By Megan Bowman, UNSW

SYDNEY: 23 May 2013 – A critical theme in the Berle V conference recently held here at the CLMR was the examination of state capital and the dynamics of financial regulation with particular emphasis on the evolution of Chinese corporate and securities law. Papers presented by Douglas Arner (Hong Kong University), Adam Dixon (University of Bristol), George Gilligan and Megan Bowman (CLMR UNSW), Greg Golding (King & Wood Mallesons), Nicholas Howson (University of Michigan) and Teemu Ruskola (Emory University) each explored the implications of state capital and Chinese corporate law for future Anglo-American practice and policy.

Arner provided a sobering broad brush analysis of market and regulatory lessons post-Global Financial Crisis (GFC). He opines that notwithstanding the rhetoric of reform agenda, no substantial mechanisms are yet in place that are capable of either dealing with acknowledged weaknesses or identifying potential future threats. In a CLMR-CIFR video interview, Arner states that: “not only have we not dealt with the causes of the last crisis, but we’ve barely begun to think about where the next crisis could come from”. Concomitantly, Arner accents the rise of outward foreign direct investment from China, findings buttressed by Gilligan and Bowman’s evidence of the changing composition of the global economy. For example, in 2011 the top five economies (based on GDP in terms of purchasing power parity) included the US (ranked 1) and China (ranked 2). Yet that ordering will reverse according to projections for 2030 with China’s GDP eventually outweighing that of the US by 1.5 times by 2050. While the focus on China has dominated regional analysis and discourse, it is clear from these statistics why that is so and why it is so essential to understand the complex nature of state capital. 

State-directed institutional capital actors, such as sovereign wealth funds (SWFs) and state-owned enterprises (SOEs) are critical actors in the transference of political power. In essence, SWFs are large institutional investors that are government-owned and/or charged with a political mandate to manage and invest a nation’s accumulated wealth, preferably without accentuating financial stability in domestic markets (ie. the Dutch disease). In a CLMR-CIFR video interview, Dixon states that “although sovereign funds have been around for decades… in the mid-2000s sovereign funds became quite prevalent” particularly in emerging economies. Again, this is consistent with Gilligan and Bowman’s empirical data, which demonstrate that China currently controls the world’s largest SWF investments, followed by the UAE, Norway and Saudi Arabia. These developments correspond in time with both the GFC and export-led growth in East-Asia. Importantly, Dixon and Gilligan and Bowman note the importance of the 2008 Generally Accepted Principles and Practices for SWFs (GAPP or the Santiago Principles). The Santiago Principles were designed to reduce contestation over the purpose and legitimacy of overt political involvement in global capital markets. They seek to encourage SWFs to contribute to more open global financial markets by adopting conventional and common standards of conduct and transparency. Although considerable effort was involved in the design of the principles, it is far from clear how effective they have been. Notably, there is a paucity of empirical evidence about the degree to which the principles have been rendered operational.

While the SWF sector has dominated international headlines in relation to the exercise of state power in investment, the role played by SOEs is even more problematic. Gilligan and Bowman analyse data showing that SOE capitalisation constitutes a significant element in all of the BRIC countries except India. It is far from clear, however, how SOE could or should be analysed. Howson provides insightful analysis on the multi-faceted dimensions of Chinese SOEs and how they link into the shifting political economy of centre-province and intra-province relations. As he explains it, the traditional Chinese SOE was an organisational form, without separate legal personality, administratively controlled by the state which had the right to appoint management and appropriate revenues. One can assume therefore that an SOE’s original raison d’etre was to pursue state purposes as opposed to market freedoms; yet to what purpose remains clouded. Since commencement of the Chinese ‘corporatisation’ program, as expressed in the 1994 Company Law and 2006 PRC Company law, Chinese companies are now legal entities limited by shares or liability or wholly owned by a state agency. In a CLMR-CIFR video interview, Howson states clearly, however, that this legal process has not resulted in wide-spread private corporate ownership, saying that Chinese companies are now “corporatised, not privatised”. Indeed, an SOE is now administratively and financially controlled by an entity of the state (central or local), whereas in the US or Australia that entity would more likely be owned by private institutional investors. Consequently, an SOE controlling shareholder in China has political as well as economic dominance, which has important implications for the nature of a state-directed corporation and who it seeks to serve.

In light of the above context, it is unsurprising that the rise of state-directed capitalisation generally and the activities of SWFs and SOEs specifically have raised questions about the appropriate relationship between markets and governments; specifically, appropriate levels of state-directed investment in foreign markets. But what are the effects of these capital actors on national and global markets in the Asian century?

Golding provides valuable insights into these developments at the Australian domestic level by way of hands-on experience in the first Sino-Western law firm, King & Wood Mallesons. Specifically, in a CLMR-CIFR video interview, Golding notes that Australia has been “grappling with Chinese investment particularly from SOEs”, which exemplifies the difficult balancing act between protecting national interests and satisfying the very real need for foreign capital in order to develop necessary domestic infrastructure. The primary mechanism to achieve policy preferences is through shifting political definitions of what constitutes the ‘national interest’ in investment policy guidelines issued by the Australian Foreign Investment Review Board (FIRB). Yet Australia’s response mirrors that of the United States, which can prohibit foreign investment on grounds of ‘national security concerns’  and Canada, which applies a ‘net benefit’ test, In each case, the adjudication is inherently political and seldom transparent. Yet ironically, this is the same accusation levelled at Chinese state enterprises.

What is clear, however, is that state capital can no longer be ignored by either the political establishment or market participants. Growing economies of scale, asset diversification and rising levels of expertise combine to accelerate a disintermediation process. Dixon documents a ‘push back’ by large institutional investors, including SWFs, against socially dysfunctional aspects of the financial services industry. He argues that a growing number of long-term beneficiary institutions are rethinking how they access markets and make investment decisions by, for example, in-sourcing asset management instead of paying external private sector actors, and reducing diversification by making fewer but larger direct investments.

Of course, the undeniable challenge with longer-term approaches to investing and asset management is overcoming human and market responses to short-termism. Arguably a key competitive advantage of SWFs in the marketplace is time. Yet even when a long-term investment strategy is sound, an investor organisation that performs poorly in the short-term may be pressured by constituents to change investment tactics. Surely this is no less true for SWFs than conventional investors. Modern humans tend to lack long-term vision; and global markets, as a human construct, can be similarly myopic. Indeed, even performance benchmarks for SWFs in the Santiago Principles appear drawn from short-term metrics for conventional investors, including the requirement that investment decisions be made to maximise risk-adjusted financial returns (GAPP 18-19) as evidenced by periodic publication of financial data and public disclosure of funds’ investment policy and financial objectives (GAPP 1-5, 11-12, 15-17).

Through the above contributions we can appreciate the differing conceptions of SWF versus SOE activities and mandates. SWFs tend to be perceived as benign de facto asset managers. In contrast, SOEs operate as competitive multinational corporations in global markets. The reality of foreign investment and acquisition by SOEs combined with their inherent characteristics engenders (rightly or wrongly) public and political concerns. On this point, Gilligan and Bowman highlight the manifestation of concerns in media and policy discourse. For example, headlines from The Australian in the past six months include: ‘China’s state-owned enterprises obtain FIRB approval by stealth’; and ‘Don’t mix politics and deals: FIRB in warning to state-owned investors’. Similarly, Canada’s recently revised investment guidelines to the Investment Canada Act provide explicitly that corporate enterprises which are ‘owned, controlled, influenced, directly or indirectly by a foreign government’ must satisfy the Canadian Minister of Industry that the project is commercial not political. Golding further shows that political decision-making itself is not immune from these concerns, citing the example of President Obama’s 2013 executive order to prohibit Ralls Corporation from owning wind farms in Oregon.

Clearly, normative questions pervade the state capital discourse; and this makes it both fascinating and complex in equal measure. The complexity of the Chinese political economy may mean that policy responses are misguided; hence the importance of fine-grained analysis as provided by Ruskola and Howson, each of whom highlighted the sui generis nature of the Chinese political-legal-corporate framework. 

Ruskola outlines the tradition of Chinese corporate law within its broader historical setting which, in a CLMR-CIFR video interview, he calls “legal orientalism”.  The economic reforms from the 1970s first took place in rural China whereby agricultural industry was decentralised to local governments, and commercial ‘township and village enterprises’ (TVEs) developed as an early form of SOE. Thus, historically, state players in SOE control were local or provincial governments, not central agencies. Ruskola further demonstrates that local government law performed many of the functions of formally enacted corporate law, and that corporate governance today comprises a spectrum of obligations derived from legal, cultural and filial spheres. Indeed, Ruskola notes that the historical Chinese view of the government/TVE business structure was a paternal family relationship as opposed to a legal one.

Howson moves the focus from historical to contemporary Chinese corporate law. He argues that the increasingly contractarian Chinese company law regime since the 1990s actually inhibits market freedoms due to the political economy of China and its corporatised SOEs. In his view, the confluence of unconstrained power of state controlling shareholders, information asymmetry between controlling shareholders and public capital providers, and a weak judiciary, provide an open invitation for dominant shareholders to "oppress" and disadvantage weaker actors in the firm. Most notably he commends the Chinese Securities Regulatory Commission (CSRC) for manoeuvring around the law to issue mandatory-type regulatory incursions, which are designed to protect the basic rights of minority capital providers.

Howson’s contribution is a valuable provocation. In essence, he recommends interventionist regulation of private corporate conduct in China as both necessary and benign. The idea that capitalist and indeed democratic market freedoms can be protected and even promoted by coercive government agency intervention might be considered by some as anathema to Anglo-American norms. Clearly, however, its desirability in Chinese corporate law is a corollary of the specific Chinese legal-political framework. The norm of shareholder primacy - in the Anglo-American sense - is not pervasive within Chinese corporate and securities architecture; and the ‘corporatisation not privatisation’ program has meant that SOE goals do not include maximising wealth for shareholders broadly conceived. Ironically, it is for this very reason that an alternative model of director primacy is not optimal either, given that most directors of Chinese SOEs will be state appointees.

Moreover, it is apparent that there are tensions within China itself: firstly, between the goals of central and provincial state entities; and secondly, between the goals of central state actors and SOE boards. On the first point, Ruskola’s depiction of local (not central) government actors as being germane to the commercial success of TVEs/SOEs is relevant. Even though nine out of eleven of the largest Chinese SOE investors in Australia are currently central government controlled, one can question the notion of a ‘China Inc’ central domination strategy given the fragmentation of SOE ownership - and potentially competing priorities - between levels of government. On the second point, Howson argues that Chinese firms are leading China’s ‘going out’ strategy, citing the example that CNOOC made its 2005 bid for Unocal despite central government opposition.

Certainly, publicly listed SOEs appear to behave like ‘normal’ multinational corporations when operating in foreign jurisdictions. Thus, one challenge for Anglo-American-Chinese commentators is to discern and appreciate the degree of independence that SOEs may have from the government entities that formally own or control them.

It might be useful by way of concluding this commentary to consider options and challenges for the way ahead. It is quite clear that any great leap forward in corporate relations between China and the outside world will require time, effort and understanding of the other. This is no easy task; but it is a critical one in the Asian Century. Commentators, researchers and policymakers will need to appreciate and allow for institutional differences, rather than advocating a one-size-fits-all (whether Chinese or Western) approach.

It is clear that challenges will include: teasing out genuine national interests from inchoate fear-mongering or protectionism; discerning whether and to what extent regulation (hard or soft) can clarify and balance competing priorities ‘on the ground’ in a complex global political economy; and acknowledging not only the heterogeneity of SWFs and SOEs but also their potential for evolution as organic capital actors in a dynamic global economy.

To this end, the question of whether global harmonisation of financial regulation is a silver bullet remains unresolved. Howson notes that attempted harmonisation at such a scale could produce unintended and potentially malevolent consequences. However, Greg Medcraft, Chair of ASIC and IOSCO, has suggested that harmonisation and mutual recognition of standards minimises the risk of fragmentation of markets and might help to achieve “the right regulatory outcomes”. Critical in this process will be the agenda developed by the G20, on which China and other major developing countries hold a seat. Having a seat is not, however, the same as exercising voice. It is as incumbent on China to engage as it is on the outside world to listen. It is in this context that Australia now has an unrivalled opportunity to influence global debate. This year ASIC holds the chair of IOSCO, a pivotal component of the Financial Stability Board, charged by the G20 to recalibrate the regulation of capital markets. Australia also serves as a member of the G20 troika, and will chair the body in 2014. Australia is therefore in a pivotal position to inform and influence the trajectory of global debate. The unresolved question is whether it will use it.