Kangmei Pharmaceutical: China court dispenses strong medicine

Jackpot payout for shareholders in China’s inaugural class action sets the bar high for investor damages but is a bitter pill for independent directors, says ACGA’s China Research Director Nana Li

A group of 55,326 shareholders of a Shanghai-listed pharmaceutical firm entered the history books in late 2021 as victors in China’s first collective investor action. The court-ordered payout of RMB2.46 billion (around US$385.51m), substantial even by global standards, sent a clear message to the market: defrauding shareholders may now come at a hefty cost.

Drugs manufacturer Kangmei Pharmaceutical was on 12 November 2021 ordered by the Intermediate People’s Court of Guangzhou to pay investor compensation for a large-scale financial fraud which took place between 2016 and 2018. The company became the target of an investigation by the China Securities Regulatory Commission (CSRC) in December 2018 and in April the following year Kangmei admitted overstating its cash positions by RMB30 billion (around US$4.6 billion).

Investors decided to mount a legal challenge and their case was taken on by the China Securities Investor Services Center (ISC), a non-profit established in 2014 under the direct administration of CSRC. It selectively represents investors in lawsuits and applied to the court to proceed as a representative action on behalf of Kangmei shareholders. The Kangmei case was the first class-action lawsuit brought in China and the damages pay-out set a high bar, thanks to changes brought in by a revised Securities Law in March 2020 which drastically increased penalties for fraud.

The court held the company’s former Chairman Ma Xingtian, his wife former Vice Chairman Xu Dongjin and four other former executives personally liable for systemic fraud at Kangmei. Ma was also sentenced by the court to jail for 12 years and fined RMB1.2m for manipulating the stock market, failing to disclose material information and bribery. Similarly, Xu and 10 other people from the company were given jail terms and fined for taking part in related securities offences.

A much bigger stick

Prior to the amended Securities Law, the maximum penalty for corporate fraud cases in China was just RMB600,000, or around US$$94,000. As we have pointed out in previous CG Watch reports, the cost of committing fraud was disproportionate to the illegal profits wrongdoers could make in China. The penalty was unlikely to act as much of a deterrent.

In the US, large-scale frauds such as Enron would see the company, its directors, management and its accounting firm facing criminal charges and civil liability if not bankruptcy. This is less the case in China. Companies such as Luckin Coffee may land themselves in a US court for financial misconduct but manage to survive in their domestic market—where they continue to grow, despite adverse findings.

The revised Securities Law significantly raised the cost of financial fraud to a maximum penalty of RMB20m, with the intention of better protecting investors. Misconduct would also attract significant personal liability: for fraud, the highest penalty increased from 5% of a perpetrator’s ill-gotten gains to 50% of the bounty.

Making an IPO regime fit for purpose

The tougher approach to financial fraud also underscores China’s desire to fully transition to a registration-based IPO system. The US-style regime places a higher emphasis on disclosure by issuers and a less active role by regulators.

China is still promoting a full transition to this model, despite doubts on the role that regulators play in the IPO application process in China. The CSRC and senior market officials continue to emphasize the prospect of reforming the IPO regime in this regard across different boards.

The US-style IPO system puts a greater burden on issuers to make satisfactory disclosure while regulators should only interfere when misconduct is found or reported. But without a proper deterrent, there was not much of an incentive for companies to improve their disclosure. The Kangmei ruling sets the stage for tough action on fraudulent activity in this regard, a step regulators may hope paves the way to completion of its IPO reform agenda.

A wake-up call for independent directors

Another notable feature of the Kangmei ruling was that all five independent directors (four were professors at local universities) of the company were held personally liable for between 5% and 10% of the total compensation. In cash terms this works out to be between RMB123m to RMB246m. Independent director salaries are notoriously low in China: to put the scale of these penalties in context, the sums are equivalent to a thousand times the independent directors’ average salary of RMB200,000, as disclosed in Kangmei’s most recent annual report.

The case sent a clear message that independent directors will be held accountable as gatekeepers for shareholders’ interests. However, as we described in our China Report published in 2018, concentrated ownership structures at most Chinese listed companies makes it challenging for independent directors to exercise autonomy. Indeed, many local CG experts in China have shared concerns that this case may adversely impact the independent director regime in China.

This regime was introduced in 2001, adopting the US system which at the time required a third of the board to comprise independent directors. This threshold has not been raised in the past 20 years. ACGA finds most issuers in China simply fulfil the regulatory requirement. In fact, the average compensation of independent directors was lower in 2017 than it was in 2007 because many companies do not see what value independent directors add to board discussions. Against this backdrop, the Kangmei case raises the bar on the diligence expected to be exercised by independent directors in China and their obligations to shareholders. Yet independent directors will continue to be seen as a regulatory burden by issuers and woefully underpaid for their work.

Already we have seen independent directors of at least 20 companies listed on the Shanghai and Shenzhen Stock Exchanges resigning after the Kangmei ruling was announced in November 2021 and most cited personal reasons for doing so in regulatory filings. Some companies are now left with less than a third of the board being independent and risk breaching the CG Code if no new directors are found soon.

It may be the beginning of a wave of resignations. The last time China cracked down on independent directors in 2013 as part of an anti-corruption campaign targeting academics who took on commercial roles, there was sustained wave of independent directors resigning in the following years.

The Kangmei ruling no doubt sought to take aim at independent directors to up their game, improve corporate governance and better scrutinise companies’ accounts. Yet such a move relies on a deep pool of candidates to fill their shoes when they underperform.

In the short term, companies may face a squeeze on independent candidates and the likelihood is that quality will be sacrificed to meet looming regulatory requirements for the requisite headcount. Further down the line however there may be a silver lining if shareholder pressure forces companies to pursue a better calibre of candidate. There is also the hope that a greater regulatory focus on independent directors will see resources directed into training and building up a pool of suitable appointees.