Legal Deterrence: the foundation of corporate governance – evidence from China

• Author: Zhong Zhang
• Published date: 01 September 2007
• Date: 01 September 2007
• DOI: http://doi.org/10.1111/j.1467-8683.2007.00621.x

Legal Deterrence: the foundation of

corporate governance – evidence

from China

Zhong Zhang*

To evaluate the Chinese government’s recent market-orientated efforts to promote good cor-

porate governance, this paper conducts a re-examination of the working mechanics for market

competition and other market-based governance mechanisms to ensure good corporate gov-

ernance. The f‌inding is that the utility of market mechanisms may have been exaggerated. Not

only are they not effective in disciplining serious managerial misbehaviour that offers man-

agers more gain than loss, even their limited value to discourage such misbehaviour as

managerial shirking is conditioned on that the opportunities for illegitimate enrichment by

managers are few. On the contrary, legal sanction is fundamental to good corporate gover-

nance, because it is the only feasible way to combat such serious misbehaviour and curb

illegitimate enrichment. Current experience of corporate governance in China conforms to this

f‌inding and poor corporate governance in China is better explained by the lack of credible

legal deterrence. This being the case, the top priority for China is to strengthen legal sanction

in order to rein in the excessive misappropriation and f‌lagrant fraud. Only once this has been

done will the efforts to implement market-orientated reforms bear any signif‌icant fruits.

Keywords: Corporate governance, China, markets, legal sanctions

Introduction

After an initial period of mania, the stock

market in China is faced with the chal-

lenge of how to survive. Notwithstanding the

fact that GDP in China has increased by more

than 9 per cent on average every year since

2001,1both the share indexes of Shanghai and

Shenzhen Stock Exchange and the total value

of market capitalisation have lost more than

half.2Among the 70 million plus registered

stock investors, a number which China took

no more than ten years to reach, about 70 per

cent had sold out their investments and with-

drawn from the markets, according to an

investigation in December 2005.3Before 2001,

on average more than 100 companies con-

ducted IPOs and were listed every year, but

the number has substantially decreased after

2001 and in 2005 IPO activity virtually

stopped.4The government’s policy to reform

medium and large state-owned enterprises

(SOEs) through corporatisation and listing,

which initiated the growth of the market, had

to be brought to a halt.5The stock market in

mainland China is being marginalised.

Why did share prices fall drastically while

the macro-economy was growing rapidly?

Why were IPOs not feasible while massive

amounts of money were deposited in banks

earning negligible interest?6Why did so many

investors f‌lee from the markets? Clearly the

downturn of the stock market has a linkage

to a series of corporate scandals which had

broken out from the end of the 1990s.

Embezzlements were widespread and it was

common for companies to lose money soon

after an IPO. But bad news was routinely

covered up and accounting f‌igures were

blatantly falsif‌ied. Many corrupt company

managers even made up stories about their

companies’ business prospects in order to

collaborate with crooked market traders to

manipulate share prices. Usually companies

*Address for correspondence:

School of Law, Williamson

Building, The University of

Manchester, Oxford Road,

Manchester M13 9PL, UK.

E-mail: zzszcn@yahoo.com

LEGAL DETERRENCE 741

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involved in frauds imploded after a scandal

was revealed and unsophisticated minority

investors suffered huge losses. Clearly inves-

tors’ conf‌idence in the integrity of the market

as well as in the management of listed com-

panies was fading away.

Because of the scandals and frequent com-

pany failures, the Chinese government f‌inally

learned that corporatisation and listing are

not the panacea for the illnesses of SOEs.

Informed by knowledge from the West, the

government recognised the importance of

good corporate governance for the success of

companies, which in turn is fundamental to

the sustainability of the stock market. Since the

beginning of the new millennium, corporate

governance has become a hot topic in China

and attracted a lot of attention from the gov-

ernment and academics, as well as from public

investors. The government has been endeav-

ouring to improve corporate governance in

China. Interestingly, the usefulness of competi-

tive markets in corporate governance has been

well accepted and the staple market-based

governance mechanisms from the West, such

as market discipline, independent director-

ship, institutional shareholder activism,

performance-based managerial pay etc., have

been highly regarded by both the government

and many academics. The malfunction of the

stock market as well as the lack of market-

based governance mechanisms have been

widely blamed as the culprits responsible for

poor corporate governance in China. There-

fore, the Chinese government’s efforts to

promote good corporate governance have

largely been focusing on making the disciplin-

ary function of the stock market operational

and introducing other market-based gover-

nance measures.7

On the other hand, the government seems

not to be very interested in tightening up legal

sanctions, in spite of the widespread mis-

appropriation and fraud.8The lacunae in legis-

lation against misappropriation and fraud

remain and there is no discussion about the

need to increase the extraordinarily lenient

criminal punishment and administrative

penalties. Even the feeble legislationthat exists

is not properly enforced and both criminal

prosecutions and administrative actions are

sporadic. As far as private actions are con-

cerned, the government is extremely cautious

and the conditions imposed by the govern-

ment for shareholders to bring derivative

actions or securities litigation are inhibitive.As

a result, deterrence from shareholder actions

essentially does not exist.

Is this the right policy to address the

problem of poor corporate governance in

China? Will the market-orientated efforts bear

the kind of signif‌icant results sought by the

government? Can market mechanisms func-

tion properly where deterrence from legal

sanctions is intrinsically weak? To answer

these questions, it would be helpful to

re-assess the validity of the theories from the

West which advocate the usefulness of market

mechanisms for good corporate governance9

and to ascertain whether they are applicable in

China, because no doubt the Chinese govern-

ment in formulating its policy is heavily

inf‌luenced by those theories and corporate

governance practicesfrom the West. In particu-

lar, the unbalanced efforts of the government

have a clear correspondence with the theory

which favours markets over legal liability. To

assess the validity of the theories, this paper

in turn undertakes a re-examination of the

working mechanics for market mechanisms

to ensure good corporate governance, which

is the basis upon which the theories are

constructed.

The f‌inding of this paper is that the value of

markets and market-based corporate gover-

nance mechanisms may have been oversold.

They are incapable of disciplining such mana-

gerial misbehaviour as one-off duty-of-loyalty

violations. Even their ability to discipline man-

agers from shirking or duty-of-care violations

is conditioned by the fact that managers

are not amenable to one-off duty-of-loyalty

violations. On the contrary, suff‌icient legal

deterrence is fundamental to good corporate

governance. Suff‌icient legal deterrence is the

only effective way to keep control of one-off

or fraudulent managerial misappropriation

which is highly detrimental to the success of a

company. In addition, by deterring such mis-

behaviour, it also provides for the condition

upon which market mechanisms may function

properly to discipline managerial shirking.

Current experience of corporate governancein

China conf‌irms this f‌inding.

This paper is arranged as follows. The next

section provides some background informa-

tion about the legal framework and practice

of corporate governanceand the recent market-

orientated reform. Applying the law and eco-

nomics approach the working mechanics of

markets and market-based mechanisms are

then analysed and the relationship between

legal sanctions and market mechanisms exam-

ined. This is followed by a section discussing

the currently poor situation of corporate gover-

nance and the inadequate legal deterrence in

China. A brief comment is then made on the

debate as to whether law matters in corporate

governance. Finally, a conclusion is drawn.

Legal deterrence in this paper indicates the

disincentive resulting from legal sanctions.

Legal sanctions take the form of criminal pun-

742 CORPORATE GOVERNANCE

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Journal compilation © BlackwellPublishing Ltd. 2007