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Liability
of Outside Directors and Corporate Governance -- A Comparative
Study - Part II III. Comparative Analysis American corporate law has attempted to attract and retain experienced and desirable outside directors with various protections while imposing duties and liabilities on them at the same time. However, it should be noted that each legal rule, while aiming at solving certain problems, has its own disadvantages. In contrast, under Chinese law, the notion of outside director has not been fully developed yet. Compared with the U.S., China has a codification system. In China, legal precedents do not have binding force on later cases and courts have to adjudicate cases according to the statutes (including legislation, regulations and rules), rather than precedents. (1) China's current outside director system The Chinese economy has since 1949 had two prominent characters: state-owned enterprises and a planned economy. Reform of the state-owned sector began in the late 1970s and frequently found expression in the creation or alteration of legal norms. Most of China's listed companies emerged as the result of the reform of China's state-owned enterprises. After the so-called corporate restructuring, however, there is no substantial change to corporate governance of the state-owned enterprises. As such, minority shareholders (public investors) can hardly count on directors to protect their interests. There are more than 1,200 listed companies in China right now, 80-90% of which came from the restructuring of state-owned enterprises and are controlled by a parent state-owned enterprises. The result is that those companies are controlled by a "keyman." This keyman is normally the representative of the majority shareholder (holder of the state shares) and usually dominates the management of corporate affairs. With the presence of a keyman, it is difficult, if not impossible, for other directors to play their role in corporate governance. Despite the existence of keymen, China's public companies have started to appreciate the importance of outside directors in corporate governance. On March 17, 2000, BaiYunShan Corp. Ltd. issued a public statement, inviting public investors and other capable people to run for the position of outside directors. This is the first public company in China that hires outside directors through an open and competitive process. As more and more public companies in China start to realize the importance of outside directors, more efforts are needed to develop a system of outside directors in corporate governance. There is a fundamental difference between China's listed companies and America's large public companies. In China, most listed companies stem from restructuring of state-owned enterprises. It is very easy to find a controlling shareholder (the parent enterprise normally controls at least 30% of the outstanding shares) in those companies. While in US, with wide dispersion of shareholding a shareholder could have his voice heard at Board meeting when he owns only 1% of the total shares. Therefore, China can hardly set up a suitable outside director system by simply copying that of the U.S. without considering the characteristics of its own socialist economy. (2) Contour of corporate governance regulations in China Company Law of the People's Republic of China (hereinafter the "Company Law"), becoming effective on July 1, 1994, sets up the basic framework of China's corporate law. Although one can hardly find any clauses in the Company Law about outside directors, various government and semi-government agencies have made or are making regulations and rules that cover duties and liabilities of outside directors. China Securities Regulatory Commission (hereinafter "CSRC"), authorized by the State Council, promulgated the "Instruction Opinions on Setting up Independent Directors System in Listed Companies" on August 16th 2001 (hereinafter "CSRC Opinions" or "the Opinions"). Shanghai Stock Exchange issued "Guidance of Corporate Governance for Companies Listed on Shanghai Stock Exchange" at the end of year 2000 (hereinafter "Corporate Governance Guidance"). Shenzhen Stock Exchange is drafting the "Guidance of Articles of Association of Companies listed on GEM" (hereinafter "Draft GEM Rule"). In the following parts of this article, we will address our discussion to the above rules, mainly to "CSRC Opinions." Distinguished from the U.S. law, these rules use the term "independent directors" instead of "outside directors." (3) Role of outside director system in corporate governance With the existence of inside directors, outside directors might not be expected to perform day-to-day management work. Since outside directors only have limited time and energy it is also unrealistic that they are required to do too much work. According to Article I (2) of CSRC Opinions, people are not allowed to act as outside directors in more than five companies at the same time. Outside directors shall ensure that they have enough time and energy to perform their duties effectively. They are also required to express their opinions on some important matters of the company, especially those on affiliated transactions. Those requirements are necessary, with controlling shareholder and affiliated transaction as serious problems in China's corporate governance. In U.S. companies, outside directors supervise the management work of chief executives and senior management staff. The role these directors play is more like "supervision" than "directing." In other words, they function like the supervisory committees found in continental law countries. In China, we have already had requirements of supervisory committee in the Company Law. Thus, the outside director system will be of less use if we expect it to play the same role it does in the corporate governance system. As such, the role of outside director should be focused on restrictions of power abuse (of controlling shareholders) and supervision of affiliated transactions. As a result, majority shareholders could only look to the company's normal value development and profit distribution for their own interest, which will then be consistent with that of the whole company as well as that of minority shareholders. Daily management can therefore be accomplished by inside directors and other management people. In this sense the goal of outside directors system will be achieved. Besides affiliated transactions, CSRC Opinions also spells out other matters that need outside director's independent opinion, such as hiring or firing and salaries of senior management staff; other matters that outside directors think might impair interest of minority shareholders, etc. (4) Scope of outside director's power Scholars and analysts suggest that there should be a minimum quorum of outside directors in the Board to make sure that the outside director system is really functioning. Since there is no special voting scheme for outside director under China's corporate regulations, outside directors could not have their voice heard in the Board if the absence of a minimum quorum. The result would be that outside directors only act as "rubber stamp" or act as "consultants" rather than as directors. According to CSRC Opinions, board of directors of listed companies shall establish independent directors, the number of which shall be no less than one third of the total number of the directors before June 30 of 2003. Provisions of Corporate Governance Guidance suggest that company shall have at least two independent directors. The number of independent directors shall not be less than 20% of the total number of directors. When the same person acts as both board chairman and president of the company, the percentage shall be 30%. It
is important to set reasonable qualifications for outside
director candidates. Outside directors shall have basic knowledge
of law, economics and finance so that they could make independent
judgment regarding affiliated transactions. Highly technical
experts might be independent, but they are not the best candidates
for outside directors. Another relevant problem is: where do outside directors come from? According to Article IV of CSRC Opinions, board of directors, supervisory committee, and shareholders who solely or collectively hold more than 1% of issued shares of a listed company may name the candidates of outside directors. Shareholders will vote for outside directors at shareholder meetings. Although directors are required to protect the interest of all shareholders, it is inevitable that they will step in the same shoes with those who select and appoint them. If the outside director system is to protect interest of the whole company or minority shareholders, it seems to the author that they shall not be appointed by majority shareholders. We have concluded that the role of outside directors is to mainly supervise affiliated transactions between majority shareholders and the company. It is hard for people to expect outside directors to satisfactorily perform their duty of supervising majority shareholders who selected them. However, this problem might be partly resolved by other schemes of the system, such as the requirement of independence. (5) Independence of outside directors CSRC Opinions requires that outside directors must be independent. People who are not qualified to act as outside director for lack of independence include: people employed by listed company or its affiliated enterprise and their lineal relatives as well as "main social relations;" natural-person shareholders who directly or indirectly hold more than 1% of issued shares of listed company and their lineal relatives; people employed by a shareholder unit that directly or indirectly holds more than 5% of issued shares of listed company and their lineal relatives; professional personnel who provides financial, legal or consultant services for listed company or its affiliated enterprises; etc. Normally, there is less doubt that outside directors are independent while being appointed. But people will question whether they could always keep their independence during their terms. There are two relevant problems here: one is the term of outside director, and the other is the remuneration of and incentive to outside directors. a. Terms of outside director Terms of outside directors influence their independence. When outside directors work with inside directors and the management persons for a long period, the friendship between them will likely make the outside directors not independent any more, or at least less independent. According to CSRC Opinions, the terms of outside directors are the same with those of inside directors stated in the Articles of Association of the company. The maximum term is six years. It is hard to say that an outside director will keep his independence after working with all the other inside directors for six years. The author considers a term of six years might be too long and suggests that the maximum term be reduced to three years. After the third year, the outside director may continue to work in the company, but as an inside director. b. Remuneration and salary of outside director Remuneration is one way to encourage outside director to work effectively. A major objective of board remuneration plans is to compensate directors fairly and in doing so to align their financial interest with long-range objectives of the shareholders. According to Article 103 of Company Law, the shareholder's meeting shall have the power to determine the remuneration of directors, including inside and independent directors. Corporate Governance Guidance requires that independent director shall get remuneration that is in accordance with his obligation and duty. CSRC Opinions says very little about remuneration of outside directors. There is a dilemma here. To make outside directors work efficiently, reasonable and encouraging salaries are needed. On the other hand, the independence of outside directors will be affected by people who decide their salary. The more they are paid, the less independent they will be. Policymakers need to find a balance point where outside directors are fairly paid on condition that their independence is not severely affected. Moreover, The author thinks that outside director shall be given competitive compensation in view of industry practices. The form of such compensation will vary from corporation to corporation and may depend on the situations of the directors that the board may be seeking to attract and retain. The Business Roundtable suggests that boards may consider aligning the interests of directors with those of the corporation's stockholders by including some form of equity, such as stock grants or options, as a portion of each director's compensation. At the same time, the Business Roundtable also realizes that the scheme may depend on the circumstances of directors, especially outside directors. For example, some outside directors whose principal occupations are in public service or academic settings may prefer current cash compensation. This may be considered by China's policymakers while setting up relevant systems. (6) Duties of outside director a. China's Company law China's Company Law does not introduce the concept of fiduciary duty of directors and managers, which incurred some sharp criticism. Instead, directors are imposed upon the duty to "faithfully perform their duties and protect the interests of the company." The regulation is too general, and there is no specific standard by which directors shall abide. Up till now, there is no relevant authoritative explanation as to this concept. It is hard to predict how the court will explain the clause in future cases. b. Other relevant regulations CSRC Opinions is relatively more specific and acceptable. CSRC Opinions adds fiduciary duty to the basic requirements of independent directors. Independent director shall comply with laws and regulations of the state and shall be responsible to all the shareholders with fairness and impartiality. Independent director shall especially protect legal interest of minority shareholders. Most importantly, CSRC Opinions focuses on the independent opinion of independent directors. Independent director shall express independent opinion upon the following affairs: financial report and profit distribution of the company; affiliated transactions; investment plan, mergers and acquisitions and such other matters as shall be determined by the board; the matter as to which there is material disagreement among the directors; the matter that independent director thinks might impair minority shareholder's interest; and so on. The opinions of independent directors and their proposals in the board meeting shall be disclosed to the public. With the inadequacy of regulation of director's fiduciary duty in Company Law, efforts are needed to set up and to further explain the concept. On the other hand, outside director system is still new to China's companies. Capable people are encouraged to act as independent directors. Therefore, it is appropriate for CSRC Opinions not to impose too much liability upon them at the starting points of the legislation. The Opinions gives the companies some freedom and possibility to attract capable people into their management. (7) Protection of outside directors from their liabilities In the absence of the concept of fiduciary duty in Company Law, it is not surprising that there is no such concept as "business judgment rule" in China's corporate law system. The outside director scheme would not work well if it only has duties and liabilities without protection. CSRC Opinions requires that the company shall provide necessary working conditions for independent directors and make sure that they can perform their duties without disturbance. When an independent director is implementing his function, the company's personnel shall actively cooperate with him and shall not interfere with his independence. This, although nearly irrelevant to the concept of "business judgment rule," provides at least some protection to outside directors discharging their obligations. However, it is still difficult for the outside director to find legal defenses when they are sued for their business decisions that turn out to be detrimental to the shareholders later on. CSRC Opinions also suggests that listed companies shall set up necessary liability reimbursement system of independent directors so as to disperse their risk during the performance of obligations. The Opinions, however, does not specify what kind of system since there are still many other relevant systems that are not ripen yet. In the U.S., large public companies and outside directors rely on D&O insurance to lower the risk. Although the insurance industry of China is rapidly developing, the insurance of director's liability has not fully emerged yet. Outside directors will find it difficult to look to liability insurance for protection in China. The good thing of CSRC Opinion is that at least it urges the listed companies to explore reimbursement system and give protection to outside directors. IV. Conclusion The discussion above illustrates the difference between U.S. law and China Law with respect to the outside directors system. In China, the notion of corporate governance is still focused on majority shareholders and the whole board of directors, while the U.S.' outside director system affords more flexibility to run the business. On the other hand, China's legislature has begun to put an eye on the development of outside directors. There are some reasons for those differences. China's legal system is more of a civil law system. It is difficult to develop some case law concept such as "business judgment rule" in China. Companies have to rely on the promulgation of new regulations and rules from different levels of legislatures to develop an integrated and advanced system of corporate governance. The motivation behind the U.S.' corporate governance system is the natural development of economy and the industry in the U.S. Relevant statutes in the U.S. are based on the "judge-made law" that was pushed by the economic requirement. While in China, the motivation of promulgation of Company Law is the reform of state-owned enterprises. China's government hoped to establish a modern enterprise system and to create a tool to promote China's industrial development. The basic questions raised by outside directors system are their role in corporate governance and what kind of protection the law shall give them. The contrast between the United States and China law in this article displays the different approaches and regulations governing the duties and liabilities as well as the protections of outside directors. The new regulations of China we have discussed demonstrate the efforts of China's legislature and the tide of development of outside director. In general terms, China's legislation focuses on the duties and liabilities of outside directors, but lacks the necessary protection and compensation measures. Perhaps the legislatures hope that introduction of outside director system could improve the standard of corporate governance of China as soon as possible. However, they seem to overlook the point that protection and encouragement are both very important to the system. On the other hand, the U.S. system furthers the efficient management of a corporation and provides for detail mechanisms to apply fiduciary duties of outside directors and to provide protections to them at the same time. The strongest benefit afforded by the U.S. law, from the standpoint of directors (inside and outside), is the flexibility to run a business. The outside director system is an important topic in corporate governance. The purpose of this article is not to just introduce the relevant system of the U.S. law, but rather to provide some possible suggestions to the setting up of China's outside director system and to enrich the content of China's corporate governance discussion. (The author is an attorney at the Hong Kong office of Freshfields Bruckhaus Deringer. References are available from the author upon request.) |