This article was a summarized and translated version of the origninal Chinese article orginally published on Caixin China ESG Development White Paper 2023.

Editor's Note: Enhancing the quality of listed companies and promoting the high-quality development of the capital market are important tasks for our capital market participants. As one of the most important institutional investors, how can mutual funds act on behalf of fund shareholders and contribute to these strategic tasks? This report invites ESG30 member institution, Yinhua Fund Management, to share their thoughts on how institutional investors can contribute to high-quality development, as well as its practices and suggestions for stewardship.

-- Caixin Think Tank

Bo Wang, CFA (Yinhua Fund Management), Shuwei Tang (ZD Proxy Shareholder Services)
November 2023

Under the comprehensive arrangement of the Central Committee of the Communist Party and the State Council, the China Securities Regulatory Commission (CSRC), along with the State-owned Assets Supervision and Administration Commission (SASAC) and ministries, has carried out a substantial amount of work aimed at improving the governance of listed companies. Since the issuance of the Opinions on Further Improving the Quality of Listed Companies by the State Council at the end of 2020, the regulation has built a relatively complete institutional infrastructure for institutional investors to participate in and promote the improvement of the quality of listed companies and the protection of investors' rights and interests:

Firstly, information disclosure of listed companies has been strengthened. Information disclosure is the core of the registration system, in addition to the further refinement of the disclosure of financial information of listed companies, In June 2021, the CSRC also published the latest guidelines on the format of annual reports and semi-annual reports of listed companies, with the core revisions including the integration of information related to corporate governance into a special chapter, the addition of a new chapter on "environment and social responsibility", and the strengthening of the disclosure requirements for prominent issues such as the occupation of guarantees and related party transactions of finance companies.

Secondly, listed companies are encouraged to prioritize investor relations management. The improvement of listed company quality means that companies need to proactively step out of the "enclosure" and strengthen communication and connection with investors. In the "Guidelines for Investor Relations Management of Listed Companies" issued by the CSRC in April 2022, listed companies are required to further increase and enrich the content and methods of investor relations management, and to include information related to environment, social, and governance (ESG) in their communication content. At the same time, investors are also advocated to enhance their shareholder awareness and exercise their rights in accordance with the law.

Thirdly, enhance and clarify the role of independent directors. Independent directors have always been expected to play a supervisory role in listed companies, and the financial fraud incident of Kangmei Pharmaceutical CO.,Ltd has caused heated discussions on the duties of independent directors. In April 2023, the State Council issued the "Opinions on the Reform of the Independent Director System for Listed Companies," and the CSRC released the "Administrative Measures for Independent Directors of Listed Companies (Draft for Comments)." The Shanghai, Shenzhen, and Beijing Stock Exchanges also adjusted their respective rules accordingly (collectively referred to as the "New Independent Director Regulations"). The New Independent Director Regulations aim to improve the quality of listed companies and represent a systemic reform of the independent director system. They clarify the duties, supervisory means and responsibility constraints of independent directors. Specific measures include enhancing the independence of independent directors, requirements for their concurrent positions and work commitment, and establishing a "special meeting mechanism for independent directors," which is conducive to independent directors better supervising and balancing the internal members of listed companies and participating in decision-making.

Fourthly, higher requirements have been set for audit firms. Audit firms play the role of a "gatekeeper" in accurately reflecting the financial information of listed companies, and strengthening the service quality of audit firms is of great importance for improving the quality of listed companies. In May 2023, the CSRC, together with the Ministry of Finance and the SASAC, issued the "Management Measures for the Selection and Appointment of Accounting Firms by State-owned Enterprises and Listed Companies," which put forward newer and stricter requirements for the rotation of audit firms for state-controlled listed companies and for the rotation of auditors for all listed companies, in order to further enhance the independence of audit firms serving listed companies. In early July 2023, the CSRC and the Ministry of Finance jointly issued the "Information Disclosure Regulations for Accounting Firms Engaged in Securities Service Business," which made more comprehensive and detailed provisions for the disclosure of information such as penalties and other disciplinary actions against accounting firms, meeting the market's demand for information disclosure after the reform of the registration system and conducive to improving the transparency of the securities audit market.

How mutual funds understand and practice stewardship

Since the reform of the registration-based IPO system, the number of A-share companies has grown rapidly. Against this backdrop, relying solely on strengthened supervision to enhance the quality of listed companies is still insufficient. Institutional investors should also actively participate in this process and exert their influence. However, as far as the current market situation is concerned, the enthusiasm of small and medium shareholders to exercise their rights remains to be improved, especially as the attendance rate of small and medium shareholders at shareholders' meetings in the A-share market has not shown a significant increase. Against the backdrop of a rapidly expanding proportion of assets managed by institutional investors in China, mutual fund managers can be more proactive in exercising shareholder rights.

Mutual funds have been tasked by regulators with the responsibility and mission to actively undertake stewardship, promoting both their own high-quality development and the improvement of listed company quality. The "Opinions on Accelerating the High-Quality Development of the Public Fund Industry" issued by the CSRC in April 2022 mentioned that the public fund industry should "become practitioners who care about 'major national concerns,' play a greater functional role in serving national strategies, promoting innovation-driven development, economic transformation and upgrading, and promoting common prosperity," and should "encourage mutual funds and other professional institutional investors to actively participate in the governance of listed companies, not only 'voting with their feet' but also 'voting with their hands' to help listed companies develop with high quality."

As institutional investors and an important force among shareholders of listed companies, mutual funds have a significant role to play in participating in corporate governance. First, the primary duty of public fund managers is to protect the interests of the holders. Exercising voting rights and interacting with companies can monitor and promote transparent and compliant management, preventing the interests of small and medium investors from being infringed upon due to various conflicts of interest. Second, stewardship can help listed companies enhance enterprise value and competitiveness. By participating in the management of ESG issues, including corporate governance, public fund managers can push companies to strengthen internal controls, improve operational efficiency, and properly manage sustainability issues, thus improving company performance and market position. Furthermore, good corporate governance can enhance investor confidence and attract more capital market investment, allowing long-term investors to benefit from the appreciation in valuation. Broadly improving the level of corporate governance of listed companies can also help manage systemic risks in this specific market. Lastly, long-term and value investors should not only focus on short-term shareholder returns but also on the long-term, sustainable development of companies. Participating in the ESG governance of listed companies can promote corporate practices in sustainable development, including baseline issues such as environmental protection and labor safety, as well as social responsibility areas such as employee satisfaction and community contribution, achieving a win-win for economic and social benefits.

The main approaches for stewardship of mutual funds include voting and engagement. In terms of voting, this specifically can be reflected in participating in the appointment and removal of board members (especially independent directors), reviewing compensation plans, information disclosure, and the decision-making process for significant matters such as related-party transactions and mergers and acquisitions, thereby strengthening external supervision of the company. Another important method is engagement. Beyond traditional company research, mutual funds can engage with the board of directors or management of listed companies on significant ESG risks and opportunities, understand the company's governance, strategic planning, risk management, etc., express the stance of small and medium shareholders, and provide constructive opinions and suggestions. At the same time, methods such as voting and engagement can usually be combined, for example, communicating with listed companies on important issues before participating in shareholder meeting voting and expressing expectations for good corporate governance practices.

In recent years, Yinhua has taken solid steps in deepening the practice of stewardship, consolidating the research and institutional foundation for stewardship, and exploring and pioneering practices in exercising shareholder rights and communicating with listed companies on ESG issues. In terms of voting practices, Yinhua mainly sets priorities based on the proportion of holdings and the significance of matters involved in the shareholder meetings. In 2022, Yinhua participated in the voting of 145 shareholder meetings of 103 listed companies, actively safeguarding the interests of the holders. For interactions with listed companies, Yinhua's research and investment teams conducted thematic or sector research and interaction with several listed companies on corporate governance, environmental, and social issues, including one-on-one communications and joint ESG discussions with local and international investors. On multiple occasions, Yinhua has made its position clear to different listed companies on specific issues and proposals that significantly affect the interests of holders, covering topics such as board and committee appointments, external donations, equity incentives, spin-offs, major acquisitions, low-carbon transition, climate risks, and production safety. We are also pleased to see that, especially after the CSRC issued the "Guidelines for Investor Relations Management of Listed Companies," more and more listed companies are willing to engage in investor communications on ESG issues and are more open to listening to investors' suggestions for improving corporate governance and managing major environmental and social issues.

Outlook and recommendations for stewardship of mutual funds

As the scale of asset management by institutional investors in China continues to grow, so does their influence on the market. Their role in corporate governance is also becoming increasingly prominent. Improving the corporate governance of listed companies and enhancing their quality, in addition to the continuous perfection of the institutional level, also depends on the active participation of institutional investors. Looking to the future, we expect institutional investors, represented by mutual funds, to play a more important role in the high-quality development of China's capital market. Here are three points for policymakers and industry colleagues to consider:

First, on the basis of the existing rules, improve the system of institutional investors' participation in the governance of listed companies.

In order to encourage and regulate the participation of institutional investors in the governance of listed companies, many countries and regions have set up specialized rule systems. The two most representative and influential models are the US model and the UK model. Among them, the U.S. model centers on the mandatory participation of institutional investors in shareholders' meetings and establishes a complete set of legally binding rules as the main mechanism to promote the participation of institutional investors in the governance of listed companies; whereas the U.K. model is reflected in the formulation of a special stewardship guideline to comprehensively constrain, regulate and guide the participation of institutional investors in the governance of listed companies, which is implemented on a "comply or explain" basis.

Although the current A-share market does not have specific rules for institutional investors to participate in the governance of listed companies, regulatory authorities have been exploring the system and have established a preliminary institutional framework. In 2018, the CSRC issued a revised version of the "Corporate Governance Code for Listed Companies," which included a dedicated chapter for institutional investors. It emphasized the importance of institutional investors' participation in corporate governance and provided new directional guidance, laying the institutional foundation for the introduction of subsequent rules. In the future, we look forward to China's capital market timely introducing rules suitable for the national conditions that cater to institutional investors practicing due management, providing strong institutional support for their participation in corporate governance.

Secondly, supporting the effective exercise of shareholders' rights of mutual funds through internal research and management systems.

The starting point for mutual funds to participate in corporate governance and shareholder meeting voting decisions is to represent and protect the interests of the fund shareholders, and this stance determines that mutual funds are to speak for the interests of small and medium-sized shareholders. As professionally managed investors under strict regulation, the voting decisions made by mutual funds are based on in-depth research and follow standardized internal processes from the standpoint of shareholders and small and medium-sized shareholders — this includes not only rigorous investment decision-making processes but also internal control mechanisms to prevent conflicts of interest and improper benefit transfers, and to compare with external independent voting opinions, in order to fulfill the fiduciary duties of the manager and avoid making voting decisions that harm the interests of the shareholders. Public fund management institutions should also continuously improve their relevant research capabilities and management systems with the deepening of the practice of institutional investors participating in corporate governance in our market, to ensure the effective exercise of shareholder rights and better protect the interests of the shareholders.

Third, mutual funds should pool their strengths and work together to help the high-quality development of the capital market.

Institutional investors' participation in corporate governance is an important measure to promote the improvement of governance of listed companies and the effective operation of the capital market. Communicating with the board of directors and management of listed companies and actively participating in the shareholders' meeting to exercise voting rights are the core means for mutual funds to carry out stewardship. Although mutual funds, as institutional investors, have more advantages in terms of resources, investment research and influence than individual investors, and it is difficult to bring about systemic improvement by the power of only a few mutual fund managers. Within the scope of legal compliance, we can also learn from the practical experience of other countries and regions, through the effective joint communication between institutional investors, to jointly convey to the company some of the expectations of investors on corporate governance and sustainable development, in order to maximize the impact.

The high-quality development of the capital market cannot be separated from the high-quality development of each market participant. In the future, we expect the mutual fund industry, in the process of its own high-quality development, to actively practice due diligence management, exercise shareholders' rights, amplify the voices of small and medium-sized shareholders in the governance and decision-making of listed companies, and jointly help improve their corporate governance and sustainability.

Special thanks to Zhizhen Hu and Zhonghua Wang at ZD Proxy Shareholder Services for their contributions to the research of this article .