Restructuring Restructuring: State-Owned Enterprise Reform in the PRC (Part 3)

[Fair warning: this is a post concerning Chinese law, and not about our experiences living in China. It is one of a series of posts concerning the modernization of State-Owned Enterprises in China. They are based upon a paper I wrote for a class in Economic Law that I recently completed in the Peking University LL.M. Program. I welcome any comments or questions.]

To maximize efficiencies without privatizing ownership structures in the larger centrally-managed state-owned enterprises (SOEs), China created a legal framework intended to transform SOEs from state-run enterprises into state-owned enterprises, while also providing for the divestment of underperforming SOEs in non-critical sectors. Accordingly, the Company Law provides that “[t]he ownership of State-owned assets in a company shall vest in the State.”

The State-owned Asset Supervision and Administration Commission (SASAC) acts as the direct owner and administrator of those assets used by central-level non-financial SOEs. Like a shareholder, unless a company is deemed an “important wholly state-owned entity,” SASAC makes all decisions as to the merger, division, dissolution, increase or decrease of registered capital, and the issue of corporate bonds in wholly state-owned companies. But in the event that the State Council does designate an SOE as “important,” any of the aforementioned events must also be approved by the people’s government of the same level as the SOE.

Beyond SASAC, auditing institutions likewise exercise supervisory authority over SOEs by assessing “the assets, liabilities, profits and losses of the State-owned enterprises.” Auditors must conduct regular, planned valuations of SOEs that “are vital to the national economy and the people’s livelihood, or the State-owned enterprises that heavily depend upon government subsidies, or have large amounts of losses, and other State-owned enterprises designated by the State Council or the people’s governments at the corresponding levels.” The State Council prescribes specific rules and regulations to govern such audits, largely to prevent asset stripping and identify inefficient management practices. Recognizing the conflicts of interest that could ensue, government subdivisions responsible for managing state-owned assets may not themselves manage asset valuation enterprises, but those subdivisions still retain the authority to supervise assessments by qualified assessment entities, entities that are themselves qualified when the departments tasked with managing state-owned assets issue them a certificate of state asset evaluation qualification.

When it Releases the Small, the Modern Enterprise System proceeds “via various forms such as transfer, auction, acquisition, merger, investment in equity, [and] debt-for-equity swap[s.]” Notably, any such transfer of state-owned property rights must occur through a government-approved state-owned asset exchange after an assessment of those property rights conducted by a government-approved auditing institution. The following events trigger the valuation requirement:

1. Auction;
2. Merger, sale, affiliation, or operation of a State-owned enterprise;
3. Establishment of an equity or cooperative joint venture with a foreign entity, enterprise, economic organization, or individual;
4. Liquidation; or
5. Where other state regulations require assessment.

It is therefore important to note that the regulations require valuation whenever state-owned assets (SOAs) are transferred, meaning that any entity seeking to transfer state-owned assets, whether an SOE or one indirectly held by the state, must comply with the regulations. To make matters more complicated, if there is more than one potential transferee of the SOAs, Chinese law requires specific bidding and auction procedures. Moreover, if the final auction price does not exceed 90% of the appraisal price, then the transfer may not occur. It is no wonder, then, that foreign investors often complain about the web of regulation surrounding China’s state-owned property.

Companies seeking to acquire China’s SOEs or SOAs must navigate not only the aforementioned supervisory authorities but also the PRC’s complex web of ministries and local governments to achieve their goals; investments in state-owned property must follow a special regulatory framework that “lacks transparency on policy toward ‘strategic assets’. . .and requires cumbersome approval procedures.” Foreign investors seeking to acquire listed SOEs, for instance, must secure consents from SASAC, the Ministry of Commerce (MOFCOM), the National Development and Reform Commission (NDRC), the China Securities and Regulatory Commission (CSRC), the State Administration of Foreign Exchange (SAFE), the State Administration of Taxation (SAT), the State Administration of Industry and Commerce (SAIC), and local authorities, among others. (Investors using state-owned assets to capitalize “cooperative medical institutions,” media distribution enterprises, and cinemas face even more hurdles.) Deals involving state-owned assets must also determine whether certain property constitutes a “state-owned asset,” whether a state-owned enterprise exists that holds property rights in those assets, and how to value those assets in acquisitions or transfers by working with the aforementioned auditing institutions. Moreover, “the acquirer and the seller must make a resettlement plan to properly resettle the employees, and the resettlement plan must be approved by the Employees’ Representative Congress. For its part, the SOE must pay all unpaid wages and social welfare payments from the existing assets of the target company to the employees.” As such, despite the seeming complexity of regulations governing the area, China lacks a comprehensive regulatory framework to govern the use of foreign investment to restructure SOEs.

Foreign investment in SOEs and SOAs involves additional wrinkles. Indeed, China’s attitude towards foreign participation in the Modern Enterprise System has “shifted back and forth along a spectrum between extremes of openness and restriction.” Efforts to control the pace and character of reform have yielded additional obstacles specifically directed at foreigners seeking to invest in state-owned property, some of them legal and others created as a matter of political economies within the administrative hierarchy of the PRC. Under the 2003 Interim Provisions on Mergers and Acquisitions of Domestic Enterprises, for instance, all foreign direct investment (FDI) must follow the Guidance Catalog of Industries with Foreign Investment, which often limits FDI in specific industries to the following arrangements:

1. Joint ventures, either equity or contractual;
2. Absolute Chinese holding positions, whereby Chinese party own 51% of a venture; or
3. Relative Chinese holding positions, wherein the total holding position of the Chinese parties in a joint venture exceeds that of the involved foreign parties.

Even so, foreign firms play an extremely important role. China’s Constitution explicitly recognizes the impact of FDI on the national economy, permitting foreign investors to “enter into various forms of economic cooperation with Chinese enterprises and other Chinese economic organizations in accordance with the provisions of the laws of the People’s Republic of China.” Indeed, FDI has driven substantial changes in the Modern Enterprise System and its supporting regulations since the inception of the Open Door Policy.

At first, instead of allowing for wholly-owned foreign entities on the Mainland, PRC regulations required foreign businesses to partner with SOEs. Seeking to rely upon the distribution networks, land use rights, and government contacts that SOEs could provide, foreign businesses entered into joint ventures with SOEs, SOEs who themselves sought the capital, management expertise, brands, and technologies that foreign companies could provide. Today, however, most recent inbound investment relies upon direct acquisitions of SOEs or SOAs. But even today, China’s domestic policy in certain instances encourages partnerships between China’s SOEs and foreign businesses “in recognition of the skills and capital that foreign investors can bring.” Indeed, Chinese regulations explicitly provide that FDI in mining, tobacco, railways, and transport vehicle manufacturing can only occur in the form of a joint venture. Some foreign entities have attempted to avoid such restrictions by entering into so-called management contracts, but few of those efforts are successful, and joint ventures continue to play a role in PRC FDI.

Many of the regulations governing the disposition of state-owned property do much to prevent illicit transfers of the kind that occurred in post-Soviet Russia and other transition economies. Notably, auditing institutions receive special attention in the form of regulations intended to limit the use of kickbacks, incorrect valuations, or other “unjustifiable” actions. Chinese law even provides for punishment of SOEs that use asset auditing institutions to strip state-owned assets at below-market values. Chinese law even provides for a form of injunctive relief in the event that an SOE is found to transfer or conceal illegally acquired assets. Indeed, China’s Constitution even includes provisions prohibiting the “[a]ppropriation or damaging of State or collective property by any organization or individual by whatever means[.]”

Even so, however, China has neither truly limited corruption nor formally separated management from ownership. To be sure, the Modern Enterprise System intended to place SASAC in the role of owner, much in the same way that limited liability companies vest ownership in shareholders with limited intervention powers and management in boards of directors and boards of supervisors. But while China has liberated SOEs from government management, clearly the central government has failed to install the necessary constraints for proper oversight. Indeed, reforms like China’s, unaccompanied by corporate governance that incorporates insights from information and transaction-cost economics, will never ensure that owners and managers behave in a manner that maximizes competition and efficiency while minimizing “predation and opportunism.”