Recently, a Chinese court made a first instance judgment on the Kangmei Pharmaceutical Co. Ltd. case, China’s first class-action lawsuit, ordering the company to compensate its investors a total of 2.459 billion yuan ($390 million) for infringements due to false statements. It ruled that five independent directors (former and current) were liable for Kangmei’s fraud, fining them hundreds of millions of yuan. This verdict sparked heated debate, and gives us cause for reflection: How should we treat the independent director system? How can Chinese companies improve corporate governance?
The independent director system was introduced to China 20 years ago. In August 2001, the China Securities Regulatory Commission (CSRC) formulated “Guidelines on Introducing Independent Directors to the Board of Directors in Listed Companies,” marking the formal establishment of the independent director system in the A-share market. Independent directors hold no post in a listed company other than director and maintain no relations with the listed company and its major shareholders that might prevent them from making independent, objective judgments. Clearly, “independence” is the soul of this system. Unfortunately, the independent director system has failed to deliver on its original goal. In China, many independent directors are appointed via personal connections or as favors; some are even dubbed “trophy directors.” The supposed-to-be supervisors have become followers. The Kangmei Pharmaceuticals case has triggered discontent that laid buried for long, showing that many people find the system naïve or useless, and some even call for its abolition. However, we cannot agree with such suggestions. Instead of letting emotions run away with us, we had better rethink why the system failed, what caused the problem, and create conditions for its improvement.
The introduction of the independent director system was aimed at solving real-world problems. Back then, the state had the lion’s share of Chinese listed companies. For these companies an absence of clear ownership was typical, while in private enterprises, a single, dominant shareholder was the norm. Theoretically speaking, the Chinese corporate governance structure, drawing on civil law, provided supervision and power-balancing mechanisms. The board of supervisors was one such mechanism. But in most cases, it became a dead letter. The purpose of having independent directors as supervisors — originating in common law jurisdictions — was to prevent insider control by bringing in outside forces, thus improving corporate governance. How to best reconcile these two legal systems has been a theoretical and controversial topic of debate. An undeniable fact is that, though not ideal, the independent director system is better than nothing since there are no alternative means. In addition, the turn of the century was also an era in which China rushed to dovetail with global standards in an institutional way. Since then, reformers have made determined efforts to promote corporate governance. For example, China implemented the “G20/OECD Principles of Corporate Governance” in 2015. But progress in corporate governance in China has not been significant — in some areas the contrary is the case. Therefore, negating everything about the independent director system is undesirable. To best honor our reforming predecessors, what we need to do is to improve the system to the best of our ability.
The truth is that regulatory authorities have attempted to solve the issue that “independent directors are not independent.” Relevant government departments have released documents, such as “Opinions on Further Regulating Party and Government Leaders and Cadres Working Part-time (Holding Office) in Enterprises” in 2013 and a “Notice by the General Office of the Ministry of Education on Special Inspection of Party and Government Leaders and Cadres Working Part-time in Enterprises” in 2015. However, these initiatives did not reverse the status quo that independent directors were not independent. The primary reason is that these improvement initiatives failed to treat the root cause.
The success of the independent director system lies in two factors. The first is to find professionally trained individuals with necessary expertise, integrity and diligence. Second, the appointment of these individuals should not be influenced or controlled by listed companies’ major shareholders or executives, or any other entity or persons that have an interest in the companies. It is not easy to accomplish these, especially the latter. Major shareholders, or the management, are naturally inclined to search for more “cooperative” independent directors. Therefore, top-level design is crucial for the independent director system to succeed. The main rules on independent directors were laid down in the “Guidelines on Introducing Independent Directors to the Board of Directors in Listed Companies” 20 years ago. Recently, the CSRC solicited public opinions on the “Regulations on Independent Directors of Listed Companies (Draft for Comments).” Still, it is only a partial fix, not a systematic innovation. We should seize the opportunity that came with China’s revision of the Company Law and give the country’s corporate governance systems (including the independent director system) a major overhaul.
Topics such as how to improve the independent director system and what initiatives can be incorporated should remain open: They need to be thoroughly discussed by officials, experts and investors, or tested out in pilot programs. Many ideas and suggestions have been put forward recently. Some people suggested that a databank of independent directors be set up with the help of regulatory authorities or stock exchanges, and a mechanism that combines job competition with elections be adopted. Some advocated for full-time independent directors. And some suggested raising entry barriers by requiring higher-level qualifications, placing greater emphasis on independent directors’ professionalism. More suggestions on the incentive mechanism for independent directors, in particular their compensation policy, were put forward. Regulators need to brainstorm ideas and choose the ones that best meet the goals and stick to them.
There have been qualified independent directors. This tells us that, for the independent director system to work under the current rules, listed companies need to be self-aware. Some companies have regular communications with their independent directors, giving them advance notice of major issues and time to review any proposals. Independent directors can make decisions that are beneficial to the whole company if they become more involved, as this gives them a chance to gain a comprehensive understanding of the business. At present, violations of laws and regulations in listed companies are still rampant. It requires no advanced skills to detect suspicious activities. The only thing that matters is conscience: Even abstention from the vote or refusal to sign information disclosure documents can be considered warnings to the market. This is how the independent directors of Kangmei Pharmaceutical could not escape liability.
Corporate governance systems are not complete without the historical and cultural environment in which such systems are embedded. This is true for the market model (which emphasizes the role of the corporate board) in the U.S. and U.K., the main bank model in Germany and the relationship-oriented model in Japan. Whatever the differences in models, a common business logic takes its course: respecting the balance of power, responsibility and interests. It should be admitted that in a culture that “worships a wise king” and “takes pride in overcoming opposition” to accomplish results, the concept of balancing power is not valued, and shareholders lack awareness of their legal rights. This has posed severe challenges to corporate governance. However, effective corporate governance is a must-have for local Chinese companies to thrive. A history of 20 years is not long for the practice of government regulations. Political, business and academic communities should not slack off. Instead, they should be more patient while keeping an open mind, staying humble and emulating global best practices like their reforming predecessors.
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