The ten largest Chinese companies trading in the U.S. rate poorly when it comes to corporate governance, according to a recent report published by a consultancy that specializes in corporate governance issues.

“The interesting thing was how uniformly poor they were,” says Victor Germack, founder and president of Rate Financials, the company that conducted the survey. “The average was pretty low.”

In the report, Rate Financials looked at the ten largest Chinese companies on the New York Stock Exchange by market capitalization. The largest was PetroChina. Also included on the list were China Mobile, China Telecom, China Life Insurance, and Huaneng Power. The total market cap of the list is approximately $750 billion.

Overall, companies on the list received an average rating of 0.5 stars for corporate governance, with five being the highest rating and three being average. Five companies received “0” ratings for corporate governance.

The problem, according to the report and explained in more detail by Germack, are the loopholes in NYSE corporate governance rules and the structure of Chinese companies. A “foreign private issuer,” a company that’s based outside the U.S., is permitted to follow its home country corporate governance rules. The New York market requires that the majority of the members of a corporate board are independent, but that is not the case in China, so Chinese companies listed on the NYSE are allowed to stack the board with inside directors.

As well, a “controlled company,” one more than 50% owned by one party, is also permitted to ignore certain listing standards, the most relevant here being the requirement for independent board members. All the companies in the report, and indeed most large Chinese companies, are majority controlled by the government.

Rate Financials says that the lack of strong outside oversight can lead to significant problems when it comes to transfer pricing, related-party transactions, intergroup guarantees, tax rates, and the valuation of contingent liabilities. The close relationship between companies and the government and the pervasive nature of these relationships is cause for concern, the consultancy argues. The government can potentially exert considerable pressure on the companies, at the expense of the shareholders, while at the same time the top executives, often appointed by the government and moved between competitors, may make decisions in a way that would be opposed by an independent board.

“In China,” says Germack, “the government is basically the majority shareholder and moves executives around from company to company in their respective industries. It divides up the market and decides whether there is too much competition or too little competition.”

Ultimately, these large companies are instruments of state policy. The shareholders are little more than sources of capital. The interests of the shareholders and the government can indeed be aligned, and very often they are. Beijing benefits when the stock prices of companies it controls do well. It wants to profit just as any shareholder would. But this is not always the case and the potential certainly exists for abuse. Germack wonders why this situation is allowed to continue. If anything, the minority shareholders in Chinese companies are due extra protection given the nature of the government’s shareholdings.

“There is more than one financial system in the world,” he adds. “If you want to attract capital to the U.S., you have to recognize certain variations in practice.”

— Frank Adams,

Partner,

Dewey & Leboeuf

“All these companies are controlled by the government,” he says. “Don’t you think the rules of the NYSE should apply more to them to protect the rights of minority investors? It seems counterintuitive.”

Not everyone agrees. Indeed, the Rate Financial report has its share of critics. Many defend the right of foreign companies to use their own home market corporate governance rules, particularly if allowing for these loopholes will attract more capital and corporations to the U.S. The argument is that we do not have a monopoly on good corporate governance and by insisting that it’s our way or the highway, we could force more companies to list in Europe and elsewhere.

Adams

“The exemptions they are encouraging the exchange to abandon were put in there for a good reason,” says Frank Adams, a partner at Dewey & LeBoeuf, of the Rate Financials report. “You can’t argue against greater transparency, but you have to be careful what you wish for. If the exchange were to make those changes, it would be very difficult for non-U.S. companies to be listed in New York.”

“There is more than one financial system in the world,” he adds. “If you want to attract capital to the U.S., you have to recognize certain variations in practice. Exceptions for foreign private issuers make sense. A one-size-fits-all doesn’t really suit the markets that well.”

Others are even more critical. Paul Lapides, a professor at Kennesaw State University, and director of the Corporate Governance Center there, has been active in advising Chinese government officials and corporations on corporate governance. He says that when they visit for training, they put up a good fight, saying that corporate governance in China and the U.S. are not particularly different. They claim that boards in the U.S. really are not all that independent—that there are significantly strong relations between the managers of a company and the directors.

“Ultimately, people will look at performance,” Lapides says. “They would much rather have performance than a board that looks really good. Boards don’t make companies, executives do. Boards don’t make the difference they would like to think they make.”

Lapides

“Institutional investors have a duty to look at best practices. Ignoring governance would be a violation of their fiduciary duty,” he adds, then getting slightly philosophical. “The question is, do we know enough about governance?”

Chinese companies put pensions and other large institutional investors in a rather difficult position. These large pools of capital are compelled in meeting their obligations to invest in companies whose share prices are rising as fast as those in China. They are also prevented from investing in companies with particularly bad corporate governance practices. Laws, regulations, and best practices both push them to invest in Chinese companies and argue for them to stay away from these very same companies.

In the end, some say, bad corporate governance is like any other piece of negative information known to the investor. There may be a problem, but if it is disclosed, a reasonable decision can be made based on the facts. It’s up to the investor to decide just how big a problem weak corporate governance is to them.

Elson

“The buyer is aware of it,” says Charles Elson, a professor at the University of Delaware and corporate governance expert. “They know what they are getting when they buy a Chinese company. The governance of the company is controlled by the communist party.”