On 18 December 2020, the United States passed the Holding Foreign Companies Accountable Act. The law stipulates that any US-listed foreign company will be removed from American stock exchanges if it does not comply with US auditing oversight rules within three years. It is well known that this law is specifically aimed at US-listed Chinese firms.
For investors, the issue of corporate transparency is paramount. When college students take their first finance course, they are taught that there are two major costs that can hinder the firm’s valuation. The first is information asymmetry. Outsiders, such as investors and lenders, do not know the firm as well as the firm’s insiders. Therefore, for example, the firm’s cost of capital might be higher than it should be. The second major cost is the agency problem. While shareholders own the firm and managers control the firm, managers may not act in the best interest of shareholders, and this problem can be greatly exacerbated when there is a high degree of information asymmetry. In the early 2000s, we witnessed how significant this agency problem can be. Because of the actions of self-serving executives at firms such as Enron and WorldCom, it contributed to an investor confidence crisis around the world, which eventually led to major corporate governance reforms world-wide.
Shareholders and managers are not the only stakeholders that benefit when stock markets function well. The country’s overall economy also benefits. Economies cannot grow unless they have well-functioning stock markets. Up until now, China was a striking exception to this rule. However, for China’s growth to continue, it recognizes that a well-functioning stock market must play a major role. Therefore, two important questions are the following. First, what is the nature of the agency problem in China? Second, what is the potential solution to this problem?
In China, the main agency problem is the conflict of interest between large shareholders and minority shareholders. Because this agency problem is among shareholders, we can call this a “horizontal” agency problem, which is unlike the “vertical” agency problem that can exist between shareholders and managers in Western countries and in other developed nations. The main reason why the agency problems are different between Western firms and Chinese firms is because unlike in the West, pretty much every Chinese listed-firm has a very large shareholder. On average a Chinese listed-firm’s largest shareholder owns at least 30% of the firm. In the West, ownership is largely diffuse, and so managers control the firms. However, in China, the large shareholders control their firms.
In China, the horizontal agency problem is quite significant. Throughout the 1990s and early part of the 2000s, controlling shareholders of listed-firms would simply take money from the firm. They claimed that these were “intercorporate loans,” but these loans were interest-free and almost never paid back. On the balance sheets, they were booked as “other receivables.” This outright theft from minority shareholders was not a trivial amount. On average, other receivables accounted for almost 10% of the firm’s total assets. Chinese securities regulators came down hard on this practice, and now it is essentially eradicated. However, as long as there are large shareholders, the horizontal agency problem will continue to exist. For example, controlling shareholders can engage in related party transactions with the firm on favorable terms. An example would be the firm buying an asset from the shareholder at a high price. Note that this form of expropriation from minority shareholders is almost impossible to detect. Therefore, this gives rise to the crucial question of how China is dealing with this agency problem.
In the West, there are many potential solutions to the vertical agency problem. For example, securities analysts, institutional investors, large lenders such as banks, independent auditors, and boards of directors, can serve as corporate monitors. However, in China, these potential monitors are limited in their ability to protect minority shareholders. For example, most board directors are not independent, and they are often appointed by large shareholders. In addition, given that large shareholders are more entrenched than firm managers, the horizontal agency may be harder to address than the vertical agency problem. Therefore, the main solution to the horizontal agency problem in China rests on having strong laws and regulations, and to enforce them.
There are many corporate and securities laws in China, including the 1985 Accounting Law, to ensure the quality of accounting information, the 1986 Enterprise Bankruptcy Law, to improve the quality of enterprises by eliminating inefficient ones, the 1993 Company Law and the 1998 Securities Law, to protect minority investors, and there is also the 1999 Contract Law and the 2007 Property Rights Law. These laws have been updated and improved upon several times. Are these laws and regulations, and the regulatory authorities, effective at mitigating the horizontal agency problem in China? According to anecdotal evidence and academic research, the answer seems to be mostly yes, and especially recently. For example, it is now difficult for controlling shareholders to engage in favorable related party transactions, and this is because of a regulation that allows minority shareholders to vote on these transactions. Throughout the 1990s and early part of the 2000s, it was common for scholars to criticize China’s laws and institutions. Today, it is more appropriate to say that China’s laws and institutions have dramatically improved.
In addition to recognizing the horizontal agency problem and identifying the potential solution, there is a third important question when it comes to Chinese firms and their stocks. What about state-owned enterprises (SOEs)? For many Chinese listed-firms, the largest shareholder is the government. SOEs make up the majority of the market capitalization of the Chinese stock markets. State ownership of enterprises is often criticized by Western scholars because of their underperformance and because the government might extract resources from the firm (that is, the government may be a “grabbing hand”). However, in China, while SOEs do underperform, they do not fail. For example, the government sometimes provides SOEs with favorable bank loans and other subsidies. Therefore, the government is more like a “helping hand.” In our view, the helping hand is justified because SOEs are tasked with the responsibility of maintaining national and social interests, such as making capital investments and maintaining industrial production, and also maintaining social stability, such as maintaining excess employment. Therefore, we feel that Western criticisms of state-owned firms, especially when it comes to China, may be misplaced.
Finally, Chinese companies not only have a responsibility to investors, they have a responsibility to all stakeholders, including society at large. Therefore, another important question is whether corporate social responsibility (CSR) matters in China. Chinese citizens and consumers care about social issues, but right now, they are relying on the government to carry out CSR initiatives and programs. The government seems to be somewhat effective in promoting CSR. However, while there is still a long way to go for Chinese firms to be truly interested in CSR, we think the future is bright.
In sum, Chinese firms are vulnerable to a significant agency problem, but China is well aware of it and is tackling the problem. This is important, not only for China, but also for the world, given that China will soon become the world’s largest economy.