Nov 24, 2021 06:20 AM

Opinion: Time to Overhaul the Independent Director System

The legal accountability sought by a Guangzhou court for outside board members in the Kangmei Pharmaceutical Co. fraud shows that China needs to rethink the responsibilities of independent directors and their liability for wrongdoing.

Kangmei’s five independent directors each faces more than 100 million yuan ($15.7 million) of fines for their role in signing off on fraudulent financial reports under a ruling by the Guangzhou Intermediate People’s Court. The case caused 2.46 billion yuan ($385 million) of losses to 52,037 investors, and the outside board members are partially liable, the court found.

The news set off a wave of resignations by publicly traded companies’ independent directors. Some directors said they quit because of the imbalance between their duties and their rights.

As an independent director of four publicly traded companies at home and abroad, I think it is time to think about how to improve independent directors’ performance under a framework of law and rules and make the system a benefit to corporate governance.

There are five issues that deserve our attention.

1. How do independent directors perform their duties?

The independent director system and corporate governance of China’s domestically listed businesses were modeled on practices in the U.S. It has been 20 years since the independent director system in the A-share market was established in 2001, but there are still many problems. At present, there are 14,000 independent directors and a great number of independent director candidates spread out over more than 4,500 A-share companies.

Outside board members should first be independent, staying away from shareholders and the personal interests of companies. Independent directors should act to protect the interests of the entire company and all of its shareholders, especially those of minority shareholders. And they need to have a deep understanding of the company, including its staff, business, major activities, management behaviors and governance practices.

2. How do independent directors avoid risks?

An independent director at all times has to devote full attention to these issues that are the main sources of risk:

• Forged financial reports.

• Internal or external collusion and share price manipulation.

• Benefit infringement committed by controlling shareholders.

• Operating violations of laws and regulations.

• Weak internal controls.

• Disordered internal management.

• Apparently inequitable related transactions.

• Violations of information disclosure requirements for major events.

• Lax corporate governance.

Some independent directors vote hastily without reading proposals carefully, which is a dereliction of duty. Some lack the professional background required to perform their duties. If they do not understand the essence of a measure, they need to study it. Some rarely attend board or stockholder meetings. Others follow the herd in voting or even cede the right to vote to interested parties. Such independent directors are likely to make big mistakes.

A-share companies have stricter information-disclosure requirements than apply to Hong Kong and U.S. stocks. For example, important matters are required to be approved in advance by independent directors. As long as the independent directors do not casually sign off on the first draft drawn up by a company’s securities department and dare to write their professional judgment and opinions on it, many important issues could be avoided.

3. Independent directors cannot escape legal liabilities by resigning or by arguing that they were kept uninformed and did not act for their own profit.

Independent directors are participants in decision-making, not external consultants. Under current rules for independent directors of A-share companies, they can leave office only after a new independent director is elected by shareholders, and they will not be exempt from legal liabilities for events during their terms of office just because they have resigned. Not being informed or not making personal profits are not reasons for exemption from liability. They must be well-informed, receive allowances and bear responsibility for individual and joint wrongdoing.

4. Independent directors’ role as counselors.

Of course, adhering to principles is not the same as blindly confronting everything that does not seem right. Independent directors should practice their skills to improve communication, and when confrontation is the only option, it should be done in a reasonable and just way to ensure that laws and regulations are followed.

The job of independent director is not to handle conflicts with rivals but to help publicly traded companies and their top managers and controlling shareholders to clearly identify pros and cons, inform them of how to seek advantages and avoid disadvantages, and recognize the value of standardized operations and law-based compliance.

5. How should the independent director system be improved?

The main factors that have caused risks for independent directors of A-share companies are:

• Information asymmetry making them unaware of what they should know when performing their duties.

• An inadequate incentive mechanism making outside board members less motivated to work conscientiously.

• A lack of detailed and operable laws and regulations enabling independent directors to actively carry out their duties.

• The lack of strong legal support for independent directors in performing their duties.

The Shanghai, Shenzhen and Beijing stock exchanges should issue work guidelines for independent directors based on widely solicited opinions. The guidelines could provide legal grounds for independent directors to proactively do their jobs.

Such guidelines should first specify the legal information sources that directors can access. For example, in addition to companies’ financial reports and public disclosures of major events, listed companies must also submit meeting minutes of the general manager’s office and major data on monthly operating activities to the independent directors. The guidelines should also specify that listed companies violating the guidelines will be given a “notice of criticism” and will be punished according to the circumstances. Further, guidelines should specify the reporting mechanism for independent directors that fail to carry out their work.

Second, the guidelines should improve the independent director subsidy mechanism. Compensation should be in line with the complexity of independent directors’ positions and their performance. A well-established system could encourage outside directors to be more professional and devoted to their duties.

Third, we need to adjust the nomination process for independent board members of publicly traded companies. Today, the system relies on nominations from major shareholders and senior managers. An alternative way could be to first let the exchange set up a database of independent directors by openly selecting experts with solid accounting, legal, or industrial backgrounds. Those in the database could apply for independent directorships published by traded companies, and the exchange, on behalf of small and medium shareholders, could then submit nominations. A company’s board nominating committee would review the nominations and pass their recommendations to the shareholders meeting for final approval. With such a selection process, independent directors would be selected from those who could represent small and medium shareholders’ interests while ensuring the directors’ independence and professionalism.

Fourth, clear requirements should be set for each outside board member’s tenure and the scope of duties as well as necessary working conditions to be provided by the companies. For example, independent directors should have the right to attend the company’s important meetings and communicate with senior executives.

Lastly, regulatory authorities — including local securities regulatory bureaus, exchanges and securities regulatory commissions — should back up independent directors. Regulators need to establish channels and mechanisms for outside directors to regularly report on their work. Response mechanisms should also be designed at all levels to respond to independent directors when they wish to report something or seek help. It is also essential to offer independent directors more rigid and robust means to perform their roles in more ways than just voting and making comments.

To sum up, we should rethink and rebuild the current fragile independent director system. By doing so, we would improve corporate governance of A-listed companies, minimize the occurrence of financial fraud and prevent tragedies similar to what happened to Kangmei’s independent directors.

Yin Xiaobing is an accounting professor at Yunnan University who has served as an independent director of several publicly traded companies.

The views and opinions expressed in this opinion section are those of the authors and do not necessarily reflect the editorial positions of Caixin Media.

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