Bonding, Law Enforcement and Corporate Governance in China
Cai, Hua, Stanford Journal of Law, Business & Finance
Protection of minority shareholders is crucial to developing a strong capital market. Yet, formal legal enforcement is one, but not the only effective mechanism to offer this protection. When a country's formal legal enforcement is weak, to attract investment, entrepreneurs have incentives to develop functional alternatives to assure minority shareholders' interests are protected, and, as such, entrepreneurs may voluntarily "bond" themselves. China's experience provides many examples of company-initiated "bonding" practices. Among the various bonding mechanisms that have been utilized, diversifying the ownership structure and cross-listing have been the most effective. As such, improving corporate governance in China is not only a question of improving the quality of legal enforcement mechanisms, but also a challenge of finding ways to encourage, facilitate, and support voluntary bonding practices. In this article, three polices are proposed to improve corporate governance, with the common theme of facilitating voluntary bonding practice. First, companies who are willing to bond themselves and improve their corporate governance should be encouraged to cross-list their stock overseas and voluntarily subject themselves to higher disclosure standards and more stringent legal liability. Second, China should facilitate competition between exchanges within its jurisdiction and allow more non-state-owned enterprises to go public. Finally, the corporate law in China should follow the self-enforcing model, where private enforcement is emphasized and encouraged.
Conventional wisdom indicates that a strong capital market cannot be created in the absence of the effective protection of minority shareholders.1 However, must this protection come only from official law enforcement? Can parties in a transaction develop non-legal means to ensure that minority shareholders' interests will not be expropriated? These remain unsettled and challenging questions; this article will explore them in the context of China. If formal law enforcement in China remains weak, can companies in China develop non-legal means to ensure good corporate governance with dispersed public shareholders?
Although effective legal enforcement probably is the "best practice" to protect minority shareholders' interests, when this is lacking, controlling shareholders and managers of a company still may arrange to protect minority shareholders by voluntarily "bonding"2 themselves so as to produce a better outcome for both investors and themselves. Therefore, the fact that China has yet to develop a robust and efficient stock market probably does not stem solely from China's lacks of effective law enforcement; rather, the inquiry should also be focused on how to encourage, facilitate and support the controlling shareholders and managers of companies to voluntarily bond themselves and reduce agency costs. It is possible for China to develop non-legal mechanisms that would, to a certain degree, substitute for and complement formal law enforcement to ensure good corporate governance.
This paper consists of six sections. Section I is an overview of China's stock market and its fundamental problems. Section II will use the Jensen-Meckling model and game theory framework to discuss, in principle, how it is possible to develop good corporate governance with dispersed public shareholders through market mechanisms without reliance on formal law enforcement. Section III will discuss the extent to which current bonding practice has improved the corporate governance of Chinese companies. Section IV will discuss the weaknesses and challenges of relying on voluntary bonding practice. Section V will offer policy recommendations, followed by conclusions in Section VI.
I. Overview of China's Stock Market and its Fundamental Problems
On February 28, 2007, the Shanghai Stock Exchange Composite Index, the benchmark index for China's stock market, unexpectedly dropped 8. …