The Independent Director System in China: Weaknesses, Dilemmas, and Potential Silver Linings

• Author: Sang Yop Kang
• Pages: 152-185

152 TSINGHUA CHINA LAW REVIEW [Vol. 9:151

THE INDEPENDENT DIRECTOR SYSTEM IN CHINA:

WEAKNESSES, DILEMMAS, AND POTENTIAL SILVER

LININGS*

Sang Yop Kang

Abstract

The independent director system in C hina has many weaknesses.

Independent directors might not be truly independe nt, 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 enforc ement

agencies, would not fully demand independent directors to approve

egregious transactions (a controlling shareholder’s “self-

censorship”). In addition, regula tions on the business role of

individuals with government/party or education experien ce 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 education al 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.1 After the Enron

* This article is based on an earlier draft that I presented in a conference held at Tsinghua University

School of Law in Beijing on November 1, 2015. Most of all, I thank my mentors, Professors Merritt

Fox, Jeffrey Gordon, Curtis Milhaupt, Katharina Pistor, and Richard Brooks at Columbia Law School

and Jesse Fried at Harvard Law School, for their support. My thanks should go to participants of the

conference at Tsinghua University School of Law. For their valuable comments, I thank particularly

Professors Merritt Fox at Columbia Law School and Xin Tang and Simin Gao at Tsinghua University

School of Law. In addition, I thank Dean Philip McConnaughay, Vice Dean Emeritus Stephen Yandle,

Associate Dean Colleen Toomey, and my colleagues at Peking University School of Transnational Law,

Vice Chancellor Jeffrey Lehman at New York University Shanghai Campus, for their advice and moral

support. Also, I thank Tong Ling, Biyu Wang, Huizi Wu, Ziyan Yuan, Dongtian Zhang, and Liusheng

Zhu, for their assistance. Last but not least, I thank my wife, parents, parents-in-law, and brother for

their endless support for me.

1 See, e.g., Sanjai Bhagat & Bernard Black, The Non-Correlation Between Board Independence and

Long-Term Firm Performance, 27 J. CORP. L. 231, 232 (2002) (“[T]he conventional wisdom [is] that

2017] THE INDEPENDENT DIRECTOR SYSTEM IN CHINA 153

debacle, the role of independent directors was reinforced in the

United States.2 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.3

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.4 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

the board’s principal task is to monitor management, and only indep endent directors can be effective

monitors.”).

2 Setting the Rules, THE ECONOMIST (Jan. 29, 2003), http://www.economist.com/node/1558898 (“Listed

companies are now required to have a majority of independent (non-executive) directors on their

boards. . . . The board’s all-important compensation, nominating and audit committees are to be

composed entirely of non-executives[.]”).

3 Guanyu zai Shangshi Gongsi Jianli Duli Dongshi Zhidu de Zhidao Yijian (关于在上市公司建立独立

董事制度的指导意见) [Guidance Opinion on Establishing Independent Director System in Listed

Companies] (promulgated by China Sec. Reg. Comm’n, Aug. 16, 2001, effective Aug. 16, 2001)

(Chinalawinfo) [hereinafter Guidance Opinion].

4 See infra Part III. C. Some studies even indicate a negative correlation between the presence of

independent directors and a corporation’s performance. Id.

154 TSINGHUA CHINA LAW REVIEW [Vol. 9:151

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.5 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.”6

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.7 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

5 See infra Part IV. A.

6 Originally, “adverse selection” in a market (e.g., a used car market) is explained as follows: “because

the potential sellers know more about the quality of what they are selling than the potential buyers, they

have an incentive to select the worst things to sell.” PAUL KRUGMAN & ROBIN WELLS,

MICROECONOMICS 560 (2nd ed. 2009).

7 Juan Ma & Tarun Khanna, Independent Directors’ Dissent on Boards: Evidence from Listed

Companies in China, (Harv. Bus. Sch. Working Paper No. 13-089, Oct. 24, 2013) at 11. For a further

explanation of this study, see infra Part III. E. 2.