The independent director’s undesirable predicament

By Yu Yue, Zhilin Law Firm
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China’s independent director system has existed for more than 20 years. It was in 2001 that the China Securities Regulatory Commission (CSRC) issued the Establishment of Independent Director Systems by Listed Companies Guiding Opinion, intending it to play a crucial role in the standardised operation of listed companies in China. However, the system has faced challenges.

FUNCTIONAL POSITIONING

Yu Yue
Senior Consultant
Zhilin Law Firm

The independent director system originated in the US as a supplement to the “unitary board” governance model. The aim was to reduce the agency cost between shareholders and company management, and to act as an internal check and balance. However, in Chinese companies with a traditional governance structure consisting of a shareholders’ meeting, a board of directors and a supervisory board, independent directors face the dilemma of overlapping with the board of directors’ management function and the supervisory board’s monitoring function.

According to current regulations – the newly promulgated Rules for Independent Directors of Listed Companies and the Guiding Opinion – the role of independent directors is “comprehensive management + supervision”. In addition to their general duties as directors, independent directors are given six special powers as specified in articles 22 and 23 of the above-mentioned new rules. This suggests their roles have been positioned to exceed the general duties of company directors, and they have been given excessive responsibilities and expectations in conflict with their part-time status as independent directors.

DILEMMA OF DUTY

From the perspective of administrative enforcement practice, independent directors belong to the category of other directly responsible personnel stipulated in article 197 of the Securities Law. According to the author’s statistics, in 2022 alone, more than 30 independent directors were administratively punished by the CSRC and its dispatched agencies due to false statements made by listed companies. With the implementation of the new Securities Law, independent directors will not only face fines that are several times higher, but also huge civil compensation under the Chinese-style collective litigation mode. After the Kangmei Pharmaceutical case, the wave of independent directors resigning fully illustrates the “responsibility anxiety” of independent directors.

This “responsibility anxiety” is not only caused by the excessively heavy civil, administrative and even criminal liabilities, but also by the imbalance of rights and responsibilities in the independent director system and an overly broad definition of rights and responsibilities. On the one hand, the exercise of the rights of independent directors is still subject to the controlling shareholder’s dominant position in the shareholders’ meeting. The Company Law has deleted the provision that “the shareholders’ meeting shall not dismiss a director without cause before the expiration of their term of office”, and strengthened the arbitrary appointment right of the general meeting of shareholders over directors (including independent directors).

Although the guidance opinion states that “independent directors shall not be arbitrarily dismissed before the expiration of their term of office”, this provision is nowhere to be found in the new rules. In reality, the dismissal of independent directors by shareholders’ meetings of listed companies happens from time to time. On the other hand, the delineation of the rights and responsibilities of independent directors remains unclear.

Current regulations on the performance boundaries of independent directors are still largely framework-based, leaving the industry perplexed about the standards for the duty of diligence of an independent director, particularly about what degree of performance constitutes “diligence”, and the difference between the duties of independent directors and those of general directors. In the Kunming Machine Tool disclosure violation case, an independent director resigned on discovering the company’s financial fraud and promptly reported it to regulatory authorities. However, the relevant penalty document still held that “[the director] failed to take more active and effective measures to perform his duties to prevent, detect and stop the occurrence of information disclosure violations, and failed to meet the requirement of diligence duty”.

In light of actual circumstances, regulatory agencies ought to fully consider the external and part-time nature of independent directors, and make differentiated regulations on the boundaries of the duties of independent directors and general directors.

RISK AND REMUNERATION

The current system places excessive value expectations on independent directors, but fails to provide appropriate compensation and incentive mechanisms. The average compensation for independent directors of listed companies in China in 2021 was just over RMB80,000 (USD11,600), which forms a huge gap against the responsibilities and risks they face. This may lead to a situation where highly qualified professionals are reluctant to serve as independent directors, resulting in the dilemma of “bad money drives out good”.

This not only undermines the effectiveness of the independent director system, but also poses potential risks to its future development.

PROTECTION MISMATCH

While China’s independent director system assigns overall management and supervisory responsibilities to independent directors, it fails to provide adequate protection. In addition to the low salary protection, the voice of independent directors in listed companies does not match their high responsibilities and their basic right to information is often not adequately protected.

For instance, in the case of the Zhongyida information disclosure violation, an independent director abstained from voting on the periodic report because he had not seen the content of the report. However, the relevant penalty document considered that the director concerned should have taken the initiative to investigate and obtain the necessary information for decision-making, and that abstaining from voting on the grounds of not having seen the report was a failure to fulfil the duty of diligence.

IMPROVE THE SYSTEM

Any company’s governance system contains multiple aspects and the independent director system is just one component. It is neither reasonable nor practical to place the entire burden of corporate governance on independent directors alone.

In the author’s view, returning to the original design purpose of the independent director system to weaken the agency cost, combined with the characteristics of the relatively concentrated shareholding of Chinese listed companies, independent directors should focus on addressing information asymmetry between the management and shareholders, controlling shareholders, and small to medium-sized shareholders. They should only express independent opinions on specific matters that may give rise to conflicts of interest, and be freed from the obligation of managing general affairs.

Yu Yue is a senior consultant at Zhilin Law Firm.

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