“China’s Presence in the Global Capital Markets”
April 16, 2004
My name is Jeffrey Fiedler and I am President of the Food and Allied Service Trades Department, AFL-CIO (“FAST”). Allow me to thank the Commission for the opportunity to present our view of PRC participation in the capital markets.
I will focus my remarks on PRC participation in the U.S. capital markets, mainly the equity markets, and raise some issues that I believe merit the further attention of the Commission and its staff.
The AFL-CIO has two primary interests in this issue. One, we are firmly committed to protecting the retirement security of the millions of people our affiliates represent; and two, we are firmly committed to the establishment of freedom of association in China as a necessary predicate to the development of a real form of democracy in that country.
Therefore, at the onset, let me make clear that we are opposed to institutional investors handling the pension monies of our members investing in either the PRC stock market, or in purchasing American Depository Receipts (ADRs) of those PRC companies listed on the stock exchanges in the United States. You may recall that we made a determined effort (with considerable success) to discourage institutional investors in this country from investing in the PetroChina IPO.
The operation of the capital markets is understandably complex. Regulatory mechanisms differ greatly from country to country. But, despite these differences the need for investor protection is universal. Rather than get into the vagaries and nuances, allow me to focus on some key elements critical to the continued success of the US equity market and whether PRC companies measure up.
Disclosure of company information, in all its many htmects, is central to the success of the equity market in the United States. There are many laws, rules and regulations governing disclosure and the Securities and Exchange Commission oversees most, but not all, htmects of the process in the United States.
The key concept underlying disclosure is “materiality.” Simply put this is information about which “an average prudent investor ought reasonably of informed.” It is impossible to legislate with specificity exactly what information is “material” for every company or every industry. Therefore, in the United States this is handled in some respects by the staff of the SEC and in others by shareholder litigation. With regard to the latter it is important to point out that in the United States investors have a private right of action. They may sue a company, for among other things, failing to disclose “material” information.
Another hallmark of the US system, which was recently buttressed by the passage of Sarbanes-Oxley, is the role of independent directors. The new legislation, stock exchange rules, and public pressure from investors as a result of a string of scandals, has placed renewed emphasis on the importance of independent directors.
Another critical part of the system is the role of independent auditors in making certain that company financial information is properly maintained and disclosed to shareholders.
The last htmect of the system I will address is the legal responsibility that investment banks have when they underwrite initial public offerings or new stock issuances. To some extent these responsibilities are shared by law firms involved in the offering process. Investors rely upon the lawyers and investment bankers performing adequate “due diligence” before a stock is offered for sale.
Before examining China and PRC companies against these elements, it should be said that despite the fact that the United States is probably the most transparent country in the world with the most vigorous securities regulation system investing in the equity market carries considerable risk and, as our recent scandals demonstrate, scofflaws abound and constant vigilance is more than justified.
While I am most concerned about the ADRs of PRC companies, one cannot think about them without understanding the environment within China.
China remains a non-market economy. The government remains controlled by the Chinese Communist Party, despite its ongoing identity crisis. While the Party may lack a truly communist ideology, it clearly still believes completely in maintaining its own power. In the interest of full disclosure, permit me to state at this point that we believe that giving PRC companies access to the US capital markets strengthens the continued existence of the current government and the Chinese Communist Party and their repressive rule. We would deny them this access.
That being said, the reality is PRC companies can raise capital in the US market.
Some 50 PRC companies are listed on various US stock exchanges; the vast majority owned substantially by the government.
It is my understanding that Chinese companies must first receive approval from the State Council before beginning the process of registering their IPO in the US. This means that the Chinese government as a matter of policy decides which companies can raise capital. The political considerations within the policy decision itself are unknown.
Similarly, most analysts concede that the Chinese government has a role in the selection of management as well as members of the Board of Directors, including the so-called independent directors.
The role of Chinese government decision-making in business raises a number of issues. One must question whether or not decisions are being made for business or political reasons or some varying combination. Quite clearly, the role state enterprises play within China’s political economy remains important. It would be too much, though, to believe that management makes its own decisions without worrying about what government officials think.
This decision making dynamic, which is no doubt different from company to company, is never, in my opinion, fully illuminated in the filings required by the Securities and Exchange Commission. Rather, we are presented with boilerplate disclosure such as appears in the recent China Life Insurance Company Limited registration statement:
“CLIC (China Life Insurance (Group)
Company, the controlling shareholder) is a state-owned enterprise. Accordingly,
the PRC government has the power, through CLIC, so long as CLIC holds the
majority of our shares, subject to our articles of association and applicable
laws, to control the composition of our board of directors and, through the
board, to exercise significant influence over the our management and policies.”
The filings also states:
“As our controlling shareholder,
CLIC will be able to exert influence on our
affairs and could cause us to make decisions or enter into transactions that
may not be in your best interests.”
Investors are not afforded any meaningful recent examples of the government’s role in China Life’s decisions. This is a serious omission for as Chen Qintai, Deputy of the Development Research Center of the State Council wrote in a paper presented in February at an OECD sponsored corporate governance conference in Shanghai:
“Government investment is not entirely for the purpose of capital growth; more importantly, it is a supplementary means of maintaining state control and exercising the functions of government.”
Furthermore, there is no information about the role individuals in management or on the Board currently have in the Chinese Communist Party. There are a mere three (3) mentions of the word “communist” in the entire China Life registration statement. All concern the previous positions of one of the non-executive directors of the company. The current Party status of all key people is omitted, as if this is irrelevant in a country where Party status is clearly material to the personal advancement of executives and directors of state enterprises. There is also no mention made of the existence of a Communist Party Committee at China Life and who heads it. Some of the smaller issue ADRs have more extensive mentions of directors current Party positions in the 20F’s filed with the SEC (see attached sample of director bios), but none have any mention of the role of the Party in corporate decision-making. I do not believe that this omission leads to the conclusion the Party has no role in company operations.
China has been characterized in a classic understatement as “opaque”. It is never been deemed “transparent”, although many would have us believe that it is becoming “more transparent”. The issue is whether China is transparent enough for prudent investors.
Transparency goes to the heart of “due diligence”. It is not naïve to ask how US investment banks and lawyers involved in the underwriting of initial public offerings actually conduct their due diligence, particularly on state enterprises. What company documents do they examine? Are they given access to government documents? If not, why not? If so, are these only public documents? Do they have access to “neibu” documents? Are they allowed to examine portions of the minutes of State Council meetings during which matters concerning China Life, for instance, were discussed? Since personal and familial relationships are so important in China, how is it the investment bankers and lawyers determine if company executives are related to regulators, or high Party officials? How do they determine if corruption is a problem in the company? How is it that those conducting due diligence determine if company executives are engaging in related party transaction with themselves or relatives? How open are Chinese banks to revealing a company’s repayment history? And, there are many more such questions of fundamental interest.
In a country in which “state secrets” include all manner of what most people would deem simply embarrassing information, due diligence as we know it, is difficult, if not impossible. My suspicion is that our investment banks have simply lowered their standards to deal with the inherent obstacles created by a lack of transparency.
Independent auditors are critical to investors having confidence in the financial information PRC companies disclose. The accounting industry in China remains in its infancy.
Chris-Devonshire Elllis, a Senior Partner at Dezan Shira & Associates in Beijing, writes this month it “China Briefing”:
“A number of times recently, Chinese firms preparing for IPOs, and some even after IPOs, were found to have engaged in illegal window dressing and misrepresentation or were exposed for having fraud problems. Consequently, some had to delay their flotations. Big accounting firms and banks should be alert to the risk that their own staff may accept bribes or other advantages from Chinese SOEs seeking a listing.”
China Life, the most recent PRC ADR offered on the New York Stock Exchange, has been the subject of reports of major accounting fraud by its predecessor company. The ADR price, of course, dropped on the news. While the new company itself is not apparently liable for the fraud, there are many questions about what China Life knew about ongoing Chinese National Audit Office investigations. And, from our point of view, it would be interesting to know if the US investment banks and lawyers involved in the IPO knew anything about the problems.
China Life, like many other companies offering ADRs in the US, keeps at least three sets of financial figures: one to comply with PRC accounting rules, another to comply with Hong Kong standards, and a third to comply with US foreign issuer standards. All of this, in a environment rife with corruption and fraud, leads a reasonable person to question the veracity of any and all financial reporting.
As stated earlier, independent directors are a critical element in corporate governance. Many of the so-called independent directors of PRC companies are former senior officials in the Chinese government. Independent seems to mean simply not employed by the company in question. It is difficult for an investor to evaluate the real independence of these directors without more detailed and reliable related party transaction reporting, information on their compensation, and their continuing relationship with the government and the Communist Party. Therefore, one cannot consider them truly independent in the sense we know independence in the US.
Corporate governance is not simply a matter of government regulation. In the United States, we rely strongly on civil litigation to keep corporations honest. China is still a country without the rule of law. While there is a growing body of corporate law, it is still rudimentary, and its use does not appear to have any significant deterrent impact on illegal conduct. In the case of fraud involving ADRs, US investors can sue the company in the United States, but the chances of recovering damages from a company whose assets are largely, if not totally, in China are virtually non-existent. US investors suing in China would be a relatively pointless exercise.
Shareholder activism is integral to corporate governance. It is absent from China as is activism of many other kinds largely because freedom of association does not exist. It does not stretch the imagination to believe that shareholder activism as we know it would be considered subversive by the Chinese government, especially since most of the listed companies are majority state owned. Investigative news reporting concerning companies, common in the US, is rare in China and, has, in some cases resulted in the arrest of the reporter. Therefore, in China sole reliance upon the government to ensure compliance with the securities laws is the unfortunate reality, and will continue to be for the foreseeable future. This will inhibit the real development of a corporate governance system.
Investing in Chinese companies, whether in the form of ADRs or on Chinese exchanges, is in my view, one of the riskiest investment propositions available. Speculators and gamblers of other sorts are welcome to lose their money, but American mutual funds and institutional investors should not take such risks.
In conclusion, allow me to suggest the Commission look into the following issues in the future:
1. How US investment bankers and lawyers conduct due diligence in China, and what obstacles do they specifically face that are fundamentally different from obstacles in the United States?
2. What unique problems do experts at the Securities and Exchange Commission perceive concerning questions of materially and disclosure regarding PRC companies listing in the United States.
3. Examine US foreign issuer related securities laws and regulations to see if they are adequate to the task of dealing with non-market countries securities. Examine whether exemptions granted to foreign issuers as a matter of law are still justified.
Thank you.