Ownership structure, corporate governance, and corporate performance : the case of Chinese stock companies

_WPS 4lq POLICY RESEARCH WORKING PAPER 1794 Ownership Structure, - - Does the ownership structure of publicly listed firms in Corporate Governance, China affect their and CoPerformance performance? Yes. anctorp orate rerrormance Institutionalsharehders seem to have a positive The Case of Chinese Stock impact on corporate Companies governance and performance; state ownership seems to lead to inefficiency; Xiaonian Xu and an overly dispersed Yan Wang ownership structure can create problems in the Chinese seting. The World Bank Economic Development Institute Office of the Director June 1997  I POLICY RESEARCH WORKING PAPER 1794 Summary findings Xu and Wang investigate whether ownership structure Republic, 42 percent in Germany, and 33 percent in significantly affects the performance of publicly listed Japan. firms in China and if so, in what way. Their empirical analysis shows that the mix and With public listed stocks, one can quantify the concentration of stock ownership do indeed significantly ownership mix and concentration, which makes it affect a company's performance: possible to study this issue. The authors use the recent * There is a positive, significant correlation between literature on the role of large institutional shareholders concentration of ownership and profitability. in corporate governance as a theoretical base. * The effect of concentrated ownership is greater with A typical listed stock company in China has a mixed companies dominated by institutions than with those ownership structure, with three predominant groups of dominated by the state. shareholders - the state, legal persons (institutions), and * The firms' profitability is positively correlated with individuals - each holding about 30 percent of the the fraction of legal person (institutional) shares; it is stock. (Employees and foreign investors together hold either negatively correlated or uncorrelated with the less than 10 percent.) fraction of state shares and with tradable A-shares held Ownership is heavily concentrated: the five largest mostly by individuals. shareholders accounted for 58 percent of outstanding * Labor productivity tends to decline as the shares in 1995, compared with 57.8 percent in the Czech proportion of state shares increases. This paper - a product of the Office of the Director, Economic Development Institute - is part of a larger effort in the Bank to understand and disseminate various models of corporate governance. The study was funded by the Bank's Research Support Budget under the research project "Ownership Structure, Corporate Governance, and Firm's Performance" (RPO 681-08). Copies of this paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Joyce Chinsen, room G5-031, telephone 202-473-4022, fax 202-522-1714, Internet address jchinsen@worldbank.org. June 1997. (54 pages) The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Produced by the Policy Research Dissemination Center  Ownership Structure, Corporate Governance, and Corporate Performance The Case of Chinese Stock Companies Xiaonian Xu Yan Wang* *Assistant professor, Amherst College, and economist, Economic Development Institute, World Bank. The authors are grateful for valuable comments and suggestions by Harry Broadman, Stijn Claessens, David Ellerman, Anjali Kumar, Vikram Nehru, Richard Newfarmer, Mike Walton, and other participants of a workshop held at the China and Mongolia Department, World Bank, and the financial support provided by the Bank's Research Committee.   Table of Contents I. Introduction and Summary 1.1. Objectives of the Research 1.2. Summary of Results 1.3. A Literature Survey II. Ownership Structure and Firms' Performance: A Descriptive Discussion 2.1. The Emergence of Stock Companies and Stock Market 2.2. Definitions of the Different Types of Shares 2.3. Organizational Structure and the Process of Incorporatization 2.4. Composition of the Board and the Supervisory Committee 2.5. Shareholders' Behavior and Corporate Governance III. Ownership Structure and Firms' Performance: Empirical Evidence 3.1. Data Description and Definitions of Variables 3.2. Ownership Concentration and Firms' Performance 3.3. Ownership Mix and Firms' Performnance 3.4. More on the Role of Legal Person Shareholders 3.5. The Inefficiency of State Ownership IV. Conclusions References Tables Annex A. A Comparative Study of Corporate Governance A.1. The Anglo-American Model vs the German-Japanese Model A.2. Increased Ownership Concentration Over Time A.3. The Need and Causes for Ownership Concentration A.4. The Experience of East European Transition Economies Annex Tables  I  I. Introduction and Summary 1.1. Objectives of the Paper Restructuring the state-owned enterprises (SOEs) has been considered as the key to the success of China's economic reform in the next decade. Two competing approaches have been proposed: the market approach and the ownership approach. The first approach is based upon a believe that if the markets for products, for factors of production, and for corporate control are created and function well, efficiency improvements of SOEs can be achieved without dramatic changes in ownership. Proponents of the second approach argue that private ownership is a necessary condition for enterprise efficiency. Reflecting the two alternative views, China has adopted a reform strategy that gives priorities to fostering markets and nurturing institutional changes, while in Russia and Eastern Europe radical ownership reforms were put in place at the early stage of reforms. This paper investigates whether ownership structure has significant effects on the performance of publicly-listed companies in China, and in what ways if it does. Publicly-listed stock companies provide a unique opportunity for the study of this issue since they allow us to quantify the ownership mix and concentration. Over 500 companies were listed on the two national stock exchanges at the-end of 1996. These companies are typically owned by five groups of agents: the state, legal persons (institutions), tradable A-share holders (mostly, individuals), employees, and foreign investors. The first three groups are the main shareholders, controlling roughly 30% of the outstanding shares each. Employees of the companies and foreign investors together hold less than 10%. The ownership concentration is high with the five largest shareholders accounting for 58 percent of the outstanding shares in 1995, compared to 57.8 percent in Czech Republic, 42 percent in Germany and 33 percent in Japan. ,Publicly-listed companies, however, represent only a small subset of China's enterprises- -a clean and perhaps better performed group of enterprises which were chosen to be listed on the two stock exchanges. These companies started more or less on an equal basis, since they undertook the same restructuring process required by China's Securities Regulatory Commission (CSRC) before their initial public offering (IPO). Accounting systems are converted to international standards, and the information disclosure has to meet CSRC's requirements. These companies enjoy a similar degree of autonomy as to what to produce and what prices to charge. Clearly, they are not representative of all enterprises in China, state or nonstate. (For broader studies see World Bank, 1996 and Broadman 1995.) In other words, our empirical study suffers unavoidably from a sample selection bias. Therefore, the results of our analysis need to be treated with caution and they apply only to large and medium sized corporations. We make no attempt to compare this group with, and to apply these results to, all state-owned enterprises. We begin with a descriptive analysis of the stock companies, the ownership structure, the internal organization, corporate governance, and the behavior of shareholders. Note that the meaning of ownership structure is two-fold in this paper: ownership concentration and ownership mix. We will then compare the performance of firms with different degree of ownership concentration as well as different types of shareholders. For these purposes, we introduce three accounting ratios, the market-to-book value ratio (MBR), return on equity (ROE), and return on asset (ROA), to measure firms' performance or profitability. The performance variables are then regressed on two concentration ratios and three ownership fractions, respectively. By examining the performance of the listed companies in the period of 1993 to 1995, we expect to find out, 3  * whether and in what pattern ownership structure affects the performance of stock companies. For example, does the degree of ownership concentration matter? Is the firm's performance negatively correlated with the proportion of state shares? Or, do individual shareholders monitor the management closely? What about legal person owners? * through what channels do shareholders influence the management and consequently the firm's performance? 1.2 Summary of Results Results from our empirical analysis show that ownership structure (both the mix and the concentration) indeed has significant effects on the performance of the stock companies. First, there is a positive correlation between performance and ownership concentration. Second, the effect of ownership concentration is stronger for companies dominated by legal person shareholders than for those dominated by the state. Third, firms' performance is positively and significantly correlated with the fraction of legal person shares, but it is either negatively correlated or uncorrelated with the fractions of state shares and tradable A-shares mostly held by individuals. Last, we find that labor productivity tends to decline as the proportion of state shares increases. These findings suggest that small individual shareholders in China do not monitor the management well, probably because of the free-rider problem (Grossman and Hart, 1980). Large legal person (institution) shareholders, on the other hand, appear to have played a positive role in corporate governance, which is consistent with the theory of Shleifer and Vishny (1986). The coefficients for the fraction of state shares are negative and significant, indicating that the state ownership does not help improve firms' performance. Parallel to the empirical study, we present evidence in the descriptive discussions to show that legal person owners can monitor the management effectively through their control over the board of directors, over the selection of corporate officers and the compensation of chief corporate officers. We argue that an active takeover market, which does not exist in China, is not likely to the mechanism for shareholders to discipline the management. In contrast, in most state-controlled companies, board members and top managers are appointed by the local government and the local organization of the ruling party. In addition, the state has set the goal as "preserving and increasing the value of state assets." The goal is unfortunately not quite the same as value maximizing of the firm. As will be seen below, the state often takes activities that are value-decreasing for the firm. These findings, largely consistent with previous studies, suggest the importance of large institutional shareholders in corporate governance and performance, the inefficiency of state ownership, and potential problems in an overly dispersed ownership structure. Comparative studies (in Annex) show that in OECD countries ownership and control rights are increasingly concentrated in the hands of financial and nonfinancial institutions. The driving force behind this trend seems to be related to the benefit of ownership concentration as a direct measure of corporate control, since concentration provides the investors with both the incentive and the power to monitor and control the management. The theme of this paper echoes some recent studies on large sharelholders' activism in industrial countries, particularly, in the U.S. We survey these studies along with others in the next subsection. 4  1.3. A Literature Sturvey Empirical studies so far have presented mixed results related to the debate on the market versus ownership approaches. For the Chinese economy, Groves et al (1994) survey 800 SOEs for an assessment of China's partial reforms. It is found that profit retention, performance-based bonuses, and management contracts have increased productivity of the SOEs. In a separate study, the authors present evidence from the same sample to show that the forming of the market for managers has contributes to gains in output per work and total factor productivity (TFP) [Groves et al (1995)]. Earlier, Jefferson et al (1992) report an average TFP growth of 2.4% for SOEs over the 1984-1987 period. In contrast, superior performance of town-and-village enterprises (TVEs) over SOEs and much faster growth of the private sector are frequently cited as in favor of the ownership approach. Svejnar (1990), for example, find that TVEs had an annual TFP growth of 13% in the 1981-1986 period, 5 times as high as that of SOEs in the study of Jefferson et al. Later, Woo et al (1994) raise the question about how successful the partial reform of Chinese SOEs has been. Taking into account changes in prices of inputs and outputs, they find that TFP growth in SOEs is zero at best in the 1984-1988 period, but positive TFP growth in collectively owned enterprises including TVEs. With respect to the US economy, results are also mixed. Demsetz and Lehn (1985) find no significant correlation between ownership concentration and accounting profit rates for 511 large corporations. Morck et al (1988) report a piecewise linear relationship of Tobin's Q with board member ownership for 371 Fortune 500 firms.1 Holderness and Sheehan (1988) analyze 114 NYSE- or AMEX-listed corporations in which a majority shareholder owns at least 50.1% of the common stock. Tobin's Q is higher if the majority owners are corporations, while Tobin's Q as well as the accounting profit rates are significantly lower for firms with individual majority owners., McConnell and Servaes (1990) find for a sample of more than 1,000 firms that Tobin's Q is positively correlated with the fraction of shares owned by institutional investors. These studies along with others seem to suggest: (i) There is a positive correlation between share holdings of large investors and firms' performance; and (ii) institutional investors appear to be more effective in monitoring firms' performance than individual shareholders. Theoretically, both of the schools can find their roots in the literature. Fama (1980), for example, argues that if a firm is viewed as a set of contracts, ownership of the firm is an irrelevant concept. A properly-functioned managerial labor market may discipline managers and solve incentive problems caused by the separation between ownership and control. Hart (1983) points out that competition in the product market reduces managerial slack, and thus provides another disciplinary mechanism. Jensen and Ruback (1983) emphasize the role of the market for corporate control. Martin and McConnell (1991) find that the takeover market has restricted non-value maximizing behavior of top corporate managers. On the other hand, economists argue that ownership matters because it affects at least to some extent the working of the markets. For I Tobin's Q is in general defined as the ratio of the market value to the replacement value of the firm, which can be measured as the market value of equity and debts over replacement value of net fixed assets and inventory. In this particular study, Q increases as board ownership rises from zero to 5%, but decreases over the range of 5% to 25%, and increases again for companies with board ownership over 25%. 5  instance, Grossman and Hart (1980) show that if a firm's ownership is widely dispersed, no shareholder has adequate incentives to monitor the management closely as the gain from a takeover for any individual shareholder is too small to cover the monitoring cost. Shleifer and Vishny (1986) develops a model to demonstrate that a certain degree of ownership concentration is desired in order for the takeover market to work more effectively. Being able to capture a chunk of the gains from watching the management, large shareholders supply monitoring at levels that would be otherwise impossible to reach in diffusely-held firms. Holmstrom and Tirole (1993) show that under certain conditions, managers' optimal incentive contracts will always include stocks (Proposition 2). Zou (1992) constructs two conceptual firms that are otherwise identical except one with absentee ownership and the other with cooperative ownership. He proves that even if firms are viewed as a nexus of complete contracts, the ownership structure matters as the cooperative firm can achieve first-best production efficiency, while the other cannot. The studies by Grossman and Hart and by Shleifer and Vishny are particularly important because they provide the theoretical foundation for this paper. In their models, the governance mechanism is outsider takeover, while in China direct control by large stakeholders seems to be the means for shareholders to discipline the management. Despite the difference, the public good nature of shareholders' monitoring remains unchanged, and hence the same arguments apply to the Chinese case. II. Ownership Structure and Performance: A Descriptive Discussion 2. 1. The Emergence of Stock Companies and Stock Market3 Stock companies and stock markets did not exist until the late 1980s when the Chinese government decided to restructure the industrial sector then dominated by SOEs. A department store in Beijing was given permission for issuing shares in 1984, the very first time since the founding of the People's Republic in 1949. Shareholders were confined, however, solely to the employees of the store. A more direct cause of this bold step was the heavy losses incurred by SOEs. In the following few years, more SOEs were "incorporated" through selling shares to their own employees or other stock companies and SOEs. New joint stock companies were organized in a similar way. Stock trading was also prohibited and low liquidity of stocks made it difficult for the companies to market their initial offerings. Consequently, curb markets emerged in several large cities. To end the chaotic black-market trading, the State Council decided in 1989 to establish two national stock exchanges. The Shanghai Stock Exchange (SHSE) was inaugurated in December of 1990, and the Shenzhen Stock Exchange (SZSE) opened in April, 1991. The number of listed companies, trading volume, and total market capitalization has increased drastically since the opening of the two exchanges. The total number of firms listed increased from 183 in 1993 to 323 in 1995 and over 500 in 1996. Total market capitalization reached US$42.1 billion as of December 1995 (IFC 1996 and Table 2.1), or 6 percent of China's 2Admati et al (1994) show, on the other hand, that while concentrated ownership promotes monitoring, it decreases risk-sharing gains which are usually realized with more dispersed ownership. 3See the World Bank (1995) for a more detailed survey. 6  GDP (declined from 8 percent in 1994). Readers should not be misled by the figures, however, when estimating the size of the Chinese stock market. Shares are classified as domestic (A- shares) and foreign (B-, H-, N-, shares) by holders' residency. There are four subcategories of A- shares: the state shares, the legal person shares, the employee shares, and the tradable A-shares mostly held by individuals. Only the A-shares held by individual and B-shares held by foreigners are traded in the open market. We clarify these definitions below. 2.2. Definitions of Different Types of Shares The state shares are those held by the central government, local governments, or solely- government-owned enterprises. It is recently declared that the ultimate owner of state shares is the State Council of China. State shares are not allowed for trading at the two exchanges, but transferable to domestic institutions, upon approval of CSRC. In many of the publicly-traded corporations, the state is the largest or majority shareholder. The state has a controlling interest in 66 (50) of 189 (168) SHSE-listed firms in 1995 (1994), and in 30 (28) of 137 (116) SZSE- listed firms. The legal person shares are shares owned by domestic institutions.4 A legal person in China is defined as a non-individual legal entity or institution. In official documents, domestic institutions include stock companies, non-bank financial institutions,5 and SOEs that have at least one non-state owners. Securities firms, trust & investment companies, finance companies, and mutual funds are major non-bank financial institutions. There is a sub-category called "state-owned legal person shares." It refers to shares held by institutions in which the state is the majority owner but has less than 100% shareholding.6 Like state shares, legal person shares are not tradable at the two exchanges, but can be transferred to domestic institutions upon approval from the CSRC. Sales of legal person shares to foreign investors had been allowed until it was suspended in May 1996. In 1995 (1994), 46 (41) SHSE-listed companies had legal person shareholders holding more than 50% of outstanding shares, and the same figure is 34 (37) at the SZSE. The tradable A-shares are held and traded mostly by individuals and some by domestic institutions. There is no restriction on the number of shares traded, nor on holding periods. It is required, however, tradable A-shares should account for no less than 25% of total outstanding shares when a company makes its IPO. These shares are the only type of equity that are traded among domestic investors at the two exchanges. The volumes reported in Table 2.1 are thus due entirely to trading of tradable A-shares mostly held by individuals. 4The legal person shares studied in this paper should be carefully distinguished from the legal person shares traded on two automated price quotation systems in Beijing: STAQ (Stock Trading Automated Quotation System) and NETS (National Exchange and Trading System). 17 companies are listed on STAQ and NETS. Companies once listed on STAQ and NETS cannot be considered for listing on the SHSE or SZSE, and vise versa. In other words, cross-listing is not permitted. 5Taking the Glass-Steagall Act of the US as a model, The Commercial Banking Law of China that came into effect in 1994 prohibits commercial banks from underwriting, holding and trading securities except for government bonds. 6 CSRC defines these shares as legal person shares, whereas the BSPM interprets them as state shares. We adopt CSRC's definition in this paper. 7  The employee shares are offered to workers and managers of a listed company, usually at a substantial discount. These share offerings are designed more like a benefit to employees than as an incentive scheme. Employee shares are registered under the title of the labor union of the company which also represents shareholding employees to exercise their rights. After a holding period of 6 to 12 nionths, the company may file with CSRC for allowing its employees to sell the shares in the open market. Only 10 (12) SHSE companies have employee owners in 1995 (1994), and the number is 121 (105) companies at the SZSE. B-shares are available exclusively to foreign investors and some authorized domestic securities firms. The B-share market is separated from the A-share market, with SHSE B-shares denominated in US dollar and SZSE B-shares in Hong Kong dollar. H-shares are the same as B-shares except that they are issued and traded at the Hong Kong Stock Exchange. Finally, N- shares are listed on the NYSE, either through IPOs or as ADRs. At the SHSE, 46 (37) companies have offered B-share or a combination of the three foreign shares, and 34 (22) at the SZSE in 1995 (1994). In theory, all the shares entitle shareholders the same dividends and voting rights. In practice, it is not uncommon that a company pays its state owner cash dividends, but offers individual and legal person shareholders stock dividends and rights offerings. This is because new shares acquired by the stati cannot be traded either in the open market. For liquidity reasons, the state prefers cash dividends to stock dividends or rights offerings, and so do legal person owners. Regarding voting rights, tradable A-shareholders are in a disadvantageous position due to the lack of proxy voting procedures, which we will discuss later. A typical listed Chinese stock company has a mixed ownership structure with the state, legal persons, and domestic individual investors as the three predominant groups of shareholders. Each of the three holds about 30% of total outstanding shares. Many listed companies do not issue employee and foreign shares. In those that do offer employee and foreign shares, they account less than 10% of total outstanding shares. Table 2.2 shows the average ownership mix of stock companies listed at the two exchanges, in which FST, FLP, FTA, FEM, and FBS represent the fractions of shares owned by the sate, legal persons, tradable A-share holders, employees and B-share holders, respectively. The proportion of state shares appears to have declined slightly from 1993 to 1995, and so does the proportion of legal person shares. The fraction of tradable A-shares seems to be on the rise. Note that all the ownership fractions have large standard deviations, indicating large variations of ownership structure across firms. On average, the state ownership is higher for SHSE-listed companies than those listed on the SZSE, while legal persons and individual shareholders seem to be more important at the SZSE. Employee ownership appears more popular in Shenzhen than in Shanghai. Table 2.3 reports ownership structure of listed companies in 1995 by sectors, namely, manufacturing, retailing, utility, real estate, and conglomerates as classified by the two stock exchanges. At the SHSE the state holds a large stake in manufacturing and utility companies, while legal persons as a group are the largest shareholder of the conglomerates. Tradable A- share holders are the dominant owner group only in the retailing industry with a average interest of 36.4%. At the SZSE, the state lost its dominant position in all industries to either legal persons as a group or tradable A-share investors as a group. The average proportion of legal person shares is greater in the retailing and utility industries than that of tradable A-shares. A- share holders are the most important group on average in the manufacturing and real estate industries as well as for the conglomerates. 8  To study the ownership distribution by firm size, we break down the samples according to the book value of the companies' total assets. The first bracket is for small firms with a book value of total assets lower than RMB 500 million. Firms with total assets between RMB 500 million and one billion fall into the second sub-sample, Medium (1). The third, Medium (2), goes from RMB one billion to 1.5 billion of total assets, and finally, those with total assets above RMB 1.5 billion are identified as large firms. For the SHSE-listed companies, the average fraction of state shares rises steadily with firm size, and exceeds 50% for large firms. This probably reflects an official stand that the state should remain in control of key industries and important firms. The pattern is less clear, however, among companies listed on the SZSE. In sum, there seems to be a tendency for the proportion of state shares to fall over time and the fraction of tradable A-shares to rise. The primary cause of the shift in relative importance of different shareholders may have been that the state prefers cash dividends to stock dividends or rights offerings as dividends. Second, the state has a larger presence, and a stronger influence, in companies listed at the SHSE, than those listed at the SZSE. We now turn to examine the intemal organization of the stock companies and the process of incorporatization. We argue that direct control over the management by the board is the main mechanism for shareholders to protect their interests in the Chinese stock companies. 2.3. Organizational Structure and the Process of Incorporatization The organizational structure of a typical industrial stock company is demonstrated in Figure 2.1. On the top are shareholders. According to China's corporate law, shareholders meet at least once a year at either the annual conference or special shareholder conferences.7 At the annual conferences, shareholders a vote on the company's operating strategy, investment plan, and other important issues such as changes in registered capital, debt issuance, mergers, dissolution and liquidation of the company, and amendments to the company's bylaw. * elect members of the board and the supervisory committee, and determine the members' compensations. * review and approve the annual reports by the board and the supervisory committee, dividend policy, and the budget for the next year. The board of directors is the decision-making body of China's stock companies. The size of the board ranges from 5 to 20, and it is responsible for8 * calling and hosting the annual or special shareholder conferences, and reporting to shareholders. * executing resolutions passed by shareholders. * making up the company's operating and investment plans, dividend policies, and debt and equity financing plans. * making proposals of merge, separation, and dissolution of the company. 7A special shareholder conference may be called when (I) the number of board members attending the annual conference of shareholders is less than what the bylaw requires; (2) the company has a loss exceeding one third of its owners' equity; (3) requested by owners with more than 10% of the company's outstanding shares; (4) requested by the board of directors; and (5) requested by the supervisory committee. The Corporate Law of China, Provision 104. gThe Corporate Law of China, Provision 112. 9  * determining the company's internal organizational setup, rules and regulations. * appointing or replacing top managers; approving nominations of vice general managers and CFO by the general manager; setting their compensations. Figure 2.1. Organizational Structure of a Typical Industrial Stock Company Shareholders Board of Directors . Supervisory Committee General Manager CGMI VGM2 ... CFO CEN DEPTs DEPTs DEPTs~~ DEPTsl Factories Subsidiaries VGM: Vice general manager. CEN: Chief engineer. CE: Chief economist. In comparison, the supervisory committee plays a fairly passive role in corporate governance. It carries out the following duties.9 * overseeing financial operations of the company. * watching board members and managers for violations of the company's bylaw. * correcting decisions by board members and managers if they hurt the interest of shareholders. * calling special shareholder meetings. * supervising board meetings. The general manager and vice general managers (VGM) are in charge of the company's daily operations. Each vice general manger has a couple of departments in closely-related operations reporting to him. The CFO is always the head of the accounting and financing department. The chief engineer (CEN) is usually the director of the R&D department and the department of quality control. In most of Chinese stock companies, VGMs, CFO, and CEN are board members, but few are on the supervisory committee. Putting general managers of 9 Ile Corporate Law of China, Provision 126. 10  factories and subsidiaries on the board is also a common practice. Chief economist is considered a less important position, as an advisor to the general manager. The board of directors is the most important organization in a firm controlling the selection of top managers and their compensations. Shareholder must control the board in order to protect their interest in the firm. The selection of the board and supervisory committee members becomes critical in the forming of new stock companies, which depends to a great extent upon the founders' administrative affiliation and their ownership before going public. The firm's former affiliation also affects the composition of the board and supervisory committee (see below). China's stock companies are either created by transformning SOEs, or launched by a group of legal persons, and sometimes by individuals. We now explain how these are done. Incorporat&zation of a SOE. The State Planning Commission (SPC) and CSRC together determine how many shares in total shouldbe issued each year, e.g., S billion for 1995. The 5 billion "total quota" is then broken down and allocated among provinces and mega-cities such as Beijing, Shanghai and Tianjin. If a SOE wants to be listed, it has to obtain an approval from the local government, the State Economic and Trade Commission, the State Commission of Economic Restructuring, and CSRC. Once the SOE has the permission with a quota of total shares to be issued, it begins a reorganization. The first step is to separate non-productive assets such as schools and hospitals from productive ones. Productive assets account for 50 to 75% of total assets of the to-be-listed stock company, while non-productive assets is left with the SOE. All retired workers also remain on the SOE's payroll. An accounting firm is then hired to audit financial statements of the SOE for the last three years and the separated productive assets. In the meantime, managers of the SOE contact other enterprises and institutions to see if they are willing to be legal person co-founders'o of the stock company. The SOE also talks intensively with the local government and party officials for candidates of managers, the board and supervisory committee members. 80 percent of such firms ends up with the arrangement where the original managers and party officials of the SOEs keep the key positions of the board and supervisory committee in the new stock company. No real restructuring is done, and board members and officers are almost exclusively insiders. The nominations must be confirmed at the first shareholder meeting. The confirmation is nearly guaranteed since the state will have a majority holding of the company. After the SOE receives an approval of the appointments from its administrative supervisor and the local personnel department of the party, the SOE finds a group of securities firms as underwriters. On the day of IPO, at least 25% of total shares are sold to the public, whereas shares classified as state or legal person owned are kept in vault and cannot be traded. After the IPO, the original SOE either disappear or becomes the majority holder of the stock company. In the former case, the local office of the Bureau of State Property Management (a central government agency, BSPM hereafter) acts as the largest shareholder of the listed company if the SOE was owned by the central government or its agencies before the IPO. Otherwise, the local finance bureau, or a local government-run holding company plays the role of the largest shareholder. The incorporatization of SOEs in China is thus being viewed as "nothing different but the logo" or "new bottles with the old wine." I