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Disinterested
or Uninterested? Some Thoughts on the CSRC's Independent Directors
Guiding Opinion Richard GUO (Editor's note: The original version of this article first appeared in China Law & Practice, Volume 15, No. 8, October 2001 and is reprinted with the permission of Euromoney (Jersey) Publications Ltd. with minor revisions.) In August 2001, the China Securities Regulatory Commission (CSRC), China's securities watchdog, released its "Establishment of Independent Directors System by Publicly Listed Companies Guiding Opinion." The Opinion mandates the adoption of independent directors bylaws at domestically listed companies within a strictly defined time frame: a minimum of two such directors per board must be in place before June 30, 2002 and at least one-third of each board in the next year must be outsiders. This Opinion appears to be based on the idea that as an independent person, an outsider automatically qualifies as an ideal monitor of corporate management and thus helps to optimize corporate governance. [1] Is that so? Does this active monitoring model of directors fit into the Chinese environment? If so, can the "independence" as defined satisfy its designed function? One cannot obtain a comprehensive- and, more importantly, comprehensible- perspective on these questions without first taking a look at ownership and control patterns in Corporate China. WHO IS THE "OWNER"? "Ownership" in Chinese law, rooted in the Roman law idea of "mancipium" or "dominium", i.e., absolute right over a thing, is far more rigid and technical than the same word as used in common law jurisdictions, where it is more utilitarian and realistic. [2] That probably explains the uneasy position of the Chinese Company Law in dealing with the notion of "equity ownership" or "stock ownership", a relatively new animal in Chinese socialist economy. Article 4 of the Company Law admits the ownership right of shareholders, albeit subject to the state shareholder's property right on the state assets of a publicly listed company. Let's assume that when the legislators were talking about "ownership right of shareholders," they meant that shareholders "own" a firm by virtue of their status as its capital contributors. Amongst all the capital contributors of Corporate China, however, none is behaving like an "owner". The
State Shareholder Public
shareholders Institutional
Investors Thus Corporate China tends to suffer from an "ownerless" syndrome in which nobody takes seriously a given firm's long-term competitiveness and acts in a responsible way to ensure that a corporation, as a combination of capital and management, works well to give its capital contributors fair share of returns. WHO IS IN CONTROL? From the beginning of widespread use of the corporate form in China, ownership has generally been closely held, with corporations dominated by a small number of controlling shareholders. Furthermore, the largest shareholder, the state or the government, still appoints board representatives and managers, and interferes with internal corporate affairs, in the same manner as in the pre-corporation era, regardless of equity interests. Therefore, Chinese publicly listed companies have inherited the conventional "insider control" problem associated with orthodox socialist state-owned enterprises, the predecessors of most listed companies. As a matter of fact, minority shareholders have never "controlled" Corporate China. Hence the issue is not returning control of corporate affairs to dispersed shareholders, as advocated in the US by Professor Berle, who has remarked on the widened separation of ownership and control in modern corporations. However, it is time for minority shareholders in Chinese corporations to reassert their long-deserved ownership rights, including at a minimum the right to use effective monitoring to curb those insiders who engage in collective rent-seeking behavior. WHO IS MONITORING? Irrational equity structures are often blamed for failures in corporate governance in China. The overwhelmingly illiquid state of shareholding in Chinese corporations deprives the capital market of necessary disciplinary capacity. Minority shareholders are locked into a situation where they can cast meaningful votes neither with their hands (by taking decisions in shareholders' meetings) nor with their feet (by selling their shares in the open market). Legal channels such as fiduciary lawsuits, derivative actions and class actions to hold management accountable for their failings are still usually not viable options, nor is the hiring of securities lawyers for potential plaintiff investors. The remaining possible monitors are the CSRC and the Supervisory Board, an internal organism "specializing" in monitoring management. The problem with both is information blockage caused by a lack of credible disclosure, which is part of a prevailing corporate culture that tends to lack self-discipline. The CSRC, in addition to its policing power, also enjoys substantial administrative authority; thus the regulator can find itself caught in a dilemma involving a conflict of interest. The greatest weakness of supervisory board is its lack of independence. Although presumably both shareholders and employees should fill the supervisory seats, more common is a supermajority employee presence, [3] which not only undermines the independence of the supervisory board, but also makes it very difficult to protect minority shareholders from management overreaching its authority. For instance, the supervisory board is not authorized to remove badly performing executives. To the contrary, management appoints supervisors, including the chairman of the board, and also sets their remuneration. The question then arises as to who is supervising whom. THE INDEPENDENT BOARD Presumably, the independent director model has been introduced as a means to bring home the long-awaited independence. But independence from whom? Returning to the 1997 CSRC-issued Listed Companies' Articles of Association Guideline [4] and 1999's Further Standardizing Operations and Intensifying Reform of Companies Listed Outside China Opinion [5] the recent Opinion precludes shareholders holding, directly or indirectly, 1% or more of equity from serving as independent directors. This rule is far more restrictive in practice than implied by the CSRC's definition that "an independent director is one who doesn't hold other office beyond his job as a director, and has no such relations with major shareholders that would interfere with the exercise of independent and objective judgment." Independent directors were instituted in the US to cure the conventional agency problems in large publicly held corporations, characteristic of dispersed ownership, and partly in response to corporate governance failures in the 1970s as uncovered in the Watergate investigation and foreign bribery cases. Therefore, it is shared wisdom that the necessary independence is in terms of corporate management, [6] rather than in terms of shareholders. For instance, the 1990 "New Compact For Owners and Directors" claims that stock ownership doesn't disqualify a director from being an outside director, and hence independent. It is commonly held that to do their job efficiently and responsibly, independent directors have to hold certain percentage of shares of the company they serve. [7] In China, the generally concentrated composition of equity means that each director tends to be loyal only to the major shareholder whom he represents, especially in the event of conflict. Thus, before overall share structure is optimized and fiduciary lawsuits become readily available, it is crucial to have minority shareholders' interests represented in the boardroom, be it on the board of directors or through a strengthened board of supervisors. Therefore, to be a means for some end, independence in a Chinese setting should be independence from any insiders, including managers, management directors and controlling shareholders, whom the monitor oversees, but by no means from minority shareholders whose voice has been unheard in boardrooms and for whose sake the monitor shall scrutinize. No convincing argument has been given as to preclusion of minority shareholders from the slate of independent directors. As best proclaimed by corporate governance experts Robert Monks and Nell Minow, directors do not become independent just because they have no economic ties to the company beyond their job as a director; to the contrary, disinterested outsiders can mean uninterested outsiders. [8] It is unrealistic to expect these outsiders, whose remuneration, as defined in the Guiding Opinion, is kept strictly separate from their performance, to act for minority shareholders' best interests without sufficient incentive to do so. To best represent the interests of minority shareholders, a monitor has to share those interests. That is, he has to be a (minority) shareholder too. The key to success is to strike a good balance between locating someone incentivised enough to protect the minority shareholders without caving in to their overly opportunistic tendencies. This may, for instance, be achieved by aligning the independent directors' compensation to the firm's long-term performance through option plans with a longer time span. In short, a monitor is needed who is not only a (minority) shareholder, but who is an "ideal owner" that has long-term vision and sufficient financial sophistication, and is willing to become fully informed about the company. There might also be other matters that make the CSRC "independent board" notion backfire, which are detailed below. Nomination
Furthermore, the CSRC will have final say regarding a candidate's independence or not. (Article 4, section 3). The risk is that by using the "independence" label, the CSRC would inevitably lose sight of the trees for the forest. That is, an individual's interests vary in accordance with contexts and transactions. An officially endorsed independent director may be caught in a conflict of interest in a specific transaction. That is why the ALI examines whether a director is "interested" in a specific transaction when a question is raised as to the directors' possible breach of fiduciary duty, but in pondering board committee membership, would check whether there is a "significant relationship" between a director and senior managers. Some may argue that the 1% requirement is just a cap CSRC imposes on the size of the shareholding of independent directors; it is thus probably not the intention of CSRC to disqualify shareholders altogether from serving at corporate boards. However, shareholding structures are not all the same across all listed companies. Thus, individual firms may have different governance needs. One percent might be significant in a highly dispersed structure, but not so in a relatively concentrated one. An outright "haircut" like this rule ignores the differences in shareholding models and thus the governance needs of the shareholders. Governance
power Even assuming that independent directors fill 1/3 of a board, which won't be reality until 2003, that percentage is hardly decisive for any real purpose. Think about the fact that, the impact of American independent board, if any, on corporate governance relies to a large extent on the supermajority board seats. [9] Without real power to set insiders' remuneration and to remove them in case of substandard performance, a slate of independent directors, obligated to speak out on every issues falling in the Article 6 category, would serve no real function but window-dressing. Duty
of care INDEPENDENT DIRECTORS OR INDEPENDENT SUPERVISORS? Without a dualist board structure as found in Germany, efforts in the US to enhance corporate responsibility had to be done within the board of directors. [9] Ever since the American Law Institute failed to bring in an active monitoring model, [10] empirical evidences vary as to real impact, if any, independent directors have on corporate performance. While Millstein and MacAvoy (1998) found a statistically significant relationship between active, independent boards and superior corporate performance, Bhagat and Black (1999) concluded that there is no convincing evidence that greater independence results in better performance, but some evidence that firms with supermajority independent boards perform worse than others. [11] Therefore, before rushing into another governance bureaucracy, it is more prudent to explore the possibility of revamping the ailing board of supervisors, which is supposed to be specializing in "supervision" as a matter of law. For instance, improving the independence of supervisors from management should receive at least the same effect as independent board (of directors). The global corporate law convergence is not achieved by borrowing and copying from one another, but is a functional convergence at the securities law level. Strict emphasis on disclosure and transparency, and thus exposing insiders to the sunlight, is probably the first and most important step for any meaningful monitoring. What model of corporate governance to choose depends on which one will be most compatible with the governance situation in a specific market. Otherwise, without a workable concept of independence and a feasible duty of care standard, corporate insiders would simply pay lip service to the Opinion. [12] "Independent directors", would thus risk becoming another layer of corporate bureaucracy, composed of figureheads, celebrities and men, which burdens shareholders and corporate resources. To be clear, no single element is decisive in achieving good corporate governance. An independent board alone can't, nor can the simple fact of an independent director being a shareholder. But whatever the governance model, and no matter how well it has worked elsewhere, it must fit into the context of Corporate China, which has somehow learned to neglect minority shareholders' ownership rights. (The author is an associate with Pillsbury Winthrop LLP, an international law firm.) Notes: |