Why good corporate governance is so important in China?

A major challenge for foreign investors is maintaining proper governance of their Chinese entity and generating a profitable business. Whilst there are significant improvements in the business environment, including regulatory reforms to streamline administrative procedures, investors, especially those residing abroad, face challenges in establishing the proper corporate governance and ensuring the Chinese subsidiary is correcting operating. Usually, the geographic and cultural distances between the shareholders and the Chinese subsidiary could generate miscommunication and misunderstanding, and without the proper corporate governance established, the Chinese subsidiary could face losses and damages.

The Challenges

For foreign investors understanding the underlying challenges of corporate governance is key to resolving the issue. Two main aspects affect China’s corporate governance and should be noted in the preliminary investment planning stages.

Semantic differences

Firstly, the definition of corporate governance in China differs from the concept formed in Anglo-Saxon jurisdictions. According to Black’s Dictionary, the definition of corporate governance is applying policies, proper implementation, and continuous monitoring. Typically done through or by the organisation’s governing body (a group of officers or persons having ultimate control). In Chinese, corporate governance is composed of the characters 治 zhì 理 lì. The character 治 zhì means utilisation and is constructed by the characters of water (left) and opening (right), which denotes to the original meaning 治 zhì 水 shuì,the utilisation of water. The second character, 理 lì, means reason. Thus, corporate governance in Chinese could be defined as the utilisation of the people through the application of reason. Such semantic differences between definitions indicate potential issues in how corporate governance is applied and perceived in Chinese culture. As a result, control of the foreign entity can be easily lost — if a foreign shareholder does not fully comprehend how to implement correct corporate governance.

Legislation

Secondly, there are potential issues in the legislation of corporate governance. Under the Foreign Investment Law of the People’s Republic of China, all foreign entities are unified under the Company Law of the People’s Republic of China. Corporate governance centres on statutory procedures and the duties and liabilities of the governing body consisting of the board of shareholders or sole shareholder, board of directors or executive director, board of supervisors or supervisor. However, there are no clear provisions to ensure the foreign entity is governed in the interest of the foreign shareholder(s). As a result, there are several challenges for foreign shareholders who may reside abroad, including entrusting the correct individuals as a director, supervisor, and senior management to maintain the interest of the foreign shareholder and so forth.

The practical solutions

Establishing correct corporate governance in China centres on activating several unwritten instruments. These are practical solutions that safeguard against the loss of governance. Thus, corporate governance can be implemented and maintained in the interest of foreign shareholders in both the overall governing body and the management of the employees. It is a matter of activating the intangible instruments.

Appointment of key individuals

In many cases, foreign shareholders reside abroad, and the entity’s governance is left to ‘trusted’ key individuals acting as directors, supervisors, legal representative, and senior management, according to the Company Law. Therefore, the shareholders need to consider such appointments in the initial investment stage and establish the limitations of each role within the articles of association. Without this first step, a resolution of the board of directors is required to remove and appoint a new individual. Therefore, where the board of directors does not represent the interests of the foreign shareholders, this procedure could be problematic and result in a deadlock. 

Corporate Seals

Furthermore, corporate governance can be implemented practically by the company’s corporate seals and company seal policies.

The corporate seal, often called a “chop”, represents an unlimited power of attorney vested in the holder of the corporate seal(s). Once the seal is affixed to a document, the company is legally bound and effective, whilst signatures are not enforceable under Chinese law. Therefore, foreign companies are strongly recommended to formulate and implement a corporate seals policy to instruct proper use, access, and safekeeping.

Each company must hold a set of corporate seals, which are deposited at the public security bureau for approval. Once the corporate seals are approved, they are micro-fined and registered. Where the company changes the seal, the company must undertake the approval and registration procedures with the public security bureau. Corporate seals include corporate seal, legal representative seal, invoice seal, department seals, and so forth.

Without the proper seal policy and adherence to such corporate seals policy, the company could be legally bounded to unapproved obligations. Furthermore, without correct authorisation established, the company could face mismanagement and serious damages.

Employee handbook 

While the labour contract governs the labour relationship between the employee and employer, an employee handbook establishes the fundamental provisions to manage the employee’s daily routine, responsibilities, and obligations. Under labour law and contract law of the People’s Republic of China, an employee handbook provisioning the company policies are required for employees. Employees adhere to the employee handbook upon accepting the job. Therefore, the internal company policies serve as a legal basis for the senior officers and board of directors to correctly manage according to the shareholders’ resolutions and ensure employees adhere to management. Without such policies, the company may face difficulties in labour disputes, as what is deemed reasonable conduct may become a subjective matter. Furthermore, foreign shareholders often face challenges in related foreign laws in the jurisdiction of their headquarters, which affect the Chinese subsidiary.

Specifically, foreign laws may stipulate work safety requirements for foreign employees dispatched to the Chinese subsidiary. Otherwise, the headquarters shall be liable in their jurisdiction. Hence, the Chinese subsidiary may face conflicts in Chinese law when applying foreign law. A practical approach is to transform such legal requirements into internal company policies, avoiding arising conflicts or legal liabilities in Chinese law.

In China, incorporating a foreign entity can be easy. The challenge is to maintain control of the foreign entity through the correct corporate governance. Recent legislation reforms signify a stronger legal framework for foreign investment. However, sustaining a profitable business in China means maintaining corporate governance through the implementation of practical but unseen apparatus in the company.

If you have questions or concerns related to China Business, Tax or Labour Law or other corporate matters, please contact Horizons at +86 21 5356 3400 or talktous@horizons-advisory.com to schedule a consultation session. Horizons can provide insight, expertise and the right solutions for you.