Comparing The Independent Director In The US And The Independent Director In China
The independent director that was conceived in the US has become a global phenomenon and is now ubiquitous throughout the world. This phenomenon has emerged notwithstanding a lack of empirical evidence that the independent director actually improves corporate performance. China is unexceptional in this regard, initially introducing the independent director regime through the guidelines for listed companies under the Shanghai Stock Exchange and the Shenzhen Stock Exchange. While the guidelines were said to be “mandatory”, they were merely self-disciplinary regulations and were therefore ineffective in spreading the independent director regime.
Subsequently, China made independent directors a mandatory requirement in every listed company through the CSRC’s Guiding Opinions on the Establishment of Independent Director System in Listed Companies in 2001 as well as the mandatory requirement for independent directors under Art 122 of the Company Law. Based on Puchniak & Lan’s hand-collected data, every country that they examined (87 in total) has adopted provisions to promote independent directors in every version of their corporate governance codes (245 in total).
One explanation for such a phenomenon is the convergence theory[footnoteRef:6], that the whole world is converging on a single efficient model of corporate law and governance – the American (or Anglo-American) Corporate Governance Model with its essential feature of independent directors. A necessary implication of this theory would be that the independent director in every jurisdiction must be identical to the American independent director – therefore this global phenomenon ushers in a global era of the American independent director. However, it is submitted that this broad level convergence is merely superficial and in substance, there is merely an illusion of convergence. If one zooms in on the forms and functions of independent directors in their respective jurisdictions, one realizes that there is much divergence and the American Independent Director has essentially remained in America.
This essay will argue that there is no real convergence in the independent director model and will illustrate this through a comparison of the forms and functions of the independent director in America and China respectively. There is neither convergence in the form nor the function of the independent director in these two jurisdictions and any form of broad level convergence has only occurred in the utilisation of the terminology “independent director”. These variations reflect the reality that there are varieties of independent directors and not just one single American independent director and the reason for such varieties is due to the unique corporate climate in each of the respective countries.
Form of Independent Directors
The form of independent directors can be analysed in terms of three different conceptions – thinnest conception, thicker conception and thickest conception. The thinnest conception of form refers to the object of the independent director’s independence – what are they designed to be independent from? Evident from the NASDAQ and NYSE rules, the American independent director was designed to be independent from management but not from significant shareholders. In contrast, China’s independent director was designed to be independent from both management and significant shareholders. This stark contrast may be explained by the different shareholder ownership environment in both countries – the predominance of the dispersed shareholding structure in most of the listed companies in US as opposed to the high concentration of concentrated shareholding structure in most of the listed companies in China. This in turn determines the types of agency problems that arises in each country and thereby implicates the functions of the independent directors, a point which will be dealt with below.
The thicker conception of form refers to the nature of the position that is occupied by the independent director. This includes the physical nature of the position that independent directors occupy within a country’s corporate governance architecture as well as the legal nature of such a position. With regards to the physical nature, the independent directors in the US sit on a single-tiered board as well as on the nomination, audit and remuneration committees of the board. In contrast, China has a double-board with the independent directors sitting on the management board. This double-board structure is distinct from the two-tiered board structure in Germany due to the weakness of the supervisory board in China in terms of lacking sufficient functional powers to properly monitor the management board. Therefore, there are clear differences in terms of the physical nature of the positions that independent directors occupy within a country’s corporate governance architecture. With regards to the legal nature, the NYSE Listing Rules makes it is mandatory for independent directors in the US to compose a majority of the board members and to compose all board-committee members in listed companies. While Art 122 of the Company Law and the CSRC Guiding Opinions makes it mandatory to have independent directors in listed companies in China, the guidelines only require one-third of the board to be filled with independent directors and if there are sub-committees, independent directors only need to fill up one-half of such sub-committees. Evidently, there is a much more stringent requirement of independent directorship in the US as compared to China and as will be discussed below, this one-third/one-half restriction of independent directors on the boards of listed companies in China serves as a built-in limit on the ability of independent directors to function as monitoring and advisory mechanisms in the company.
The thickest conception of form refers to the personal characteristics of a typical independent director that sits on the board of the listed companies as well as the proportion of the board that is composed of independent directors. In the US, majority of the independent directors are corporate executive from other companies and these independent directors generally have little formal or informal connections with the government. In direct contrast is China, where almost half of all the independent directors are university professors with a significant proportion of independent directors having formal or informal connections with the government. Robert D. Kaplan explains that such a unique composition of Chinese independent directors may be attributed to the Confucian tradition in China, which regards individuals with high education and research experiences as highly respectable persons in society. He also observes that corporations tend to hire persons with government connections as independent directors because of the fact that these persons are likely to the most capable persons in society with great experience not just in the domestic economy (since the Chinese government has an active role in the economy) as well as in the understanding of the complicated, cumulative government regulations and thereby being able to provide possible answers to solve regulatory issues (such as by finding regulatory loopholes in favour of corporations). Nevertheless, such a trend may be changing in China given the new restrictions that have been imposed by the Chinese government on individuals who have government background as well as on professors from becoming independent directors for the purposes of reducing corruption.
A survey on independent directors in China was conducted among 7, 595 independent directors in 2, 285 listed companies in the domestic stock exchanges. 38. 59% of the surveyed independent directors were scholars or professors; legal experts including lawyers accounted for 10. 44%; people with government backgrounds accounted for 8. 45% and 6. 54% came from audit firms. In October 2013, as an anti-corruption measure, the Organization Department of the Central Committee of the Communist Party of China issued a notice subjecting former Communist Party leaders and govern- ment o cers to more stringent approval proceedings if they planned to work or continue working for business organisations. 28 is has made it very di cult for in-service and retired Communist Party leaders and government o cers to act as independent directors for listed compan- ies. In turn, since the anti-corruption measure was issued, hundreds of so-called ‘leader-directors’ (Guanyuan Dongshi) have resigned from their companies. e percentage of independent directors with a govern- ment background has thus decreased substantially since 2014.
Ministry of Education announced that professors with certain positions were also subject to restrictions. Until recently, university professors at state universities had thought themselves exempt from a 2013 ban on high-level government officials and Communist Party members holding corporate jobs, a restriction installed as part of the nation’s anti-corruption drive. ” This belief was tested “when the education ministry threatened disciplinary action against higher-ranked academics who fail to register their corporate assignments. ” Recently, “hundreds of senior academics are quitting lucrative seats on the boards of Chinese companies”. With regards to the proportion of the board that is composed of independent directors, a typical board of a listed company in the US is composed almost entirely of IDs with the exception of the CEO. As of 2013, 85% of directors on large US listed companies are independent directors and 65% of boards have only 1 non-independent director (the CEO). On the other hand, there is a mixed view on the proportion of independent directors on Chinese boards depending on whether one considers the directors of the supervisory board to be independent. Gopal, who seems to take the view that supervisory board directors are independent reported that almost 70% of boards in China had a majority of independent directors. In contrast, a survey by the Asian Corporate Governance Association, which appears to only consider members of the management board designated as independent directors to be independent directors, reported that approximately 20% of boards in China had a majority of independent directors. Nevertheless, on a self-reporting basis, a typical board reports having 1/3 of their directors as independent directors. Even on the basis of proportion of independent directors on the boards, US appears to have a supermajority of independent directors on their board even though the law only mandates a majority requirement while China appears to have conformed rather rigidly to the one-third requirement imposed by the CSRC Guiding Opinions.
It is clear that there are significant deviations in the forms of the independent director in China and US. The only similarity is in the thicker conception of form in that both countries make it mandatory to have at least some independent directors on their boards. Beyond that, the most apparent observation is divergence rather than convergence.
Function of Independent Directors
The function of independent directors can be analyzed in terms of their expected function and their actual function. In this analysis, it is crucial to consider the institutional environment in US and China and to consider how the environment shapes the functions of independent directors.
Expected Function of Independent Directors in US
Listed companies in the US generally have a dispersed shareholding structure. The problem with such a structure is the lack of persons to monitor the management and to prevent managerial rent-seeking behavior which occurs at the expense of shareholders. This is because the dispersed shareholders themselves are unable to monitor management due to collective action problems including high coordination and information costs. As a result, the primary expected function of the independent director in the US is to monitor the management on behalf of the dispersed shareholders so as to provide a solution to the shareholder-manager agency problem.
Expected Function of Independent Directors in China
In stark contrast, listed companies in China typically have concentrated shareholder ownership structures. Ownership concentration is high not only in the non-circulating share block of Chinese listed companies, but also in the circulating share block and in particular, where state share ownership exists, it appears to be concentrated as well. In a concentrated shareholder ownership environment, the predominant agency problem shifts from the shareholder-manager agency problem to the controlling-noncontrolling shareholder agency problem – the risk is that the controlling shareholder will exploit the noncontrolling shareholder to obtain private benefits of control through devices such as manipulating prices in transactions with controlled entities. Indeed, this is a reality in China as shown by a recent study which revealed that 40% of listed companies in China engaged in related-party transactions with their top ten shareholders. Such a phenomenon can occur even when the state is the controlling shareholder because as Clarke notes, the whole purpose of having the state as a dominant shareholder is so that the state can use that control to achieve objectives other than profit maximization which may include employment or strategic control of a particular industry. Therefore, the primary expected function of independent directors in China is to monitor these controlling shareholders to ensure that they do not abuse their power to manipulate the boards so as to extract private benefits of control for themselves. Lou and Yan reported that as of May 10, 2001, 177 out of 1206 listed companies (15%) were more than 66% owned by a single shareholder; 510 (42%) were more than 50% owned; 742 (62%) were more than 37. 5% owned; and 888 (74%) were more than 30% owned. In companies listed on the Shenzhen Stock Exchange, for example, about 9% of the shareholders own about 58% of the A-shares. In a 1997 sample of 300 companies listed on the Shenzhen Stock Exchange, only 42 companies listed individuals among their five largest shareholders. Out of 541 listed companies with some state share ownership in 1999, in 312 the state shareholder was the only shareholder with a stake exceeding 5%. In over 87% of the 541 companies, the state held a controlling interest either through a majority holding or a dominant holding.
A recent 2002 study of corporate governance by the CSRC and the SETC revealed, on the basis of self-reporting alone, that 40% of listed companies engaged in related-party transactions with their top ten shareholders – while not all related-party transactions are made on unfair terms, given the lack of institutional safeguards that might ensure fair terms, there are legitimate grounds for concern. The CSRC/SETC study further found that 676 listed companies had had their funds misused by their parent company (the controlling shareholder) in the amount of almost US$12 billion.
The secondary expected function of independent directors in China is to monitor the management board in Chinese listed companies. Pertinently, there is a problem with too much insider control (neibu ren kongzhi) in Chinese listed companies. What this means is that managers are able to abuse their powers with the result that the corporation’s assets are tunneled away from the company and converted through various subterfuges into the personal property of management. This is made possible by the “devolution of considerable managerial authority to the enterprise level coupled with the legalization of new forms of trade and new privately-controlled entities to which the stripped assets can, by means of controlled transactions, be transferred”. While the typical expectation is that the controlling shareholder will be able to monitor the management to prevent such acts, this expectation is only accurate in China where the state is not the controlling shareholder. Where private parties are controlling shareholders, they will be able to monitor the management efficiently given that they are likely to be well-equipped and well-versed with complex transactions. The problem when the state is the dominant shareholder is that the state does not have the capacity to manage such complex property relations and ownership forms. As Clarke puts it, the state “remains designed for the simple structures of an earlier day, when private ownership of significant property was not allowed, and transfers between enterprises were physical and not financial”. Therefore, the problem where the state is the dominant shareholder is that there is an “absent owner” (suoyouzhe quewei) and therefore there is an inability to monitor management – the problem with monitoring management is not the collective action problem that dispersed shareholders are faced with, but rather organizational problems that are internal to the state as a shareholder. As such, independent directors are needed to monitor the management on behalf of the shareholders to prevent such wealth tunneling by the managers. This secondary expected function of the independent directors is reinforced by the perceived failure of the Chinese supervisory board. The Chinese double-board was inspired by the German two-tiered board system and therefore the supervisory board was expected to be responsible for monitoring the management board in Chinese listed companies. However, the Chinese supervisory board has been largely ineffective in their monitoring role given that they are not well-equipped for such a function. As such, there is an even greater need for the independent directors to function as a mechanism to monitor management to serve as complementary monitors (and not substitute monitors) to the supervisory board.
Wang Jiangyu notes in his textbook that China’s supervisory board apparently does not possess such a wide range of powers as German supervisory boards. For instance, a Chinese supervisory board’s statutory powers do not include any authority to control the appointment or business decision-making of the management board. Hence, as a matter of law, it is impossible for the SB to act ‘as supervisory organ in the sense of checks and balances, which appoints, control, advises – and where necessary also dismisses – the Management Board’, as prescribed in the German corporate governance structure.
Evaluating the Expected Functions of Independent Directors in US and China
Additionally, in both US and China, the independent directors may serve an additional advisory/consulting role. This role doesn’t solve any agency problems but merely provides strategies for the company to progress and grow. Independent directors will be beneficial in this regard because their independence from management provides a level of objectivity that enhances their advisory capabilities by allowing them to provide valuable different perspectives. It becomes obvious that on the aspect of expected functions of independent directors, there are distinct divergences between US and China. Such divergence is attributed to the different shareholder ownership environment in both countries as well as the weakness of certain functional substitutes in China such as the supervisory board. Even within China, the expected functions of independent directors are complicated by the different identities of the controlling shareholder.
Actual Function of Independent Directors in US
The actual function of independent directors in the US remains to be the monitoring of management. However, the effectiveness of this monitoring function varies depending on the type of decision that is being made – this is because the independent director is typically a part-time job and only at certain critical junctures for the corporation that involves the making of certain high stakes decisions will such decisions be able to capture the director’s full attention. Additionally, independent directors are being used as a defensive mechanism by management to approve various proposals. Such a defensive mechanism arises because decisions made by boards with independent directors have been seen to be more legitimate and therefore corporate managers take advantage of this view and perceived independent directors as tools to preserve managerial autonomy against the pressure of the market in corporate control. Therefore, one of the actual functions of independent directors is as a defensive mechanism for management – a shield for the management. This is inferred from the decision of Unocal and Moran v Household International Inc.
Actual Function of Independent Directors in China
The actual functions of independent directors in China varies significantly from their expected functions. Firstly, similar to the US, independent directors in China potentially play the function of a defensive mechanism for management. A study by Ma & Khanna revealed that 211 out of 24, 212 opinion reports issued by independent directors, from August 2001 to June 2010, were identified as dissenting opinions which meant that such dissenting opinions only accounted for 0. 9% of all opinions issued by independent directors. This extremely high approval rate of independent directors is problematic as it raises the concern that independent directors are merely “rubber-stamping directors” and that independent directors are in fact abused as a defensive mechanism that justifies decisions made by controlling shareholders and corporate insiders. This is evidence by the extremely high approval rates of independent direcotrs.
