Independent directors originated in dispersed ownership systems as a means to strengthen the board’s monitoring role. They were subsequently exported to other corporate governance systems, which are generally characterized by concentrated ownership. In this paper, we consider the role attributed to independent directors in a number of jurisdictions where concentrated corporate ownership is prevalent, such as Continental Europe, Latin America, China, India and Japan. Our analysis shows that independent directors on average play a different and somewhat narrower role in these countries.
Core functions of independent directors in diffuse ownership companies - such as the hiring and firing of managers and the setting of their remuneration - are performed by controlling shareholders. In many jurisdictions independent directors are not even tasked with the vetting of related party transactions and other conflict-of-interests situations. Generally, the requirements and role of independent directors are not defined in detail, so that it is not easy to distinguish in practice between independent directors and other non-executive directors (and to some extent also between independent directors and statutory auditors, when present).
On the whole, the weak regimes applicable to independent directors, particularly outside Europe, generate the impression that independent directors have been introduced mainly to persuade foreign institutional investors that modern, western-style corporate governance is practiced in the jurisdictions concerned. In the last part of the paper, we advance some policy suggestions to enhance the concept and function of independent directors in controlled corporations around the world.
Keywords: Independent Directors, Concentrated Ownership, Conflict of Interest Transactions
1. Introduction - 2. Independent directors in dispersed ownership systems - 3. Independent directors in concentrated ownership systems - 4. Independent Directors in Europe - 5. Independent directors in Latin America - 6. Independent directors in other countries: Japan, China, India - 7. Critical assessment of the role of independent directors in concentrated ownership systems - 8. Policy recommendations - 9. Conclusions - NOTE
In this paper we analyze the function and relevance of independent directors in companies with controlling shareholders. Our main thesis is that the role of independent directors in controlled corporations is to a large extent different from that played by the same in diffuse ownership companies. Firstly, their number in the board is lower, almost never reaching the board majority that is required in those countries, like the US and the UK, where large listed companies have diffuse shareholders. Secondly, important functions like hiring and firing the top managers, and setting their remuneration, are mainly exercised by controlling shareholders either directly or through their representatives in the board. Thirdly, the controllers generally also set the main corporate strategies and are active in the monitoring of managers, which they do of course mainly from their perspective as block-holders, not necessarily targeting shareholder wealth maximization. Fourthly, independent directors are mainly relevant for the protection of minority shareholders with respect to the agency costs of majority shareholders. Therefore, they should be (and often are) particularly active in audit committees and in the monitoring of related party transactions. In this paper, we explore such differences and show how they are reflected in the legal regimes applicable to independent directors in jurisdictions where controlled corporations are the dominant paradigm in corporate governance. We consider, in particular, the corporate governance provisions and standards applicable to independent directors in Europe, Latin America, Japan, India and China, comparing the same with those applicable in diffuse ownership jurisdictions like the US and the UK. The outcomes of our analysis, on one side, confirm our thesis that independent directors have a different and narrower role in controlled corporations; on the other, reveal that several jurisdictions only pay lip service to the concept of independent directors as a central governance mechanism in listed companies. Indeed, what often drives acceptance of modern corporate governance standards, including the appointment of independent directors to corporate boards, is the issuers' goal to attract new capital and appease institutional investors, particularly foreign ones, rather than their willingness to really change traditional corporate governance practices which may substantially diverge from those international [...]
Independent directors originated in dispersed ownership systems as a means to strengthen the board's monitoring role. In his seminal work on the rise of independent directors in the US, professor Gordon extensively elaborates on the correlation between the rise of independent directors and the shift towards monitoring boards.[2] While outside directors have been present in US corporate boards since the '50s, it was only in the '70s that independent directors entered US boards. The collapse of Penn Central was determinative in this regard, as it showed the practical failures of the board of directors. At the same time, corporate scholarship was strongly influenced by professor Eisenberg's book on the Structure of the corporation, which highlighted the monitoring of corporate management as the main function of the board in large corporations and the ensuing need to make the board independent from the executives.[3] The "monitoring model" of the board and the idea that independent directors can improve board performance gained traction over the years, determining an increase in the number and functions of independents. However, the scandals which hit major US corporations like Enron at the start of this century highlighted that serious failures still existed in the board monitoring of financial accounting and internal controls. The regulatory response to these scandals was, once more, to increase the proportion of independent directors in the boards of listed corporations and to enhance their duties and functions. The Sarbanes-Oxley Act extensively reformed accounting and financial disclosure regulation, mandating the establishment of an audit committee made up entirely of independent directors.[4] Amendments to NYSE, NASDAQ and AMEX regulations required listed companies to appoint a majority of independent directors to their boards and upgraded the standards of independence. Moreover, also nominating and compensation committees became mandatory and should consist entirely of independent directors. However, new requirements of independence are only binding on diffuse corporations, as controlled ones (i.e. those where a single shareholder or a group of shareholders hold 50% or more of voting shares) are exempt.[5] As a result of these reforms, large US companies' boards comprise only one or two inside members and about 80% of independent directors.[6] Also the role of independent directors in management oversight has been enhanced, especially with [...]
Firstly introduced in the US and the UK, independent directors were subsequently exported to most other corporate governance systems, which are generally characterized by concentrated ownership. However, the actual ownership structure affects the balance of powers within the corporation and, in particular, the relationship between management and shareholders. In dispersed ownership companies the primacy of managers raises potential conflicts of interest between the latter and the shareholders' class. Moreover, shareholders face coordination and rational apathy problems as to the exercise of their rights. In concentrated ownership companies, controlling shareholders (or dominant coalitions of shareholders) effectively exert their power of appointing and removing directors and are therefore in a position to better control the managers' agency cost. However, in these companies a different agency problem arises in the relationship between majority and minority shareholders, to the extent that the former may extract private benefits from the company to the detriment of minority shareholders.[20] This agency problem is aggravated by the divergence between cash-flow rights and control rights, which occurs when the largest shareholder is able to control a public corporation with a relatively small stake in its cash-flow rights, e.g. through a pyramid structure or dual class shares.[21] Empirical studies show that relative firm value (as measured by the market-to-book ratio of assets) increases with the share of cash-flow rights in the hands of the largest shareholder.[22] While concentrated ownership is dominant,[23] corporate governance systems based on this ownership structure tend to be heterogeneous. The primary element of diversity derives from different political and cultural contexts. For present purposes, we shall distinguish between EU national systems, which have been approximated by company law harmonization and are converging towards common corporate governance principles under the coordination of the European Commission; Latin American systems, which are converging as a result of regional proximity, cultural similarities and comparable levels of economic development; and other systems (such as China, India, Japan), which have to be considered on a national basis, given their specificities which are a reflection of different approaches to capitalism. The diversity between corporate governance systems further depends on the board models adopted. [...]
In a Communication adopted on 21 May 2003, the European Commission presented its Company Law Action Plan, which included a section on the board of directors emphasizing the need for independent directors: «In key areas where executive directors clearly have conflicts of interests (i.e. remuneration of directors, and supervision of the audit of the company's accounts), decisions in listed companies should be made exclusively by non-executive or supervisory directors who are in the majority independent». In the Commission's opinion, Member States should enforce these requirements at least on a "comply or explain" basis, while minimum standards of independence should be set at EU level. The Commission proposed to introduce the relevant measures by way of a Recommendation to the Member States touching upon the creation, composition and role of the nomination, remuneration and audit committees, with special emphasis on the latter «in view of the recent accounting scandals». These measures should be applied to both one-tier and two-tier board structures. The notion of "supervisory directors" clearly refers to supervisory board members in two-tier structures. As a result, the Commission adopted a Recommendation on the role of non-executive or supervisory directors of listed companies and on the committees of the (supervisory) board on 15 February 2005. This text is not binding on Member States, which are free to adopt the recommended provisions either in their laws or corporate governance codes. The Recommendation's Preamble emphasizes the role of non-executive or supervisory directors «in overseeing executive or managing directors and dealing with situations involving conflicts of interest», while admitting that the presence of independent directors «capable of challenging the decisions of management, is widely considered as a means of protecting the interests of shareholders and other stakeholders». As for the number of independents in a board, the European Commission adopted a flexible solution. On one side, the board should include an "appropriate balance" of executive and non-executive directors, such that no individual or small group of individuals can dominate decision-making (§ 3.1 of the Recommendation extends this requirement to two-tier board structures). On the other, a «sufficient number» of independent non-executive directors should be elected to the board of companies to ensure [...]
In order to introduce the role of independent directors in Latin America, some general features of the corporate governance systems of that region should be considered. Firstly, listed companies have concentrated ownership and limited free float.[72] Therefore, the main agency problem appears to be, like in Continental Europe, the extraction of private benefits of control by majority shareholders, [73] and independent directors are regarded as a tool to protect minority shareholders. Secondly, board elections take place in shareholder meetings under a majority rule and are therefore dominated by controlling shareholders. Some countries, however, have rules in place entitling minority shareholders to appoint directors, including independent ones, to the board. In Brazil, for example, shareholders with at least 15 % of the voting shares are entitled to appoint a director (not necessarily an independent one). In Chile, minority shareholders holding 15% of the voting shares are entitled to appoint an independent director. However, given coordination problems amongst shareholders and the relatively high threshold, independent directors are rarely appointed by minority shareholders. In Columbia, a lower threshold of 1% leads significant minority shareholders (usually institutional investors) to appoint independent directors to the board.[74] Thirdly, the notion of independence is often defined in national laws and in a uniform way across countries.[75] Independence is excluded if the director is an owner or is closely related to a significant shareholder. The threshold for significant shareholdings, when defined, is remarkably higher than in Europe: 35% in Argentina and 20% in Mexico.[76] Independence is also excluded if the director has been an executive, an officer or a relevant employee in either the corporation or its affiliates in the previous year (Columbia), two years (Panama) or three years (Argentina, Brazil, Mexico).[77] In addition, other kinds of professional and contractual relationships with the corporation undermine independence. Some jurisdictions provide for a very detailed description of these relationships. Brazil and Columbia, for example, exclude independence if a director receives from the concerned corporation any kind of compensation other than directors' fees, implicitly excluding the possibility of any other contractual relationship with the corporation for independent directors. In Chile, impediments to independence include [...]
Japan Comparative research highlights that corporate governance in Japan was influenced both by the European and US models,[85] resulting however in a system different from those models. Japanese corporations present a significant degree of ownership concentration, but large shareholders are financial institutions and institutional investors[86] rather than founders, families, parent companies or groups of shareholders, like in Europe and Latin America.[87] This is sometimes explained as the result of corporate regulations adopted in Japan in the second half of XX century offering a good level of investor protection.[88] Japanese boards can be organized along either the one-tier or the two-tier models. In the two-tier model, the shareholder meeting nominates both the directors[89] and the board of corporate auditors.[90] While directors are empowered to manage and represent the corporation, corporate auditors have a monitoring function.[91] The scope and substance of this function, however, are not clearly defined and it is debated whether the auditors should only monitor the lawfulness of the board's actions or also their fairness.[92] The 2002 Corporate law reform introduced the one-tier model, which does not envisage the board of corporate auditors being organized through committees of the unitary board. Companies opting for this model are required to establish nomination, remuneration and audit committees, each of them made up of at least three members, with a majority of independent directors. However, the definition of independence in the Companies Act is rather narrow, being mainly based on the absence of business relationships with the corporation and/or its affiliates (such as having served as executive director, officer, auditor or employee of the concerned corporation).[93] Conversely, personal and business relationships with significant shareholders are not listed amongst the impediments to independence. Independent directors characterize the one-tier board model, however they also sit in the boards of corporations following the traditional two-tier system. The Tokyo Stock Exchange Securities Listing Regulation requires all listed companies to appoint either an independent director or an auditor having no conflict of interest with shareholders.[94] However, it is mainly in board committees of the one-tier model that independents have a more active role, given their higher number in the board and their monitoring and management functions [...]
As shown in our comparative analysis, independent directors were exported to a great number of concentrated ownership systems. However, considerable variations exist as to the ways in which the relevant concepts were received in the various countries, which on the whole reflect the more limited role reserved to independent directors in the corporate governance systems at issue. This is generally consistent with our prediction that independent directors have a different and somehow narrower role in the presence of controlling shareholders. Nonetheless, the variations amongst the jurisdictions considered in this paper do not entirely derive from differences between ownership structures, but also depend on other factors such as corporate law tradition and structure, political ideologies, culture, etc. In particular, variations may reflect different levels of engagement in corporate governance and different choices as to the tools needed to effectively control the management of business enterprises. Independent directors, after all, are just one of these tools, possible substitutes being the various gatekeepers (auditors, lawyers, financial intermediaries, etc.), shareholder activists, the market for corporate control, the regulators and private enforcement. In this paragraph, we summarize the main outcomes of our comparative analysis, whereas in the next one we adopt a policy perspective and try to suggest ways in which a reformer should deal with the same issues in a country where concentrated ownership is dominant. Firstly, independence requirements in concentrated ownership systems should be wider than in the diffused ownership, as they should also cover the relationship with controlling shareholders. However, our comparative analysis shows that the notion of "independence" varies across the jurisdictions considered, in some countries focusing exclusively on the absence of personal and business ties with the corporation and its managers. A similar concept is generally too narrow to cover the relationship with controlling shareholders, save for the case in which the latter are also managers of the company. Moreover, definitions of independence, even when considering block-holders, may be under-inclusive to the extent that social ties are not relevant to exclude independence (similarly to what seen also for the US and the [...]
As shown in our comparative analysis, independent directors play a narrower role in concentrated ownership systems, especially outside Europe, than in dispersed ownership systems. In this section, we try to address a few policy recommendations to a benevolent regulator (be it a legislator, a securities commission or a best practice committee) intending not only to make reference to independent directors as a governance mechanism, but also to enhance their role in a jurisdiction where controlled corporations are prevalent. Firstly, the notion of "independence" of directors should include all ties with either controlling or significant shareholders, i.e. with those blockholders owning enough votes to condition the governance of the company concerned. Secondly, the number of independent directors should be sufficient to let the same perform their monitoring role both in the board's plenary sessions and in the work of committees. Thirdly and as a consequence, the establishment of board committees which consist of a majority of independent directors and are empowered to review specific issues - such as the nomination and remuneration policy - should be mandatory or at least subject to an effectively enforced "comply or explain" provision. In addition, committees should be empowered either to take decisions or make proposals to the board, rather than expressing mere advice that the board can easily ignore. Fourthly, the role and powers of independent directors should be clearly defined. The monitoring function assigned to independent directors should be coordinated with similar functions assigned to other gatekeepers (such as statutory auditors in Brazil, China, Japan and Italy). Fifthly, independent directors should always be involved in the assessment of managerial operations likely to raise conflicts of interests and, in particular, they should always be tasked with the vetting of related partied transactions. As to the type of regulation, we believe that the regime applicable to independent directors could be found either in soft law or hard law, depending on the legal system at issue. In countries where reputational constraints for directors and pressure from institutional investors determine a good level of compliance with corporate governance codes, the need for hard law provisions is lower. In a similar context, best practice recommendations as to the role of independent directors can influence the boards' functioning also under a comply-or-explain [...]
Independent directors originated in dispersed ownership systems as a means to strengthen the board's monitoring role. They were subsequently exported to most other corporate governance systems, which are generally characterized by concentrated ownership. In this paper, we consider the role attributed to independent directors in a number of jurisdictions where concentrated corporate ownership is prevalent, including European and Latin American countries, China, India and Japan. The results of our comparative analysis confirm our thesis that independent directors, despite variations amongst the jurisdictions considered, on average play a different and somehow narrower role in concentrated ownership systems. In particular, current definitions of "independence" appear mainly focused on the absence of personal and business ties with the corporation and its managers, without considering the ties with either controlling or relevant shareholders. As a result, the standards of independence may result under-inclusive with respect to the main principle/agent conflict of concentrated ownership systems, i.e. the conflict between majority and minority shareholders. Also, the number of independent directors is, on average, lower when there are dominant shareholders, while the voluntary establishment of board committees contributes to keep this number lower than in the US and the UK. Moreover, independent directors have a narrower role to play in other respects. Firstly, specific functions - such as the hiring and firing of managers and the setting of their remuneration - which in diffused systems are assigned to boards made up of a majority of independent directors, in concentrated systems are substantially performed by controlling shareholders. Secondly, the role of independent directors in committees is modest, especially outside Europe. In most cases, independent directors sit in the audit committee, but their participation to other committees is less frequent. Thirdly, in some countries independent directors are not tasked with the vetting of related party transactions and other conflict-of-interests situations. Fourthly, in some systems, the functions and role of independent directors are not defined in detail, so that it is not easy to distinguish in practice between independent directors and other non-executive directors (and also between independent directors and statutory auditors, when present). On the whole, the weak regimes applicable to independent [...]
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