The Political Dimension of Venture Capital Law in China

By employing a comprehensive study of the legal practices of the venture capital industry, my recent article ‘The Political Economy of China’s Business Organisation Laws and its Implications for Legal Transplantation: Evidence from the Venture Capital Industry’ aims to explain how the governance failures in Chinese business organisations are caused by state control over the economy. Using a detailed study of the political economy of China’s business organization laws, the research also makes efforts to establish an analytical framework for assessing the effectiveness and efficiency of business organisation law in transitional economies.

Ever since the promulgation of China’s first Company Law in 1993, the status of state-owned enterprises (SOEs) in the Chinese economy has directed the path of Chinese corporate governance. In the first place, the highly concentrated ownership structure of SOEs cannot tolerate a company law that encourages diversified corporate governance structure. Therefore, the class share regime is still not recognised by Chinese company law. In terms of the corporate governance of privately-held companies, however, the class share system is essential for balancing the interests of entrepreneurial controllers of the investee company and the minority shareholders. As reflected by the case study of Gome regarding the conflict between the entrepreneurial controller and representative directors of minority shareholders, a large number of Chinese entrepreneurs feel strongly that the founder should always determine the management of the company.

Consequently, venture capital investors as minority shareholders are at risk of oppression. Because of the very deep-rooted influence of Confucian culture in China, it may be quite difficult to foster the spirit of contract and equality in Chinese entrepreneurship within a short time. Therefore, the dual-class share system is very likely to be fully adopted by future Chinese company law. However, the progress of the class share system under the Chinese company law also depends heavily on how far SOE reform can go.

Similarly, because of state control over the venture capital industry, the legal system of limited partnerships in China followed a path very different from partnership law in common law countries. Ever since the limited partnership was adopted in the Law of Partnership Enterprises in 2006, local investors as limited partners in Chinese venture capital limited partnerships are mainly the local government, state-owned securities companies, and state-owned banking groups, most of which use publicly-owned capital to invest in venture capital projects and assume limited liability. Political concerns hinder the improvement of the governance of limited partnerships in China; that is to say, the political relationship between limited partners and SOEs gives rise to a lack of ability to ‘pierce the limited partners’ veil’ in Chinese partnership law. Overall, the political barriers to establishing a standard limited partnership regime mean limited partners’ interventions in fund management have increased transaction costs in the Chinese venture capital industry.

As mentioned before, the limited partnership is the primary investment vehicle in China’s VC market. Trust corporations, however, have also been involved in this thriving market since the mid-2000s. After the limited partnership was legally recognised in 2006, the investment trust is not favoured by investors as much as before, but currently some of the trust corporations still play an active role in the Chinese VC market, such as CITIC. With regard to the governance structure of China’s venture capital investment trusts, political influence is also considerable. The fiduciary duty system in China is quite weak because adjudication is firmly controlled by the Chinese Communist Party, which has strong motivation to prioritise the interests of state-owned trust corporations, rather than act as a professional decision-maker. Therefore, the regulator allows beneficiaries to actively participate in fund management. As a consequence, the economic efficiency of Chinese trust funds, which is realised on the basis of trustees’ independent management, is badly weakened by their distorted governance structure.

Based on case studies, my research offers the following useful implications for legal transplantation in practice. First, no matter where the destination country is, the institutional transplantation of business organisations must respect the inherent economic structure of the given business organisation in a capitalist economy. Otherwise the transaction costs in organisational governance will increase and, consequently, efficiency inside the business organisation will be negatively impacted. Second, the balance of internal and external protection mechanisms for investors in business organisations is important. Legislators and policy-makers in the importer country should make every effort to guarantee that the regulatory and judicial system are capable of providing sufficient protection for investors in each type of business organisation. Otherwise, the failure of governance between investors will increase the burden on other social systems and impact the efficiency of the society as a whole. Third, it is inevitable that any transplantation of legal regimes may modify some legal features of business organisations in accordance with the given social cultural backgrounds of the imported jurisdiction. In this regard, suitable qualified investor regimes are significant as reasonable control of market entry can to a large extent enhance the carrying capacity of transaction costs inside organisations and mitigate the risk of governance failure.

For countries running a market economy under authoritarian politics it may be unwise to insist on introducing a single system of enterprise law for both private and public sectors. Instead, a ‘dual-track legal system’ may be a feasible way of improving the economic efficiency of privately-owned firms and financial investment, and the state may still firmly control the specific industries for public interest. This is a political compromise for transitional economies under authoritarian ideology, like China and Russia, or for state capitalist countries like Singapore.

Further research could cast light on the effectiveness of business organisations across different jurisdictions for the purpose of testing and developing the preliminary theoretical framework outlined in this paper.

Chi Zhang is a lecturer in commercial law at the University of Glasgow.