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Independent Directors: A New Chapter of the Development of Corporate Governance in China

Proceedings of the 15th Annual Conference of the Association for Chinese Economics Studies Australia (ACESA)


Independent Directors: A New Chapter of the Development of Corporate Governance in China



Helen Wei Hu*

Monash University




Abstract

This paper examines the development of corporate governance in China, with a focus on independent directors. Corporate governance is regarded as the core of the ongoing State-Owned Enterprises (SOEs) reform, and the newly introduced independent director system is viewed as a revolutionary change to the Chinese corporate governance development.


This paper analyses the characteristics of independent directors in the Chinese context, proposes five internal factors that would affect independent directors’ performance, namely independence, remuneration, qualification, assurance and autonomy. It is suggested that these factors are essential for independent director system to work effectively, and hence will lead to better board performance.

As China begins to implement its commitments under the WTO, the policy focus on corporate governance in China sends a strong signal that the government is committed to further market reforms’, (Wolfensohn, 2002).1

  1. Introduction

China launched a major economic reform and liberalisation program in 1978, which transformed the planned economy to a market economy. Since then, the reform of state-owned enterprises (SOEs) has been considered the key to the success of China's economic growth. In 1992, the Chinese government reformed its SOEs through corporatisation, and the concept of ‘modern enterprises’ was introduced accordingly.2 During this process, the separation of state ownership and control was adopted, and company managers were granted fourteen control rights in July 1992. However, with increased managerial autonomy and unclearly defined property rights, the agency problem of Chinese managers was more serious than that in Western countries (Qian, 1995).


Insider control problems occurred during the SOE reform. Examples of these problems include collusion between managers and workers; transferring firm assets from the state-owned enterprise to non-state-owned enterprise; tax evasion and corruption among SOEs’ managers, and ultimately led to poor firm performance (Lee and Hahn, 2001; Qian, 1995). In fact, the existence of insider control problem can be explained by the fundamental principle of agency theory, which is the conflict of interests between the principal (owner) and the agent (manager). Hence, an effective control mechanism needs to be in place that not only maximises shareholders’ interests, but also reduces the cost of monitoring.


By addressing insider control problems and poor SOEs performance, many Chinese researchers urge the need for an efficient corporate governance system (Qian, 1995; Wu et al., 1996; Zhang, 1998). Moreover, after China’s entrance into the World Trade Organization (WTO) in December 2001, Chinese companies became exposed to the opportunities and challenges of today’s international market. In order to remain competitive and attract more financial and human capital, Chinese authorities see the urgent need for sound corporate governance.3


However, empirical studies from the West show that good corporate governance has no direct impact on financial performance (CBI et al., 1996; Daily and Dalton, 1998). But, sound governance provides improvement when the company is under-performing due to poor management (Lipton and Lorsch, 1992), or leads to a better performing board (Investors Relations Business, 2000). From the study of bankrupt firms and hostile takeover, results suggest that good corporate governance is positively related to the successful reorganization of a financially distressed firm (Daily and Dalton, 1994), or reduce the probability of a firm paying greenmail (Kosnik, 1987).


As Van den Berghe and De Ridder described, ‘Corporate governance is not an end in itself, but a means of achieving the corporate objectives and strategy. In making a significant contribution to prosperity corporate governance has also national importance’ (1999, p.15).

The paper is organised as follows. Section 2 reviews the theoretical and empirical studies of the effectiveness of board composition and examines the development of independent directors in China. Section 3 introduces the Chinese independent director performance model by identifying key factors and challenges that independent directors face, followed by a conclusion and discussion in Section 4.

  1. Theoretical background of the development of independent director System


In most transition economies, insider control problems exist when the government hand-over its control rights to the management (Aoki, 2000). Due to the absence of external market control mechanism and inefficient internal monitoring system in China, management tends to have stronger autonomy in business operation and decision-making. As agency theory argues that individual is driven by opportunistic behaviour, thus, managers would engage in self-interest serving instead of maximising shareholders’ returns.


In the case of Chinese joint stock companies, it is found that over 1,200 listed companies in China to date, about 80% to 90% came from the restructuring of SOEs, and the state still owns about 50% shares of the listed companies (Tong, 2002). Under the ‘socialist market economy’ background, central and local government agencies tend to carry out shareholder functions, appoint directors to the board and give direction to firm management (Broadman, 1999; Tam 1999). Many researchers argue that the interest of the state shareholders might not be the same as that of other institutional or individual shareholders. Because government might be more interested in pursuing social and political goals instead of profit maximisation (Berkman et al., 2002; Xu and Wang, 1997).


Obviously, a firm is either controlled by insiders or the state shareholder, without proper monitoring from outsiders is not healthy for the development of country’s economy (Qian, 1995). In August 2001, the China Securities Regulatory Commission (CSRC) released the “Guidelines for Introducing Independent Directors to the Board of Directors of Listed Companies” (CSRC, 2001; hereafter referred to as the ‘Guideline’)4 to strengthen the importance of board independence, and protect the interests of nearly 60 million Chinese shareholders. Four months later, the “Code of Corporate Governance for Listed Companies in China” (CSRC, 2002; hereafter referred to as the ‘Code’) was introduced to further speed up the development process, and hence improve individual company’s corporate governance practice.


The official definition of independent directors is, ‘directors who hold no posts in the company other than the position of director, and who maintain no relations with the listed company and its major shareholder that might prevent them from making objective judgment independently’ (CSRC, 2001, article 1.1).


After introducing the independent director system, the remaining question is, “Will firm have better performance by having independent directors on the board?” Studies from the West show that there are some controversial views on the effectiveness of board independence in relation to firm performance.


On the one hand, some researchers agree that independent directors do have a positive relationship on firm’s corporate performance. Early work by Fama and Jensen (1983) contends that independent directors provide a means to monitor management activities through an increased focus on firm financial performance. Lee, Rosenstein and Rangan (Lee et al., 1992) support this view, provide evidence that boards dominated by outside directors are associated with higher returns than those dominated by insiders. Similarly, Pearce and Zahra (1992) point out that there is a positive correlation between the proportion of independent directors and firm financial performance. Baysinger and Butler (1985) report that changes in board composition over a ten-year period from 1970s to 1980s appear have a causal relationship with accounting performance. In addition, Millstein and MacAvoy (1998) find a statistically significant relationship between active, independent boards and superior firm performance.


On the other hand, scholars such as Patton and Baker (1987) question the resolve of outside directors to actively monitor top management who often select them as candidates for their board seats. Some recent studies offer hints that firms with a high percentage of independent directors may perform worse. Started with Yermack (1996), he reports a significant negative correlation between proportion of independent directors and contemporaneous Tobin's q. Furthermore, Rosenstein and Wyatt (1997) argue that insiders are more effective because they have superior knowledge of the firm and its industry than outside directors, and they are just as diligent as outside directors, given their legal responsibilities and their own interests in the firm. Similarly, Bhagat and Black (1999) also state there is no convincing evidence suggesting that greater independence results in better performance, but some evidence shows that firms with supermajority independent directors perform worse than others.


A recent meta-analysis conducted by Dalton, Daily, Ellstrand, and Johnson in 1998, which included 159 studies covering 40,160 companies over more than 40 years. They concluded that ‘empirical work in the area does not provide consistent guidance on the relationship between company performance and board independence’ (Daily and Dalton, 1998, p.7).


From the above discussions, it is obvious that scholars have not reached a consensus view of the board composition in the corporate governance literature. However, the role of independent directors as effective monitors and controllers of firm’s management is perceived by many researchers. Fama and Jensen (1983) view that outside directors who hold multiple directorships have a greater incentive to monitor corporate performance because the professional directors have a personal investment in establishing their reputations as decision making experts. Additionally, outside directors may reduce managerial consumption of perquisites (Brickley and James, 1987), will not be intimidated by the CEO (Weisbach, 1988), and act as a positive influence over the directors' deliberations and decisions (Pearce and Zahra, 1992).


Moreover, the importance of independent directors as a governance mechanism to protect shareholders’ interests and safeguard managerial employment contracts is recognised worldwide. For instance, the OECD Principles of Corporate Governance (1999) suggests that company’s board should provide independent and objective judgements on corporate issues, apart from the management. The Combined Code and the Higgs report believe independent directors are essential for protecting minority shareholders and can make significant contribution to firm’s decision-making. They indeed recommend that half of the board members, excluding the chairman, should be independent (Combined Code, 2003; Higgs, 2003).


By seeing the significance of independent directors, the Chinese authorities took the step, and a new chapter of corporate governance just began.


  1. An independent director performance model


The emergence of the independent director system in China should act as a functional means to increase board independence and enhance board effectiveness. Obviously, a number of external and internal factors such as market control mechanism, government regulation and legal framework; social-economic development, concentrated ownership and board structure do play significant roles in the formation of independent directors. But, it is more important to understand the nature of the independent director system, the existing problems it faces and possible solutions it can have. In this paper, it sees five critical aspects that will affect independent directors’ performance, and the model is generated as follows.




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Diagram 1: Independent director performance model


















3.1 Independence


Independent directors will only be able to enhance board efficiency provided they are truly independent. Without independence, the existing conflicts of interests between management and shareholders would affect the objectiveness and fairness of their judgement.


Although CSRC has provided a detailed guideline for determining directors’ independence as stated in article 3, there are still some loopholes in the description. According to the world’s most influential Corporate Governance Codes, a company’s ex-employee can only be qualified as an independent director after certain cooling off period. For example, a period of five years passage time is required by the NYSE5 (2002) and the CalPERS6 (1998) in the United States, or three years required by the ASX7 (2003) in Australia. However, the CSRC guideline requires a one-year break time for ex-employee to be an independent director, which is far from the actual concept of being truly independent. The whole idea of introducing independent director is to provide objective and independent judgement on management’s performance, without being influenced from the company’s management or major shareholders. But, by requiring only a one-year cooling off time, it is possible that the ex-employee might still have some sort of loyalty or connection with the company, which is difficult for him/her to raise opposition or act tough to the management. Thus, I reckon a minimum of three-year passage time is mandatory.


Secondly, the CSRC guideline does not clearly specify whether a company’s current non-executive director can switch to be an independent director. In China, a listed company has quite a number of non-executive outside directors, whom either come from firm’s controlling shareholders or other affiliations. For example, Mr. Zhou was a director in one of the biggest Chinese listed firms in 2001, but he was simply transferred and became an independent director in the following year. Company’s total number of independent directors increased from 3 to 4 in 2002 by adding Mr. Zhou’s participation, and now the company just met the CSRC’s requirement by having 1/3 of board members are independent. The question is if a company’s non-executive director can be easily switched to independent director, why we need independent director in the first place. Officially, this non-executive director may be qualified as an independent director, but by serving at the same firm and the same board for a certain period, how independent can this director be? Shouldn’t the independent director be more ‘original’? Otherwise, the implementation of the independent director system is just like the “old wine in new bottles”.

    1. Remuneration


The remuneration issue of independent director always triggers hot debate in China. The article 103 of China’s Company Law states that shareholders’ general meetings should determine the remuneration of directors, for both inside and independent directors. With increased job responsibility and higher liability, it is agreed independent directors need to be paid appropriately.

In many countries, directors’ remuneration is often paid in two parts, one is a fixed fee and the other is often linked with firm performance, such as shares or stock options, so that to better align directors’ interests with that of shareholders. In China, directors are mainly paid by a fixed compensation fee, which is low in general. There are cases that many independent directors absent during board meetings, pay could be one of the reasons as individual always wanted to maximise his own return. On the other hand, a high remuneration might not be good either. If independent director is getting too high, it is possible he may lose his ‘independence’ and become a ‘yes’ man to company’s management.

It is suggested that separate type of payments should be encouraged, such as payment for attending meetings, stock option or other performance-related payment. In fact, stock option might seem to be appropriate because it not only directly aligns directors’ interests to their shareholders, also indirectly aligns directors’ share return in according to firm performance. This will provide a greater incentive for independent directors to work hard and achieve better performance.


    1. Qualification


According to CSRC, an independent director shall meet five basic requirements in order to be qualified. However, among these requirements, there is only one condition that the candidate must meet prior to becoming an independent director. That is ‘with more than five years' work experience in law, economics or other fields required by his or her performance of the duties of an independent director’. By looking at the current pool of independent directors in China, lacks of relevant knowledge is always questioned by the public (People’s Daily, 22 August 2001). Hence, qualification is essential in the independent director system.


Countries like the United States, where companies’ CEOs are the most popular candidates for independent directors. In a survey of 856 CEOs of public Fortune 1000 firms, it shows that 54 percent of the CEOs are directors of two to four boards, and nearly 10 percent of the CEOs sit on five or more boards (Daily and Dalton, 1998). Also, many retired CEOs and company senior executives frequently act as independent directors in other companies, because their working experience and management know-how do make valuable contribution to firms.


In contrast, most of the independent directors in China are either academics or government civil servants, who often have no experience of running a company; low level of sense of responsibility to firm’s financial performance; and most importantly, they lack of sufficient knowledge in dealing with a listed company. It is very difficult for them to provide sensible judgement on firm’s critical decisions, such as related party transactions or mergers and acquisitions. Therefore, it is reckoned that the independent directors’ training and examination should be compulsory, and foreign talents should be encouraged.


    1. Assurance


Director and officer (D&O) liability insurance is common in Western countries and outside directors heavily rely on D&O insurance to lower their risk.8 After the adoption of the Sarbanes-Oxley Act in 2002 in the US, with increased directors’ responsibilities and liabilities, D&O insurance played a more significant role in providing legal protection for the corporate entity as well as its directors. Simply because in the process of insuring, D&O insurers will first conduct a strict examination of each individual director before providing any insurance services to them. In a way, it practices a monitoring role on directors and better aligns directors’ interests to their shareholders.


Empirical studies suggest that D&O liability insurance is positively related to shareholder wealth (Bhagat et al., 1987), and the D&O insurance would result in higher percentage of outside directors in which to improve board independence (O'Sullivan, 1997). Without such legal assurance, conservative management is more likely to result and shareholders interests is less likely to be protected (Jensen, 1993).


As a matter of fact, it is acknowledged that the mature insurance market in the West also attributed to country’s fully established bankruptcy law, potential threat of hostile takeover and on-going shareholder lawsuits. Unfortunately, non-of-these external mechanisms are active in China, so managers are less threatened of losing their jobs and hence more opportunistic behaviour will result. Currently, company’s insider control problems, stock market manipulation and insider trading are serious issues in China, which infringed the interests of shareholders. In order for the independent directors to act effectively as internal monitoring mechanism, directors’ legal assurance is urgently required.


Nevertheless, the guideline and the code recognise the importance of directors insurance and suggest that a listed company may purchase liability insurance for their directors. But the problem is even if the company or directors are keen to purchase D&O insurance, there is no such coverage currently available in the market. Therefore, under the current circumstances, any increase in directors’ responsibilities would lead to difficulties in attracting good candidates, or cause the existing independent directors to hesitate in lifting opposite opinions. Although the Chinese authority is determined of building sound corporate governance, the remaining question is “how well and how soon can the D&O insurance system be implemented in China?”

    1. Autonomy


With inside directors and directors of the controlling shareholder dominating the board, greater autonomy is necessary for minority independent directors to effectively exercise their power. In order for independent directors to play an active role in the internal monitoring system, CSRC authorised independent director the power to approve ‘major related party transactions’,9 or raise independent opinion on major events occurred in the listed companies. More specifically, the role of independent directors is to protect the overall interests of the company, especially that of the minority shareholders. And directors should make objective judgement without influencing from the controlling shareholders or company’s management. By looking at these rights, it is argued that independent directors’ autonomy can only function effectively provided they are truly independent.


In China, listed company practiced a two-tier board structure. Unlike other Asian countries namely Taiwan or Indonesia, where firm’s supervisory board is responsible for monitoring and evaluating the performance of board of directors and senior managers, so certain degree of independence of the supervisory boards is required. Also unlike the US companies, where there is only one unitary board with independent directors to be the majority, and the board has both the supervising and controlling roles of its senior management staffs, including the CEO. Furthermore, these outside directors organise annual meetings without the CEO or other inside directors’ presence, which means they have had higher autonomy and hence more objective independent judgment can be expected.


In comparison, the supervisory board in Chinese companies comprised of mainly shareholder representatives and an appropriate proportion of representatives of the company employees, so the weakness link of the Chinese supervisory board is a lack of independence (Hu, 2003). According to the Company Law (1994), shareholders monitor and control the supervisory board and board of directors in parallel, they have the right to elect and dismiss both supervisors and directors. But supervisory board also has the right to oversee company directors, to examine firm’s financial affairs. Under such structure, independent directors’ autonomy is definitely undermined. This is because with the majority supervisors being insiders or from the controlling shareholder, their nominal control right makes more difficult for independent directors to make objective judgement.


The recent corporate governance scandals happened in China shows that there are many cases in which controlling shareholder or parent company conducted non-transparent related transactions with the listed company at cost of public shareholders. For example, the parent company sold own products to the listed company at a very high price or purchased high quality products from the listed company at an unreasonable low price, which caused the listed company to soon become financially distressed (Wang, 2003). Looking at these cases, clearly the independent directors did not play an effective role since they have the official right to first approve the transaction deal before it can be actually submitted to the board. Therefore, it is advised that for independent directors to perform effectively, strong autonomy must be given. Simultaneously, for supervisory board to carry on its monitoring function of the board of directors, the basic criterion of ‘independence’ has to be satisfied. .

  1. Conclusion


In the past, few listed companies had independent directors as board members, company decisions were either made by the management or the controlling shareholder without any monitoring mechanism from outsiders. Ultimately, poor performance was resulted due to firm’s inefficient corporate governance system, especially the low productivity and profitability of SOEs compared with that of township and village enterprises (TVEs), collective-owned, foreign invested and private enterprises.


In order to increase the effectiveness of the internal control mechanism, enhance the independence of boards of directors, the independent director system was introduced to Chinese listed firms. However, independent directors will not function effectively if some basic criteria are not met. This study shows there are five important factors that need to be considered in the independent directors’ performance model.


Firstly and most importantly, is the ‘independence’ of directors. In country like China, with the concentrated ownership structure and serious insider control problems, for independent directors to monitor firm’s major related transactions without minority shareholders’ interests being infringed, the basic element of ‘independence’ must be fulfilled. Directors should be independent not only from the management, but also from the controlling shareholder. If independent directors have close relationship with any of them, they are not truly independent. Consequently, independent judgement or fair opinion is unlikely to be delivered, and interests of minority shareholders are less likely to be well protected. Therefore, ‘independence’ is the prerequisite in order for the whole independent director system to take off.


Secondly, from the perspective of motivation theory, money is often equated with the lowest level of needs (Maslow, 1965), or important hygiene factor to prevent dissatisfaction (Herzberg et al., 1959). But others argue that money is important and it has a direct impact on satisfaction (Vroom, 1964). The more income an independent director receives from his job, the more efforts he is likely to put in. In China, with no other payments such as shares or stock option available in the market, a sufficient incentive is necessary in order to attract good candidates and better align independent directors’ interests with those of shareholders.

Thirdly, sufficient knowledge is required in order for independent directors to make sensible judgement. With independent directors’ responsibility of handling company’s related party transactions, their understanding of business know-how, product and financial knowledge is essential. Otherwise, they can be easily manipulated by the company or making irresponsible decisions. However, the current pool of independent directors is mainly drawn from academics or government departments, whom may lack of experience in dealing with business decisions of public listed firms. It is suggested that in order for independent directors to perform effectively, relevant training must be given and experienced foreign talents should be encouraged.

Fourthly, it is argued that in the absence of D&O liability insurance, it is very difficult to expect independent directors to play an active role. In fact, with increased job responsibilities, insurance becomes more important to indemnify directors from negligence, error, breach of duty and so on. To encourage independent directors to provide objective opinion, it is possible that they may need to stand up and against management’s decisions, so sufficient assurance must be given. Under the current situation, it is important to see how soon the D&O insurance system can be implemented to Chinese listed firms.

Finally, for independent directors to function properly, great autonomy and resources are necessary. And the autonomy can only be useful provided the outside directors are truly independent. Without independence, higher the autonomy may lead to worse the performance. To assure independent directors’ autonomy, job description need to be clearly defined, job-overlapping need to be avoided and company’s interference need to be minimised. Overall, through the accomplishment and satisfaction of the five factors, independent directors will be better motivated, high sense of responsibilities will be resulted, and better performance will be achieved.

In summary, this paper analyses five internal factors that play key roles in the effectiveness of the independent director system. Nevertheless, there are other board characteristics like board structure, board size; board meetings and CEO role duality will also affect the performance of independent directors. In addition, the effectiveness of the external market control mechanisms, the implementation of the legal system and the development of human capital market are all vital to the success of independent director system. Further research in these areas will be beneficial to the development of corporate governance in China.

References


* Correspondence to:


Helen Wei Hu

Department of Management

Faculty of Business and Economics

Monash University

Caulfield, Victoria 3145


Email: [email protected]

Ph: +613 9903 1525


The author would like to thank Professor On Kit Tam for his helpful suggestions and comments.

1 James D. Wolfensohn’s speech at the International Conference on Building the Institutions for a Modern
Market Economy: Corporate Governance Reform in Post-WTO China, 26 May 2002, Beijing, China.

2 A modern enterprise is a company with clarified property rights, clearly delineated rights and responsibilities, financial independence and accountability, separation of government from enterprise management and scientific commercially oriented management (Lin, 2001, p.32).

3 At the 4th Plenum of the Chinese Communist Party's 15th Central Committee in 1999, the authority once again stated that as long as the SOEs restructuring continued, corporate governance was regarded as the core of the ongoing reform.

4 According to the Guideline, listed companies should have at least two independent directors of the board of directors by 30 June 2002, and at least one third of board members shall be independent directors by 30 June 2003.

5 NYSE: New York Stock Exchange

6 CalPERS: California Public Employee Retirement System

7 ASX: Australian Stock Exchange

8 Director and officer (D&O) liability insurance is a form of malpractice insurance for corporate boards of directors. It provides coverage for acts, errors, and omissions by individual company D&O to the extent those acts are committed during the course of their employment.

9 Major party transactions is referring to transactions that the listed company intends to conclude with the related party and whose total value exceeds RMB three million or 5% of the company's net assets audited recently.

Hu, H.W., ‘Independent Directors: A New Chapter of the Development of Corporate Governance in China’. - 18 -


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