High-Level Corporate Governance

China Corporate Governance Report (2012): Investor behavior and corporate governance

Abstract

Sophisticated corporate governance and capital market are supported by rational investment behavior and listed companies’ healthy investor-relationship. It is fair to say that without shareholder activism, especially institutional shareholders activism, corporate governance cannot be fundamentally improved.

China's capital market has made considerable progress over the past twenty years, leading to developments in individual investors, domestic institutional investors and foreign institutional investors. Recent years witnessed rapid growth of professional institutional investors,from securities investment funds, insurance companies and social security funds, to enterprise annuity, QFII and corporate bodies. By the end of 2011, individual investors held 26.5% of China’s A shares by free-float market capitalization, enterprise legal person 57.9%, and professional institutional investors 15.6%. But it should be noted that the trading by individual investors accounted for more than 85% of trading value in China.

Due to the small scale of institutional investors and tilted investor structure, the market is overwhelmingly retail-driven and short-term oriented. Irrational trading behaviors by small and medium investors, who speculate on newly listed stocks, small-cap stocks, poorly-performing stocks and change hands quickly have been the norm in China’s capital market. As a result, the valuation of stocks issued by poorly performing companies, small-cap stocks and hot-spot stocks are much higher than that of large-cap stocks and blue-chips. The over-heated seller's market fails to correctly reflect the true value of listed companies, which leads to short-termism of the controlling shareholders and management. Hence ineffective allocation and inefficient utilization of listed companies' resources.

Compared to individual investors, institutional investors that advocate value investments and long-term investments are relatively stable in the market. They can also impose more positive impact upon the market participants, including the checks and balances in listed companies’ decision-makings, tackling problems caused by excessive equity concentration, and improving the quality of listed companies. In recent years, China's securities market reform has been extended and deepened, corporate governance of listed companies improved continuously, and rules and regulations on investor protections more sophisticated, altogether providing an enabling institutional and policy environment for institutional investors to actively participate in corporate governance. Institutional investors are more actively involved in the corporate governance and set up many successful examples. Nevertheless, due to the ownership structure, legal environment and other factors, “activism” among the institutional investors in China is still in its infancy, mainly in general corporate governance, including refinancing, management relationship, related party transactions and information disclosures. And it is still "passive" and "speculative".

The practices of shareholder activism build on listed companies’ sound investor relationships. As China’s capital market open up at an accelerated pace, more listed companies go global and multi-list on overseas market. Investor relations become a widely-accepted concept. From road shows to opening of investor relations website and the investor visits, listed companies in China realize the importance of investor relations management in corporate governance and are learning to communicate with investors.

Both theoretical studies and previous experiences show that investors especially institutional investors’ participation can play an active role in solving insider controlling problem and promoting shareholder activism. But constrained by internal and external barriers such as imperfect market mechanism, low quality of listed companies, small scale of institutional investors, retail investors’ irrational behavior and incomplete legal environment, shareholders’ role in corporate governance is still limited. To improve listed company’s corporate governance and shareholder activism, efforts are needed from the market, regulators, investors and listed company.

First, improve capital market mechanism, build a matured and stable market environment. On the one hand, improve listed company’s quality; solve the problems of majority shareholder hegemony and insider control; develop more mature blue-chip companies to fulfill needs from all types of investors. On the other hand, improve the system of initial public offering, delisting and cash dividend, increase the whole market’s investment value, disseminate long-term and rational investment philosophy, and discourage over-speculation on newly-listed, small-cap or poorly-performing stocks, to attract institutional investors such as QFIIs, social security funds and employer annuities that focus on long-term and steady investment and guide investors to invest in companies’ long-term intrinsic value.

Second, foster different kinds of institutional investors. With a large holding scale, institutional investors are the market’s ballast. To leverage their role, social security funds and employer annuities should be encouraged to upscale their holding. As mature and active institutional investors, QFIIs have a much larger role to play in China’s capital market given their abundant know-how and experience in corporate governance. With larger quota and more open institutional environment, QFII will accelerate their pace while increasing their scale.

Third, develop qualified investor system to ensure that products are sold to appropriate investors. Investment is a professional economic activity which involves lots of complex financial knowledge. Different investors may vary in knowledge structure, risk tolerance and market experience. Qualified investor system is the key in guiding investors to choose the products they know, build rational and long-term investment philosophy, and then participate in corporate governance actively and effectively.

Fourth, further optimize legal system to provide shareholders with legal safeguard to participate in corporate governance. First, laws should be revised to balance power inside a company and solve the problems caused by majority shareholder hegemony and insider control; second, enhance the protection of retail investors and adoption of judicial remedy; third, lax legal restrictions on institutional investors’ participation to get more involved in corporate governance. Fifth, advocate long-term, intrinsic value-oriented and rational investment, cultivate sound and rational capital market culture, build investor eligibility system and discourage the illusion of making quick money. Meanwhile, it is critical to restrict over-speculation on new, small-cap or poor-performing stocks in the light of actual situation and establish rational investment and value investment culture. Investors should be advised to analyze company’s business model, corporate governance and operating condition carefully, pay close attention to the industry’s condition and avoid being misled by rumors or following others blindly.