Chapter 3: Corporate Governance, Accounting Procedures and Prevention of Insolvency

In a time of global financial crisis, bankruptcy prevention and corporate governance are at the forefront of the public consciousness, with a hypothesis that there is a fundamental link between these two concepts. A business failure is commonly accompanied by poor corporate governance within the organization. The failure to adopt an effective corporate governance model often leads to a sterile, inactive board of directors and may hasten a firm’s demise. Conversely, attention to corporate governance concerns can greatly benefit firms in staving off bankruptcy or in emerging from bankruptcy. 1 Board independence and equity ownership, along with the principle of good corporate governance, can create an environment in which management is effectively monitored and bankruptcy generally is avoided. 2 Following a recent spate of global corporate abuses such as Enron, WorldCom and Parlamat, China has experienced its own corporate governance scandals resulting in the destruction of investor confidence. The exposure to such Enron-like corporate collapses has acted as a global wake-up call for states to undertake corporate governance reforms within an urgent timescale. Enhancing investor confidence must be achieved through meaningful transparency, effective oversight and strong governance, while effective bankruptcy legislation may also be regarded as a cornerstone of good corporate governance. However if corporate governance is to realize its full potential any reforms must work effectively in combination with company law and other legislations.

This broader context to effective insolvency prevention will be considered in this chapter. The chapter will begin by defining ‘corporate governance’. Attention will be paid to differing approaches to ownership and board structure, since these matters provide an important context for the consideration of corporate governance issues. Another important contextual factor that one may note, as a direct result of the overwhelming dominance of state ownership in China, is a lack of independence among board directors. The introduction of the ‘independent director’ institution in China is intended to alleviate the weakness of the supervisory board and to hold the board accountable for the company’s interests. In addition, the problem of transparency, posing challenges to proper accounting procedures, calls for improvements to ensure accurate and timely disclosure of all material matters. China has recently enacted some new laws to commit itself to the values of accountability, transparency and responsible ownership. One of the fundamental aims of these reforms is to streamline corporate governance and accounting procedures in firms, so as to prevent financial difficulties which may result in insolvencies. It remains to be seen whether the EBL 2006 can efficiently assist in the maintenance of sound corporate governance, in combination with other relevant legislations.

Particular consideration must be given to the prevention of business failure in the context of bankruptcy, such as through reorganization and composition: see further Chapters 11 and 12. Since most state owned enterprises (SOES) are usually obliged to carry out public functions, China has made considerable efforts to rescue those problematic companies in the form of a new reorganization process and a compromise procedure: see further Chapter 15. The enterprise Bankruptcy Law of the People’s Republic of China (EBL 2006) 3 introduces a reorganization scheme similar to the United States Chapter 11, which allows some troubled companies to avoid bankruptcy and further to recover their businesses.

A paradoxical issue is to be highlighted, namely, how, through a sound corporate governance regime, such as through applying healthy accounting procedures, may China avoid needless bankruptcies, and how may the efficient application of the newly-established bankruptcy law improve corporate governance. The interactive and interwoven relations between the governance and prevention of insolvencies will be considered in this chapter.

Corporate governance is a mechanism under which corporations are operated and controlled, seeking to mitigate financial, ethical and operational irregularities. Directors may be deterred from manipulating their position to gain benefits at the expense of the company or of non-controlling shareholders. Minority shareholders or creditors may pursue appropriate remedies with reliance on a sound corporate governance system. There are many different views of the concept of corporate governance, one of which was developed by the Organization for Economic Co-operation and Development (OECD): 4

Corporate governance is the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance.

The current corporate governance mechanisms are likely to remain imperfect...