CHINESE UPDATE – Limitations on Overseas Direct Investment, A First Step of Temporary Capital Controls?
During this sensitive time when capital control measures are about to come out, through an interview of officials of the State Administration of Foreign Exchange (“SAFE”), the Xinhua News Agency on December 8 revealed the details and direction of policy on the recent tightening of overseas direct investment (“ODI“). The effects on ODI from the tightening of policy restrictions, starting from several months past and up to present, are rapidly magnifying.
At the opening of the news interview, it was stated that cross-border capital flows were generally stable, and according to monitoring, there was no finding that desire for foreign exchange purchases by enterprises or individuals would surge sharply; however, it was pointed out that a large number of ODI projects have already been placed under scrutiny of various departments (i.e., NDRC, MOFCOM, PBOC, and SAFE). During the interview, SAFE officials pointed out that four categories are considered abnormal circumstances of ODI behavior: (1) newly established enterprises without substance of business carry out overseas investment; (2) the scale of overseas investment is far greater than the registered capital of the domestic parent company, and the operational status as reflected by financial statements of the parent company is not comparable to support the scale of overseas investment; (3) no correlation exists between the main business of the domestic parent company and the overseas investment project; (4) the RMB used for investment obtains from an abnormal source, being suspect of illegally transferring assets for Chinese individuals and illegal operation of underground money exchange. Having such a wide range for the definitional scope of abnormal behavior is really rare. From the perspective of SAFE, only enterprises with the capability and qualification can make overseas direct investment, while pooling of funds by individual investors for conducting overseas direct investment does not conform to the so-called “authenticity and compliance” principle.
In addition, this interview once again mentioned the ways of foreign exchange payment violations by individuals, that is by way of split where the annual remittance quotas of other individuals are used in performing fund remittances; as well as the possible consequences of such violations, that is these individuals might be put on an “Attention Name List,” and have their annual remittance quotas for the next two years canceled, and where circumstances are serious, be put on file for punishment.
Our Interpretation: Except for ODIs conducted by enterprises possessing ample financial strength and where the ODI is closely related with the main business of such enterprises, other types of ODI would basically be stopped. In addition, there is a large possibility that the next step of SAFE will be to take further steps in regulatory and enforcement measures regarding overseas investment by individuals.
The new Dutch Corporate Governance Code, issued December 8, 2016, provides an interesting analog to The New Paradigm, A Roadmap for an Implicit Corporate Governance Partnership Between Corporations and Investors to Achieve Sustainable Long-Term Investment and Growth, issued September 2, 2016, by the International Business Council of the World Economic Forum. The new Dutch Code is applicable to the typical two-tier Dutch company with a management board and a supervisory board. The similarities between the Dutch Code and the New Paradigm demonstrate that the principles of The New Paradigm, which are to a large extent based on the U.S. and U.K. corporate governance structure with single-tier boards, are relevant and readily adaptable to the European two-tier board structure.
Both the New Paradigm and the Dutch Code fundamentally envision a company as a long-term alliance between its shareholders and other stakeholders. They are both based on the notions that a company should and will be effectively managed for long-term growth and increased value, pursue thoughtful ESG and CSR policies, be transparent, be appropriately responsive to shareholder interests and engage with shareholders and other stakeholders.
Like The New Paradigm, the Dutch Code is fundamentally designed to promote long-term growth and value creation. The management board is tasked with achieving this goal and the supervisory board is tasked with monitoring the management board’s efforts to achieve it.
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The evolution of corporate governance over the last three decades has produced meaningful changes in the expectations of shareholders and the business policies adopted to meet those expectations. Decision-making power has shifted away from industrialists, entrepreneurs and builders of businesses, toward greater empowerment of institutional investors, hedge funds and other financial managers. As part of this shift, there has been an overriding emphasis on measures of shareholder value, with the success or failure of businesses judged based on earnings per share, total shareholder return and similar financial metrics. Only secondary importance is given to factors such as customer satisfaction, technological innovations and whether the business has cultivated a skilled and loyal workforce. In this environment, actions that boost short-term shareholder value—such as dividends, stock buybacks and reductions in employee headcount, capital expenditures and R&D—are rewarded. On the other hand, actions that are essential for strengthening the business in the long-term, but that may have a more attenuated impact on short-term shareholder value, are de-prioritized or even penalized.
This pervasive short-termism is eroding the overall economy and putting our nation at a major competitive disadvantage to countries, like China, that are not infected with short-termism. It is critical that corporations continuously adapt to developments in information technology, digitalization, artificial intelligence and other disruptive innovations that are creating new markets and transforming the business landscape. Dealing with these disruptions requires significant investments in research and development, capital assets and employee training, in addition to the normal investments required to maintain the business. All of these investments weigh on short-term earnings and are capable of being second-guessed by hedge fund activists and other investors who have a primarily financial rather than business perspective. Yet such investments are essential to the long-term viability of the business, and bending to pressure for short-term performance at the expense of such investments will doom the business to decline. We have already suffered this effect in a number of industries.
In this environment, a critical task for boards of directors in 2017 and beyond is to assist management in developing and implementing strategies to balance short-term and long-term objectives. It is clear that short-termism and its impact on economic growth is not only a broad-based economic issue, but also a governance issue that is becoming a key priority for boards and, increasingly, for large institutional investors. Much as risk management morphed after the financial crisis from being not just an operational issue but also a governance issue, so too are short-termism and related socioeconomic and sustainability issues becoming increasingly core challenges for boards of directors.
At the same time, however, the ability of boards by themselves to combat short-termism and a myopic focus on “maximizing” shareholder value is subject to limitations. While boards have a critical role to play in this effort, there is a growing recognition that a larger, systemic recalibration is also needed to turn the tide against short-termism and reinvigorate the willingness and ability of corporations to make long-term capital investments that benefit shareholders as well as other constituencies. It is beyond dispute that the surge in activism over the last several years has greatly exacerbated the challenges boards face in resisting short-termist pressures. The past decade has seen a remarkable increase in the amount of funds managed by activist hedge funds and a concomitant uptick in the prevalence and sophistication of their attacks on corporations. Today, even companies with credible strategies, innovative businesses and engaged boards face an uphill battle in defending against an activist attack and are under constant pressure to deliver short-term results. A recent McKinsey Quarterly survey of over a thousand C-level executives and board members indicates most believe short-term pressures are continuing to grow, with 87% feeling pressured to demonstrate financial results within two years or less, and 29% feeling pressured over a period of less than six months.
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