Home / Issues / Volume 9, Number 2 / The Independent Director System in China: Weaknesses, Dilemmas, and Potential Silver Linings
The Independent Director System in China: Weaknesses, Dilemmas, and Potential Silver Linings
By Sang Yop Kang | Article | 9 Tsinghua China L. Rev. 151 (2017) | Download Full Article PDF

The independent director system in China has many weaknesses. Independent directors might not be truly independent, and they are not always equipped with the necessary information and expertise. The controlling shareholder ownership aggravates problems of the independent director system. Particularly, it is highly likely that the system based on rubber-stamp directors is used to justify corporate policies and transactions in favor of controlling shareholders. Nonetheless, independent directors in China can bring positive effects to society. Some tainted proposals are screened out before submission by corporate insiders to a formal board meeting since independent directors sometimes raise objections during informal sessions or private conversations (independent directors’ “direct deterrence”). Controlling shareholders, due to the concern of revealing negative information to a capital market and enforcement agencies, would not fully demand independent directors to approve egregious transactions (a controlling shareholder’s “self-censorship”). In addition, regulations on the business role of individuals with government/party or education experience should be carefully reviewed. On the one hand, these regulations can facilitate anti-corruption campaigns that the Chinese government currently pursues. On the other hand, there is no guarantee that alternative groups are more capable, independent, and ethical than the group with government/party or educational experience.

I. Introduction

Corporate governance scholars, economists, policy-makers, and courts generally consider the independent director institution as a main solution to corporate governance problems. After the Enron debacle, the role of independent directors was reinforced in the United States. In the late 1990s, Korea adopted the outside director system (which is functionally similar to the independent director system) as a corporate governance reform in response to the Asian financial crisis. China also joined this trend: in 2001, the China Securities Regulatory Commission (CSRC) issued the “Guidance Opinion on Establishing the Independent Director System” (hereinafter Guidance Opinion), which required the independent director system in listed companies.

The independent director system, however, has many weaknesses. Most of all, there is no clear definition of or objective standard for the adjective “independent”: the title “independent director” does not guarantee the independence of directors. In addition, independent directors, who work on a part-time basis, often do not receive enough information from the corporation they direct. Also, critics maintain that independent directors—even if they are truly independent—often lack expertise, and face time constraints in understanding significant corporate business policies. Moreover, empirical studies do not show a significant correlation between the presence of independent directors and a corporation’s performance. Even worse, it is possible that corporate insiders—either management or controlling shareholders—abuse the independent director system by using it as a defense mechanism for transactions and policies that they pursue: to the outside world (including markets in general, the enforcement agencies, and the court), a corporation’s transactions and policies appear to be “justified” by the advice and monitoring process of independent directors, even when they are not truly independent. Furthermore, independent directors have an incentive not to lose additional compensation opportunities, which might be significant. Accordingly, independent directors are likely to follow corporate insiders, who are influential when recommending, nominating, and electing directors.

Based on the overview of the weaknesses of the independent director system, this article develops in-depth analyses of these issues in the context of Chinese corporate governance practice. For instance, it is probable that the controlling shareholder ownership, which most corporations in China are based on, could aggravate the problems associated with the independent director system. This is because a controlling shareholder—unlike a CEO in a widely-held corporation—exercises direct control backed by her/his majority of voting rights and influence on virtually all corporate policies including recommendation, nomination, election, and renewal of independent directors.

Based on the reputational mechanism, in theory, incentive/efficiency problems of independent directors can be cured. In jurisdictions with controlling shareholder ownership (including China), however, it is highly likely that the main audience in the reputation market that independent directors consider is not public investors in a capital market, but controlling shareholders. Thus, the mechanism of invisible hands via word-of-mouth would not work well. Since social networks in China are cumulatively connected in a complicated matrix through regional, educational and other backgrounds, the “bad” reputation of an independent director—i.e., the reputation that the independent director is truly independent—will easily spread in the business community. Accordingly, controlling shareholders, who in practice have the power to elect independent directors, screen out truly independent directors from their list. If the trend is strong enough, only compliant independent directors will remain in the market, which will create a situation analogous to “adverse selection.”

According to a recent study, independent directors in Chinese corporations issued only 0.9% of dissent opinions (including abstention as well as overt disagreement) in board meetings. Such a high approval rate (99.1%) strongly indicates that independent directors in China are acting as rubber stamps for controlling shareholders and corporate insiders. It is worth noting, however, that what the study examined was only the opinions of independent directors in official board meetings.

More specifically, the 99.1% approval rate does not reflect two important processes, wherein the institution of independent directors—directly or indirectly—can screen out undesirable proposals: (1) given the presence of independent directors whom a controlling shareholder may trust less than managers, a controlling shareholder—directly or through an inside director or manager—may voluntarily censor egregious proposals due to fear of leaking sensitive information (what I refer to as a controlling shareholder’s “self-censorship”); and (2) in unofficial, private sessions (before the official board deliberation), independent directors can sometimes persuade corporate insiders to withdraw potentially problematic proposals (what I refer to as independent directors’ “direct deterrence”). In this respect, the independent director institution in China can, to some extent, enhance the quality of corporate governance.

Another dilemma that the independent director system in China presents is the question of which groups are suitable for the position. Many independent directors in China are professors or people with a Communist Party/government background. Perhaps independent directors are beholden (and compliant) to corporate insiders. Nonetheless, compared with inside directors, independent directors—particularly those from universities and the party/government—are not fully obedient to corporate insiders. Due to less hierarchy between independent directors (e.g., professors and people from the party/government) and corporate insiders, corporate insiders find it (relatively) difficult to coerce independent directors to pass unjustified corporate policies and egregious transactions. Particularly for privately owned corporations, even if a hierarchy exists between corporate insiders (without political backgrounds) and independent directors with a political background, the hierarchical relationship could possibly be reversed in favor of the independent directors.

In this respect, regulations on the business role of individuals with government/party backgrounds should be carefully analyzed. On the one hand, this restriction would exert a positive effect by breaking off a questionable tie between business elites and people from the party/government. Indeed, these regulations are understood as a means of the anti-corruption campaign. On the other hand, without an alternative (better) group to fill the vacuum in independent directorships, this restriction would crowd out the director candidates, who are most capable (and perhaps more independent than other groups from corporations).

The remainder of this article is structured as follows. Part II presents an overview of the independent director system in China (with further explanations of the system in the United States). Part III provides classical criticism of the independent director system, and analyzes weaknesses of the system in the context of Chinese corporate governance. Part IV explores other considerations of the Chinese independent director system. Part V summarizes and concludes. In Chinese corporations, supervisory boards (or supervisors) also play an important monitoring role. However, since the supervisory board system relates to another set of significant and complicated corporate governance issues, this article emphasizes only issues of the independent director system.

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