what we think

[The below text is an extract from Chapter 10 (Corporate Governance) of “Chinese Commercial Law: A Practical Guide”. Published in October 2010 by Kluwer Law International, author Maarten Roos (Managing Director of R&P China Lawyers) wrote this book for foreign managers with operations in China. It is available through the publisher (www.kluwerlaw.com) or in online bookstores including www.amazon.com.]

Before going into more detail on how the management and supervision of foreign-invested subsidiaries can be structured, it is important to gain a basic understanding of some of the specific challenges that foreign investors face relating to the control of their Chinese entities. [Focus 10.1]

The first and one of the most obvious difficulties to overcome is the physical distance between the subsidiary and its foreign parent company, or where it is not the same, the actual headquarters of the group. Subsidiaries are generally meant to function as part of the global organization, and this often translates into Chinese managers reporting to commercial, financial or administrative supervisors who are based in other countries.

This presents a particular challenge for relatively small organizations that concentrate management functions in the hands of a few, and who then rely mostly on personal relationships and face-to-face, direct communication to manage the business. When these businesses expand, their managers must switch to alternate methods to reach their local management teams abroad. However, long-established management practices and limited (human) resources make this switch difficult, which may well mean a compromise on effective corporate governance of the subsidiary. [Focus 10.2]

This problem of physical distance is aggravated by a factor which is relevant to China in particular: the manifest cultural differences between Chinese and western companies, that is, the divergence in those values and business practices that convert into concepts that in western organizations are considered good corporate governance. Most foreign investors expect their subsidiaries to adopt the group’s values – including, among others, full compliance with the law and ethical business practices. Very few businesses in China, however, can meet such high standards, and it is far from easy to stimulate values that are not prevalent in the immediate business environment. Foreign investors must be willing to invest considerable resources so that best practices continue to be followed despite local influences that pull Chinese managers and staff in opposite directions. And while some of the typical Western values, such as transparency and accountability, may well create a direct return, it is good to remember that this may not always be the case. In some cases, applying western standards may even put the subsidiary at a competitive disadvantage in the local Chinese business environment, which means a further cost that the foreign investor will have to bear through its subsidiary.

Another challenge to good corporate governance is the lack of familiarity and understanding by foreign management of the subsidiary’s commercial and regulatory environments. Unsurprisingly, many foreign managers find it difficult to fully grasp the intricacies of the Chinese subsidiary’s operations and challenges, and as a result they struggle to accurately and timely monitor the performance of the local management. This often leads to one of two responses. In some cases, foreign management takes such a restrictive approach to its local (i.e. locally-place) counterparts that those managers are unable to make the most of the available business opportunities. More common, however, is that local managers are given too much freedom, which not only
signifies a lack of control over their activities; it also leads to an over-reliance on these local managers. This affords the managers the opportunity to build up individual positions of power within the subsidiary and the business which are extremely difficult to overcome, and this may eventually become an expensive liability to the foreign investors.

There are plenty of examples of local managers abusing their power in a variety of means, such as collecting personal commissions from suppliers and customers, routing
transactions through affiliated companies, hiring (real or on paper) family members in the business, or establishing a parallel business in direct competition with the foreigninvested company. When operating a subsidiary in China, foreign businesses should be aware of these risks, and accordingly expend time and effort building a corporate governance system to curtail them to the greatest extent possible. [Focus 10.3]

When looking for such risks, it is important not only to consider a manager’s personal enrichment. A decision may have even been made to improve the business, but where
this decision is irreconcilable with the company’s values then it may still be undesirable. A typical example of this is a decision on declaring HS codes for customs declaration (see Chapter 2 on Trade & Distribution). A local manager may feel that by using a more favorable HS code, the company can make a bigger margin. But is the foreign investor willing to risk the considerable penalties and criminal prosecution if it is caught?Corporate governance should be designed to ensure that decisions are made at the appropriate level.

Focus 10.1 Balancing Values

The choice between adhering to western values and following locally-accepted business practices is sometimes extremely difficult. Take, for example, the prevailing local practice of maintaining good relations with government departments. The offering of gifts, dinners and entertainment to local official runs counter to best practices in the west. However, refusing to maintain or simply ignoring relations with local government departments may come at a cost: the company should expect little empathy or support in case of need; in the worst case, the company’s refusal to ’play the game’ could lead to stricter supervision and even discretionary harassment.

Focus 10.2 Incompliant Business Practices

Experience suggests that very few companies in China are fully compliant with the law. The main exceptions are some of foreign-invested companies, who are generally held to a higher standard – by Chinese authorities as well as by their own shareholders. These are some of the most common practices:

• two (or more) different sets of accounting books
  (including one for the tax authorities);
• using a lower salary to calculate social insurance
  premiums;
• importing goods under different customs codes to avoid
  duties and taxes; and
• failing to obtain building construction permits and
  paying off inspectors to pass safety approvals.

Focus 10.3 Director Powers

In the case of a wholly foreign-invested company in Shenzhen, the general manager (who was also a director) at one point refused to cooperate and implement a decision by the shareholder unless certain demands for commissions were met. The shareholder was left the choice to give in to the manager’s demands, or to literally force him out over this relatively minor issue.

The manager was able to ‘blackmail’ the company based on his combined authority (i) as director, since he could block any board Resolutions that had to be made unanimously according to the company’s articles of association; and (ii) as
general manager, since he was in physical control of the company stamps which are needed to make any applications on behalf of the company, including replacing him as director or general manager.

This is a typical case where the investor gave too much power to a local manager. The situation would have been much easier to control had the manager not had the legal right to block major decisions through his position on the board of directors.