatization movement was conducted among traditional SOEs.7 Through this movement, almost all SOEs have been corporatized and equipped with modern corporate governance institutions. However, it did not substantively change the role of governments as participants in microeconomic activities. The underlying orientation of governments was still “economic involvement” but not “public servant”.8 In 2007, President Jintao Hu pointed out that the establishment of a public servant government ought to be the latest goal of China’s political reform.9 According to the official explanation, this kind of government is responsible for creating a fair and competitive environment for economic participants by offering premium public goods, such as laws and regulations.10 In addition, the public servant government is also committed to providing a well-devised system to safeguard the lives of ordinary persons.11 Specifically speaking, four tasks should be fulfilled in this aspect. First, government should build a widely covered social security system and a market-oriented employment system.12 Second, government should improve the qualities and lower the prices of education, medical care and cultural activities.13 Third, governments should protect the environment and develop infrastructure.14 Fourth, government should keep the safety and order of the whole of society.15 Since then, this goal of building a public servant government has provided the direction for the transformation of Chinese governments. After briefly introducing the most recent steps of China’s political reform above, it will next turn to the latest progress related to the corporate governance of Chinese state-controlled listed companies – the divestiture of state-owned shares.

4

Ibid. See Sect. 2.2.2. 6 See footnote 46, Chapter 2. 7 See footnote 47, Chapter 2. 8 Chang X (2010) How do we establish a public servant government. http://theory.people.com.cn/ GB/49150/49152/9369415.html. Accessed 2 Feb 2010. 9 Hu J (2010) Report to the seventeenth CPC national delegates’ conference. http://news.xinhuanet. com/newscenter/2007-10/24/content_6938568_5.htm. Accessed 2 Feb 2010. 10 See footnote 8 above. 11 Ibid. 12 Ibid. 13 Ibid. 14 Ibid. 15 Ibid. 5

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7.2

7 Conclusion

The Reform of Corporate Governance: Divesting State-Owned Shares

As the result of corporatization, Chinese state-controlled listed companies have been furnished with modern corporate governance institutions from the beginning. However, due to the concentrated ownership of the state in those companies, both internal and external governance mechanisms have malfunctioned.16 Therefore, the fundamental approach to improve the corporate governance of Chinese statecontrolled listed companies is to substantially divest their state-owned blocks. In 2001, the State Council issued an official document entitled “Provisional Administration Methods regarding Enlarging Social Security Funds by Decreasing State-owned Shares”, which represented the first attempt of Chinese governments to divest state-owned shares.17 According to the document, when state-controlled listed companies issued new shares, at the same time, they must sell the state-owned shares worth 10% of financing amounts of the new issues.18 This method meant that the divestiture prices of state-owned shares were the same as those of newly issued shares.19 However, before this kind of divesture, those state-owned shares were not allowed to trade on the secondary market, which determined that their prices should be lower than tradable shares.20 Therefore, the pricing mechanism of divesting stateowned shares was unfair to public investors.21 Naturally, it failed because of the rebuffing of other participants in Chinese stock markets.22 Apart from the unreasonable pricing, the deeper root of this failure was the ingrained notion of “economic involvement” governments at that time. It was the reflection of China’s political reform at that time. In 2005, the CSRC launched the equity-division reform. With the completion of this reform in 2006, state-owned shares have become tradable on the secondary market. On this basis, the CSRC, the SASAC, the MOF and the SSF jointly issued an official document entitled “Implementation Methods Regarding Transferring Some State-owned Shares to the SSF” in 2009.23 In terms of this document, when companies with state-owned shares are approved to conduct IPOs, they must transfer the state-owned shares worth 10% of the financing amounts of IPOs to the SSF.24

16

See Chapters 2 and 6. Available at http://www.ssf.gov.cn/xxgk/flfg/200904/t20090427_910.html. Accessed 2 Feb 2010. 18 Ibid. 19 See footnote 20, p 88, Chapter 1. 20 Ibid. 21 Ibid. 22 Ibid. 23 Available at http://www.ssf.gov.cn/zjcj/gzdt/200906/t20090625_2277.html. Accessed 2 Feb 2010. 24 Ibid. 17

7.3

The Harmonization Principle: Agency Costs and Adaptive Efficiency

109

This time, because state-owned shares have been tradable on the secondary market, it is fair that their selling prices are the same as those of IPOs. The initiative symbolizes a new round of divesting of state-owned shares. On a deeper level, it reflects the progress of China’s political reform. The substantive change of the divestiture of state-owned shares described above implicates the policy signal that it is the direction for improving the corporate governance of state-controlled listed companies. Thus, it is the latest step in this area.

7.3

The Harmonization Principle: Agency Costs and Adaptive Efficiency

The establishment of the public servant government and the divestiture of stateowned shares are symbiotic. The authentic decrease of state-owned shares requires the transformation of governments from “economic involvement” to “public servant”. In turn, a real public servant government also means its withdrawal from participating in microeconomic activities. The two aspects interact in this process. The ultimate result is the substantial divestiture of state-owned shares in current state-controlled listed companies, which significantly facilitates the minimization of agency costs.25 In addition, this reform will eliminate the control-based model which is an institutional barrier to adaptive efficiency. Moreover, governments as public servants are committed to achieve the efficient allocation of resources among market participants and to build a fair and competitive market environment. It can definitely accelerate the healthy development of Chinese domestic VCs and then increase the adaptive efficiency of Chinese society. Therefore, it is concluded that the direction represented by the latest reform measures for the corporate governance of Chinese state-controlled listed companies is consistent with the harmonization principle. It is believed that some may hold a pessimistic attitude toward the possibility of accomplishing the above two reform missions within the socialist regime of China. They may argue that the two missions are unrealistic unless China abandons socialism. In this aspect, this book holds an opposite opinion that the two reform goals can be fulfilled without shaking China’s socialist polity. Overall speaking, the optimism is on the basis of the radical changes of Chinese society under the framework of socialism in the past 30 years, for example, the substantive shrinking of the stateowned economy. But in the meantime, it is also admitted that the accomplishment

25

As analyzed in Chapter 2, the corporate governance framework of Chinese state-controlled listed companies is called the control-based model, which means the state commonly holds the controlling blocks of those giant enterprises. The concentrated ownership of the state has led to severe agency problems in Chinese state-controlled listed companies. Thus, the divestiture of state-owned shares is the fundamental approach to substantially reduce their high agency costs.

110

7 Conclusion

of the two reform missions cannot occur overnight due to the effect of path dependence. It needs time and patience. The next section briefly proves this prediction that the two reform missions mentioned above can be gradually achieved within the socialist polity of China.

7.4

The Prospect of the Two Reform Missions: Political Entrepreneurs Versus Path Dependence

Since the late 1970s, China has started its transformation from a centrally planned economy to the market economy. After Xiaoping Deng’s inspection trip to the south of China in 1992, the goal of the establishment of a socialist market economy has been officially recognized and stipulated by the Constitution of the PRC and the Charter of the CPC.26 This goal has twofold meanings. First, the building of the market economy in China must be within the framework of socialism which features the sole leadership of the CPC. Second, the establishment of the market economy is the primary concern of Chinese supreme leaders. They have been and will be striving to accomplish this goal by carrying out economic, political and legal reforms. China’s successful practice to develop its market economy in the past 30 years has empirically demonstrated the feasibility of the goal to establish the socialist market economy. On the one hand, it confirms that socialism is basically compatible with the market economy. On the other hand, it also shows Chinese supreme leaders’ continuous determination to reform inefficient institutions so as to promote the building of the market economy. Therefore, on the side of current Chinese supreme leaders and their successors who act as political entrepreneurs, it is believed that they will continue to push the goal of the construction of the market economy further through institutional improvements within the socialist regime, among which is the establishment of a public servant government mentioned above. However, the establishment of a public servant government must endanger the vested interests of local governments and the agencies affiliated to the Chinese central government because it will definitely narrow the range of their powers. Consequently, this reform mission is destined to suffer from the thwarting of those affected parties, which determines the effect of path dependence to a large degree. Up to now, it is believed that some may ask which one of the determinations of the political entrepreneurs and the effect of path dependence will win in the context of China when they clash with each other. The answer of this book is that the former will triumph even though the process is on a marginal basis. A persuasive piece of empirical evidence in favour of this prediction is China’s reform itself. If Chinese supreme leaders who act as political entrepreneurs had not had an upper hand

26

See Article 15 of the Constitution of the PRC and the General Provisions of the Charter of CPC.

7.4 The Prospect of the Two Reform Missions…

111

against the obstruction from path dependence, China would have still been struggling in the mire of poverty and inefficiency. Since the establishment of a public servant government will incrementally develop in China, the divestiture of state-owned shares in Chinese state-controlled listed companies will accompany it accordingly because it is the inevitable result, given their causation. The fact that the two reform missions mentioned above will be achieved incrementally in China means that the presence of the appropriate institutional environment for the development of Chinese domestic VC and the increase of adaptive efficiency of Chinese society is also on a marginal basis. There does not exist a quick solution. If the findings of this book are able to help speed up this process, the ultimate significance of academic research is achieved well.

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Index

A Acquisition, 75 Adaptive efficiency, 1–15, 106, 109–111 Agency costs, 3, 6, 9, 14, 36, 57, 58, 106, 109–110 Anti-dilution protection, 59

E Economies of scope, 73 Effect of attention diversion, 63 Enterprise bonds, 41 Exit mechanism, 60 External innovation, 6–9

B Bank deposits, 41 Bankruptcy, 75, 96, 97, 101–103 Board representation, 13, 56, 58, 59, 64, 65 Buyback, 75

F Financial bonds, 41, 46 Financing stages, 90, 97 Fraudulent information disclosure, 3, 5, 97–99, 101

C Chaebol, 1 Control-based model, 21, 28, 32, 33, 35, 36, 40–42, 45, 47–53, 56, 60–71, 73, 76, 80–83, 86–89, 96–106, 109 Control-reversion, 75 Convertible preferred stocks, 13, 56, 58, 59, 65–68 Corporate governance, 1–15, 17–33, 35, 40, 55, 57, 58, 66, 99, 105–109 Corporatization, 20–22, 26, 29, 32, 65, 96, 107, 108

G General partners, 57, 61–64 Governmental bonds, 46

D Dual-control policy, 81, 82 Dual-recommendation policy, 82 Dual taxation, 57, 62 Due diligence, 67

H Harmonization principle, 106, 109–110 Homogeneity, 43 Hostile takeovers, 97, 99–101

I Incentive inadequacy, 95–104 Incentive mechanism, 12, 13, 35, 55, 56, 60–71, 73, 74, 102, 105 Industry guidance funds (IGF), 47, 52–53 Information asymmetry, 9, 55 In-house innovation, 6–8 Initial public offerings, 84

121

122

Index

Institutional investors, 1, 36, 40, 45, 51, 103, 105 Insurance companies, 38, 46 Interested-aligned effect, 33, 41, 42, 45, 46, 51, 53, 86, 103 Investment portfolio, 41, 43–44 Investment strength, 47, 48

R Rational persons, 55 Real estate, 44, 46, 51, 85 Redemption rights, 59 Risk absorption, 95–104 Risk tolerance, 10, 12, 14, 35, 40, 89–105

L Limited partners, 13, 39, 57, 58, 60–64, 76 Liquidation preference, 59

S Social security funds (SSF), 41–46, 108 Soft budget constraints, 13, 67, 68, 101, 102 Staged financing, 13, 56, 58–60, 64, 65 Start-ups, 6, 9, 36, 45, 51, 55, 56, 58, 62, 73, 74, 89–93, 95 State-controlled listed companies, 12–14, 17–21, 26–32, 35, 40, 42–46, 49, 51, 53, 55, 56, 62, 63, 66–69, 73, 81, 83, 86, 89, 96–102, 105–109, 111 State-entrepreneurism, 33, 49, 52, 53, 63, 65 State-owned commercial banks, 42, 43, 46 State-owned economy, 18, 26, 28, 40, 43, 49, 51, 109 State-owned enterprises (SOE), 1, 2, 17, 18, 20–32, 42, 43, 46–49, 63, 65–68, 81–84, 86, 96, 99, 102, 104, 107 Stock options, 13, 56, 58–60, 68–71, 97, 102 Supervisory committee, 21, 28, 31–32

M Main boards, 13, 76, 80–84, 86, 87 Maternity insurance, 41, 42 Medical insurance, 41, 42 Modern corporate model, 25–32 Mutual funds, 41, 46

N National debts, 25, 41, 43 Non-GEM listed companies, 46 Normative significance, 14

O Opportunism, 9, 39, 52, 74, 80–84, 88

P Parentalism, 51, 96–103 Path dependence, 13, 28, 67, 110–111 Pension funds, 13, 37–48, 51, 53 Planned economies, 13, 22, 23, 25, 33, 110 Political entrepreneurs, 110–111 Positive significance, 14 Private equity, 39, 43, 45, 53, 59, 62 Profitability, 74, 75, 87 Profit-maximization, 25, 37, 50 Prudent man rule, 37 Public servant, 106–107, 109–111

T Technological intensity, 90, 94 Track record, 74, 76 Traditional model, 22–24, 78 Transitional model, 23–25

U Uncertainty, 9, 39, 55, 58, 91, 94 Unemployment insurance, 41, 42

W Wuhan model, 68, 69