Sep 03, 2020 07:48 PM

Opinion: As Chinese Firms Rush to List, Corporate Governance Should Come to the Fore

Joel A. Gallo is CEO of Columbia China League Business Advisory Co., a Guangzhou-based management consulting firm, and a former executive at Deloitte, E&Y, PwC, and EMC Corp.

With the reform and opening of China’s financial sector forging ahead, corporate governance is featuring prominently in company boardrooms. No longer relegated to the hinterlands of a firm’s functional purview, today, corporate governance is coming to the fore, on its way to becoming a benchmark for firm-wide excellence that ultimately enhances value of the business.

After several decades of enterprise reform, corporate governance in China has come a long way. From granting firms more autonomy and decision-making authority to establishing a legal structure for a modern enterprise, China finds itself at a new stage of corporate governance evolution. Moving forward, efforts will emphasize system-wide capacity building, incorporating additional international standards where it makes sense, yet remaining flexible to accommodate local nuances.

With a slew of company listings on the STAR Market — inducing fervor among investors — corporate governance acts as a highly effective beacon, guiding the behavior of a firm, preventing it from going astray, while protecting the interest of stakeholders. The flurry of IPOs, along with lingering repercussions from the Luckin Coffee scandal, demand that corporate governance take on all the more importance.

Corporate governance covers a wide cross-section of topics. But two of its most distinguishing features — information disclosure and the role of the board of directors — take on outsized significance for investors.

Information disclosure, a legal obligation for companies, is all about ensuring equal access to information that provides the basis from which investment decisions are made by investors. Disclosures are typically communicated through company management reports issued on a periodic basis, subject to review by an external auditor.

This is no easy task for the auditor. New companies that strive to list on a stock exchange function with a start-up mentality and operational leanness — useful for outfoxing the competition but undesirable when evaluated by auditors and regulators. This mindset inhibits investments in core internal operations. Formalized systems for accounting and financial reporting receive minimal funding.

Last year, I met with the CEOs and chief financial officers of dozens of companies all over China, many of whom expressed a yearning for taking their company public in New York or Shanghai. When I asked about their process for producing financial statements and whether reports were audited, many returned a blank stare. As I discovered, much of the accounting was based on “fapiao” recordkeeping, paper-based, error-prone and few had engaged an auditor.

“Accounts are prepared on a ‘fapiao’ basis and few firms are capable of setting up a streamlined process to capture accurate and complete accounting source data and prepare accounts on an accrual basis. Therefore, the books are neither accurate nor really helpful for strategic decision-making,” according to Melissa Yang, managing director at Axel Standard, an accounting consultancy based in Shanghai.

Disclosure goes beyond discussing obvious financial results, to include related party transactions, foreseeable risk factors, renumeration policy for top management including directors and far more. Without a unifying framework to synchronize company-wide reporting, getting a true pulse on the financial and operational health of the organization, makes its obligation for accurate and timely disclosure an operational nightmare.

As young firms come of age and their business models mature, running vital corporate functions on a shoestring budget will not cut it. Investors expect firms to adopt an institutional set of behaviors, including providing adequate funding to mission critical functions within the organization. Long-term success mandates that companies establish effective corporate governance habits early on.

What practical steps for establishing a corporate governance model can developing firms — who lack deep pockets — put into action? Plenty as it turns out. “Start with developing the company’s code of conduct and code of ethics for all employees to have a foundation and basis of compliance expectations. Then, advance by developing guiding ethical principles and standards for everyone to adhere, and finally implement these principles by linking them to the Key Performance Indicators of each employee annual performance reviews,” according to Dr. Tim Klatte – partner and head of Shanghai Forensic Advisory Services at Grant Thornton China.

Perhaps no group is in a better position to set the proper tone at the top and raise awareness for effective corporate governance than a firm’s senior leadership. The board of directors, in particular — who are entrusted to act in good faith, protecting shareholder rights and the interests of the company — can be a persuasive advocate. Many companies view corporate governance as an expensive compliance exercise. Battling institutional inertia to convince managers to view governance frameworks as a way to increase the profitability of the enterprise is taxing but necessary.

Director independence is a critical facet of the board’s composition and essential for providing an unvarnished assessment on corporate matters. Though Chinese firms possess independent directors on their boards, they are in the minority.

The Luckin Coffee case provides a vivid illustration of the importance for directorial independence. After the coffee-maker was accused of roasting its books, the board moved to oust Charles Lu, the co-founder and chairman. In the ensuing power struggle, Lu was able to retain his seat and later wrestled for control by attempting to shove out independent directors and other board members who were hostile to his takeover. A second showdown with the board resulted in his ultimate departure.

The Form F-1 Registration Statement Luckin filed with the Securities and Exchange Commission in January reveals 10 directors and executive officers that comprised “management.” Seven of the 10 are deemed directors, only two of whom are denoted as “independent director.” The Luckin case is instructive in that it highlights the struggles that independent directors encounter in adverse circumstances, when loyalty to individuals is valued over objectivity and independence from undue influence. The significance for investors is that the board of directors acts as a top of the house, last line of defense against reprehensible actions by company insiders.

Effective corporate governance is more than just meeting the minimum statutory requirements. It is a mindset that engenders good company behavior that can act as a compass — keeping firms out of trouble.

Moreover, it is playing a more visible role given the spate of companies rushing to list on China’s exchanges. Add Luckin Coffee’s downfall to the brew and corporate governance becomes an indispensable framework for protecting investor funds, upholding investor confidence and safeguarding China Inc.’s reputation in the global marketplace.

The views and opinions expressed in this opinion section are those of the authors and do not necessarily reflect the editorial positions of Caixin Media.

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