Mystery of CCB scandal

Sabotage by hardliners could be as much the problem as poor corporate governance.

At first glance, blatant corporate governance abuses would seem to be behind the recent spate of banking scandals in China.

Slack supervision and insider collusion has led to some spectacular cases: In the past few months alone, it appears that Rmb 30 million ($4 million) was stolen in Beijing from Bank of China (BOC), Rmb 33 million from China Construction Bank (CCB) by a humble typist in Harbin, and Rmb 115 million from Agricultural Bank of China (ABC) in North China, not to mention another Rmb 50 million stolen from BOC in Dalian.

The latest scandal involves the alleged corruption of CCB chairman Zhang Enzhao. In terms of the high rank of the participant that makes it the most serious scandal since chairman Wang Xuebing was fired from the same bank in January 2002.

The facts of the case are familiar by now. In a court case filed last December n California, Zhang is accused of taking $1 million in bribes from a US company Alltel Information Services, since purchase by Fidelity National Financial. The incident is alleged to have taken place in mid 2003 in relation to restructuring IT system contracts with CCB. The restructuring allegedly enabled AIS to cut out the plaintiff (mainland company Grace Digital Information Technology), which as the original middle man appointed in 2001, was set to collect almost $60 million in commission for setting up the CCB deal with Alltel.

The story highlights a crucial aspect common to all Chinese companies, namely the way the chairman acts as a magnet for businessmen willing to countenance under the table payments. That is essentially due to the immense power concentrated in the chairman's position, which until the recent shareholding reform initiative, also incorporated the position of president, the equivalent of a CEO in the West.

Throw in a third title, that of head of the Party structure (Party secretary) within the company and it is easy to see why the chairman can act with such impunity: By crossing the chairman, directors risk opening themselves up to the accusation that they are also crossing the Party.

Opposing the Party (along with opposing the Country and the People) is equivalent to treason in China, and the penalties for such transgressions are harsh.

One lawyer in Shanghai tells of how when she was working on the acquisition of a mainland company by a foreign company, the chairman of the mainland company refused to hand over the company seals and resign.

The foreign buyer nevertheless wanted to go ahead with the deal, and solve the problem after the consideration had been paid.

"I advised him strongly not to go ahead, since in China the chairman is so powerful. With the seals and his signature making him the company's legal representative, he has a lot of power in terms of signing major contracts, for example," says Stella Leung, a partner at law firm O'Melveny and Myers' Shanghai office.

Leung adds that even in those few instances relating to major transactions (such as mergers and acquisitions, or changing the articles of association) when the chairman does need to be authorized by a board resolution, it is rare in China that this authorization be asked for.

Indeed, it would appear that a Chinese president is even more powerful than American CEOs - who, as their plundering of company coffers in the late 1990s shows, are plenty powerful enough.

The parallel with the US throws up some useful insights about what constitutes good corporate governance.

Shareholder rights activists have long complained about the excessive power of management at listed US corporations. With company share ownership diffused through thousands of large and small institutions and investors, it is difficult to keep managers in check.

Given the 'agency problem' in the US, combining leadership and shareholding might seem a solution, since it aligns the shareholder with the interests of the company.

That would imply Chinese SOEs are theoretically better able to provide corporate governance since they are majority-owned by a single shareholder, the government.

Since this is obviously not the case, the argument must be wrong.

Indeed, in developed economies, an important legal concept has arisen ensuring that the owner does not have unlimited authority to dispose of his company as he might dispose of his house or car, for example.

The owner must appoint a number of directors to stand between him and the company. Their responsibility is not to the owner, but the company as an independent legal entity. To this, they owe a fiduciary 'duty of care and loyalty'.

It is clearly important to establish that principle, because it is the bedrock of minority investor protection.

In China, however, it is difficult for managers of state-owned companies to understand that distinction. They are after all, civil servants, appointed by the government, and it is to the latter that their loyalty predominantly lies.

For most Chinese bank officials it is not surprising that the idea of a bank being an independent entity is still alien. Chinese banks for decades were, and still are in many ways, a vital part of the government's central control of the economy through the channeling of funds to favoured projects, individuals, companies and industries.

Given this instinct to conflate the company and the government, the fact that a traditional SOE chairman is so powerful is bad for the company.

However, some reforms to corporate governance have been made.

Thus, after Bank of China and China Construction Bank started restructuring, the function of president (the equivalent of CEO) and chairman were divided last year. Could this mean that Zhang Enzhao, in the restructured CCB, no longer had the same authority?

It is doubtful, because he kept the more powerful post of chairman of the board and Party secretary, with the presidency going to a colleague. The new president, Chang Zhenmning is another civil servant, although he is not a lifelong employee of CCB like Zhang.

Prior to his appointment at CCB in September 2004, Chang worked as vice president of Citic Industrial Bank, and most recently was responsible for financial services in Hong Kong. Prior to his appointment to CCB, he had been with Citic conglomerate for more than 20 years.

Similarly, the head of the supervisory committee has prior experience on the supervisory boards of China Life and China Reinsurance, although it is not clear whether he held executive posts at those two institutions.

Stoyan Tenev, an expert on China's private sector and corporate governance at the International Finance Corporation, told FinanceAsia that China needs a 'managerial market'. Otherwise, it is impossible to guarantee the appointment of senior staff in SOEs rewards the best candidate, as opposed to the most pliable civil servant, he says.

For example, there is no reason why Zhang Enzhao should have been kept on, since he was closely identified with the old CCB - a business model which observers agree was unsustainable, to put it politely.

Given the government owns all the companies and universities these cadres previously worked for, and given they are all Party members appointed by the Party to their present post, it is not likely they will aggressively check and balance each other.

That leaves a lot of responsibility on the independent directors. But the picture is not very bright here, since there are only two independent directors, one Tsinghua University professor and the Japanese CEO of Shinsei Bank.

It is difficult to see how a (government-appointed) academic and a foreign national could have any real impact on a group of senior Party cadres who have known each for years.

So how about other shareholders?

In the wake of its restructuring into a shareholding company, CCB does now have other shareholders, who were introduced when the government corporatized last year.

Might these check the power of the chairman?

The biggest of these is Huijin, a government investment vehicle, which took an 85% stake in CCB following a $22.5 billion capital injection into CCB in December 2003. The other four shareholders include: Changjiang Electric, China's biggest hydropower company; the State Grid Corporation of China and Baogang Steel. All are massive SOEs under close government control.

As extensions of the government, they are unlikely to react against the management's desire to please the government shareholder, even if the corporation suffers in the process.

Add to this concentration of power the pay structure of top officials, who get paid very low civil servants rates, and you have a recipe for a chairman looking to monetize his official position.

According to local sources, a top official like Zhang Enzhao would only be paid around Rmb 11,000 per month in net salary, rising to Rmb 30,000 with bonus and allowances thrown in, despite having enormous budgetary power. That combination of immense power and relatively low cash remuneration would make him an irresistible target for corruption.

So is it simply a question of poor corporate governance, with bank managers cast in the role of villains?

Not so fast, says some observers, who question the relatively small $1 million bribe, (a small amount by the standards of past corruption cases, for example the multi-billion smuggling operation in Fujian during the Jiang Zemin years), and the timing of the spate revelations. Indeed, although the government is quick to clamp down on corruption when it is done by players outside the system, such as entrepreneurs, it is slow to investigate, and even slower to pass sentence, on economic crimes committed by brother civil servants/Party members.

The theft of Rmb 320 million at the Jilin branch of CCB was discovered in April 2001, but the prime suspect was only arrested in 2004, for example.

The size and speed of banking scandal revelations has led some observers to speculate that it is not so much the bank managers who are holding up the reform process, as government insiders seeking to sabotage the listing process because they oppose the whole package of pro-market ideology.

Thus, it is these opponents who leaked damning insider information to Grace Digital, giving them the ammunition to take AIS to court about the way the contracts were changed, and to the Chinese media who first broke the story, some observers argue.

One senior Chinese banking executive explained to FinanceAsia that many officials are convinced that introducing market reforms to the domestic banking system, as mandated by the World Trade Organization, is not a good thing. In fact, they speculate that it will devastate the local banking industry. The Chinese banks will become small-time domestic players while all the high-end personal and corporate customers migrate to Citibank, HSBC and Standard Chartered.

Some of these officials believe the international IPO system is in effect a covert system of bribes by foreign players to weaken Chinese state banks, and hence the government itself.

Thus, once a local bank takes on board a strategic investor and/or sells its shares abroad, the bank's management will, in line with international norms, see a huge rise in their salaries - from the measly $1,500 per month currently paid to even the highest banking official, to ten times that.

That will give banking officials an incentive to transfer their loyalties to foreign shareholders and to Westerns ideas of efficiency. That makes the anti-reform officials worry how the government will obtain funds for developing China's backward provinces, and what will happen to the millions of bank employees who will be thrown out of work as unprofitable branches are shut.

Worse, not only will listing the bank eventually deprive the government of the unrivalled patronage opportunities offered by having control over the country's purse strings, the reform of the banking sector will eventually lead to the rise of private Chinese banks, further undermining Party and state control of the country.

In this scenario, Zhang Enzhao was denounced by officials angered that an 'unpatriotic' act such as selling one of the country's biggest banks to foreigners would result in a huge income rise.

Such a conspiracy theory might sound far fetched. But dissent in the government is surely quite likely, especially under the new and untried leadership of Hu Jintao.

Whether it is corporate government abuses or hardliners, these developments could show that the whole reform process is balanced on far more of a knife edge than most foreign investors would dream of.