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China Cascades Corporate Governance Reform Fusing Party Leadership to Steer Modern Risk Controls

Posted by on September 7, 2020

Chinese banking and insurance regulator released its action plan on August 17 to initiate corporate governance reform in the financial sector, with enforcement actions in parallel. This briefing highlights the policy direction and major regulatory focuses and likely enforcement scenarios.

  1. Executive Summary

The action plan’s key idiosyncrasy is fusing the Chinese Communist Party Leadership with the modern risk control rules (e.g., effective shareholder/board oversight and effective compliance with robust risk control). It applies to all financial institutions in China, including foreign-invested ones. The grander policy direction is to build up “replicable” precedents first in financial sector, which stresses fusing CCP organisation with modern corporate governance (党建嵌入公司治理). The “best practices” will gradually cascade further to business undertakings in critical sectors (关键领域), as part of the broader SOE reform.

2. Analysis

Below please find our preliminary analysis from corporate counsel and regulatory compliance perspectives.

Context: SOE Reform & Corporate Governance Modernization

The financial-sector corporate governance reform is part of the broader SOE reform action plan (2020-2022), the full text of which remains unreleased. As we alerted on August 12. Zhou Xiaochuan, former chair of PBOC has stressed that the weak or absence of corporate governance is the root causes for troubled or failed financial institutions, and the reform priority should be “effective corporate governance and regulatory oversight.”

On November 25 2019, China Banking and Insurance Regulatory Commission (CBIRC) released the Measures for the Regulatory Assessment of Corporate Governance of Banking and Insurance Institutions (for Trial Implementation) (“Corporate Governance Assessment Measure“). The Corporate Governance Assessment Measure outlines the regulatory assessment of corporate governance into three prongs: i.e.

  • Compliance assessment, focusing on legal & integrity and rectifying/corrective actions undertaken or absence/failure to rectify
  • Effectiveness assessment focusing on key problems and good practice
  • Event-driven downgrading risks, e.g., major deficiencies / failure in a financial institution’s corporate governance

Targeted Deficiency / Failures in Corporate Governance

Targeted major deficiencies or failures in corporate governance include:

(1) Refusal to accept or obstructing the regulatory scrutiny of corporate governance (拒绝或者阻碍公司治理监管评估)；
(2) Concealing material facts in governance or material risks in asset quality, or providing false materials (隐瞒公司治理重要事实、资产质量等方面的重大风险或提供虚假材料)；
(3) Situations whereby any shareholder makes fictitious or false capital contribution, circular capital injection, or withdraws capital contribution directly or in a disguised manner (股东虚假出资、出资不实、循环注资、抽逃出资或变相抽逃出资)；
(4) Situations whereby any shareholder conceals the ultimate beneficiary, affiliation, sleeping shareholder, shareholding/voting proxy, or tacit covenant for concerted actions or other implicit acts to evade regulatory scrutiny, which has material impact on the right to contro/drivel in a financial institution (股东通过隐藏实际控制人、隐瞒关联关系、隐形股东、股权代持、表决权委托、一致行动约定等隐性行为规避监管审查，对银行保险机构的控制权或主导权造成实质影响)；
(5) The corporate governance mechanism fails, resulting in the failure to normally convene the (general) meeting of shareholders or the board of directors or failure o make decisions for a long time (公司治理机制失灵，股东（大）会、董事会长期无法正常召开或做出决策)；
(6) It has a redemption crisis or is seriously insolvent (出现兑付危机、偿付能力严重不足)；
(7) Catch-all: Any other circumstance of corporate governance mechanism failure determined by the regulatory department.

What’s New

The action plan shoulders dual mandate to both enhance market-based risk control and enhance Party leadership, Priorities in the action plan include:

  • Embed CCP leadership through KPIs at board level
  • Target white-collar crimes from financial fraud to shareholder abuse
  • Protect minority shareholder oversight and enhance transparency and disclosure of irregular behaviors of abusive shareholders in financial and insurance sector
  • Promote disclosure and voting mechanisms to ensure effective governance especially in material transactions such as M&As and change of control and transactions by and among related parties
  • Enhance the role of independent directors, selection and appointment of board members and senior personnel, delegation of authorities, and outside oversight by auditors
  • Enhance the role and function of compliance and ethics at board level as well as the remuneration and incentives for personnel dedicated for CCP affairs, risk management and internal control.

ESG Through Greater Role by Party Leadership?

Analysts view the above action plan “as part of the regulators’ effort to lift environmental, social and governance (ESG) standards in mainland China.” However, the action plan itself does not address or refer to ESG, except reference to OECD counterparts on corporate governance generally, however. We will closely monitor the substantiating policies and actual execution of the corporate governance reforms.

Next Steps

The action plan’s timetable is as follows:

By the end of 2020: complete the initial assessment on corporate governance at financial institutions nationwide

  • By the end of 2021: roll out the pilot reform programs based on the outcome of the initial assessment as well as implementation of corrective actions mandated
  • By the end of 2022: based on lessons learnt from assessment to execution, establish clear and effective corporate governance benchmark systems and performance indicators especially concerning risk rating and solvency oversight.
  • More enforcement in parallel and to come: as of September 4, 2020 CBIRC has imposed penalties ranging from 7 to 13 million US dollars on major instituions China Huarong Asset Management, Agricultural Bank Of China, China Construction Bank, China Zheshang Bank (2016.HK), Minsheng Bank (1988.HK), Guangfa Bank, Huaxia Bank, on issues varying from shady behaviors to fraud.

3. Outlook

It remains unclear how to demarcate between board and CCP organization.

The principle uttered so far is that the company direction, overall leadership and execution will be under the auspices of CCP organization at company-level, while the board remains accountable for strategic management, decision-making and risk control, according to the Secretary General of SASAC, China’s regulator for state-owned assets.

Counter-intuitively, stewardship with Party leadership would contribute to the shift from the criticized mercantilist focus on “shareholder value maximization (only)” to balanced considerations inclusive of ESG factors and roles of representatives from both the blue-collar and those investors with”minority” participation.

Ambiguity and administrative discretion unchecked, if any, however, might also expose companies to regulatory uncertainty in China.

China starts this wave of reform first with the toughest areas – the financial sector where it deems systematic risks could lead to stability risks. Once the”best practices” and precedents sophisticate, it will gradually cascade further to business undertakings in critical sectors (关键领域), such as infrastructure, railway, power, petrochemical and energy sectors.

In terms of enforcement, foreign financial institutions are not yet targeted, but could be exposed to the enforcement if prior dealings with the penalized ones reveal irregularities. It remains to be seen how far this wave of enforcement will reach, including those underwriting prior unicorns and now fighting investigations overseas, such as Luckin Coffee.