The Independent Director Requirement And Its Effects On The Foreign Investment Climate In China: Progress Or Regress?

• Author: Matthew Weinstein
• Pages: 09

Matt Weinstein is a J.D. candidate at American University, Washington College of Law. He holds a B.S. in Computer Engineering from the University of Maryland, College Park. Prior to attending law school, Mr. Weinstein founded and sold a network and telecommunications integration consulting firm. He plans to join the Washington D.C. office of Dickstein Shapiro LLP upon graduation.

Introduction

Centrally owned businesses are the backbone of China's economy. Since enacting the Company Law in late 1993,¹ the State has converted many of its traditionally structured enterprises to corporate entities and issued publicly traded shares to raise funds.² By 2004, listed companies under the control of State-owned holding enterprises represented more than 71 percent of the listed companies on the Chinese securities market.³ In 2006, China disclosed that the top twenty-one listed centrally owned enterprises by market value (including Sinopec, Bao Steel, Huaneng, Sinoair and COSCO) "accounted for 68 percent of the total profits of the top 100 listed companies."⁴ In addition, those same twenty- one listed companies accounted for almost one-fifth of the total market value of all listed com panies in China.⁵ Indeed, the Chinese government truly is an '800 pound gorilla in the room' in the Chinese securities market.

The number of listed companies continues to multiply and foreign investment continues to flood into China. Yet, China is one of the only countries where one can find both a booming securities market and State control of the vast majority of companies. Contrary to common Western practice, the State (as controlling shareholder) often pursues different objectives compared to traditional, profit-seeking investors.⁶ Thus, foreign investors must be vigilant of significant risks involved in such an investment climate and it is more important than ever to understand the fundamental differences between Western corporate governance systems and those in place in China. To that end, this article examines China's realization of a fundamental element of Western corporate governance - independent directors - and examines both the positive and negative effects this implementation has had on the investment climate in China.

I Comparing Chinese Corporate Governance To The West

Even though China has a surprisingly long corporate tradition, corporate governance in China has developed slowly and the State has been careful not to dive headfirst into adopting Western practices. In fact, as one scholar has noted, "China had a world leading economy for a considerable time prior to modern history."⁷ By the dawn of the Western industrial age, however, China had fallen behind Western economic powers, which in turn "caused China's recent history to be subject to commercial and political turmoil."⁸ Though the Chinese introduced modern corporate concepts as early as the late 19th century, the adoption of communism led to the near elimination of private ownership.⁹ As it has been said that "the corporate structures that an economy has at any point in time depend in part on those that it had at earlier times," China's political tradition helps provide an explanation for the evolution of Chinese corporate doctrine and the integration of practices from Western developed economies.¹⁰ Only after a short but sustained period of economic, legal, and political debate did China begin to take slow but steady steps to promote privatization.¹¹ After setting up the Shanghai and Shenzen stock exchanges in the early 1990s and enacting the Company Law in 1993, it was not until 1997 that China announced it planned to convert most state-owned enterprises to corporations.¹²

Donald Clarke, Professor of Law at George Washington University, defines corporate governance in China as:

[T]he set of rules and practices regulating relationships among participants in a post-traditional Chinese business enterprise and governing decision making within that enterprise. By 'post-traditional' enterprise I mean any enterprise that is no longer bound tightly within the traditional State planning system and operated by its adminis trative superior agency essentially as a division within a larger enterprise. It is an enterprise in which voluntary, con tractual relationships are important and top-down commands from government are less important.¹³

As corporate governance reform progressed, some scholars argued an independent director institution would solve numerous corporate governance problems entangling Chinese listed corporations.¹⁴Though Sibao Shen, Dean of the Law School of China's University of International Business and Economics notes that the concept of independent directors appeared in China as early as December 1997,¹⁵ it was not until 2003 that the 'minimum one-third' independent director system now in place was mandated.¹⁶ By June of 2003, "1244 of 1250 corporations listed in China's two stock exchanges had independent directors on their boards."¹⁷ Though companies integrated the system quickly, there was natural resistance to introducing a customarily Western corporate institution.¹⁸ The independent director in China as it has developed, however, is distinct from and exists for different motivations than an independent director in the West.

A Independent Directors in the West: Protectors of Shareholder Interests?

"Corporations have been the common business structure in the Western world since at least the beginning of the 19th century."¹⁹ The corporate structure thrives because of limited liability, encouraging funds to flow freely to businesses from the global investor pool.²⁰ The modern corporate structure also gives businesses functional independence from their investors.²¹Dean Shen offers that "independent directors first appeared in the United States to cure the corporate governance problems of public corporations, which have widely dispersed shareholders."²² Independent directors were created for two major reasons: First, to act as securities law monitors in the aftermath of the massive securities frauds of the 1920s and 1930s; and second, to provide profit-seeking shareholders with more adequate controls over the performance and reliability of management.²³

In a Western system, tensions within corporate governance structures require compromises between authority and responsibility.²⁴ Western independent directors are leaders in their fields and trusted business advisors who are expected to provide guidance with respect to corporate strategy.²⁵The purpose of having directors independent of management is so that the many (often conflicting) interests of employees, shareholders, and business partners can be adequately recognized.²⁶ Thus, independent directors can act as a powerful social responsibility instrument for the public, serving to calm investors and reassure them that management is ultimately accountable for their actions.²⁷

With regard to public companies in the United States, directors are expected to be - as Professor Clarke puts it - "systematically independent of management."²⁸ As this is the primary concern and requirement for independence, stock ownership is allowed.²⁹ Both major U.S. stock exchanges, however, require listed companies to have at least half of its board of directors be independent.³⁰ Requiring that the board be comprised of a majority of independent directors empowers such directors to more effectively carry out the responsibility of maximizing shareholder value in the companies they oversee and guarding against conflicts of interest.³¹This is because the United States' system takes a view of independent director representation one level deeper than simple 'on-its-face' independence - independent directors who are also disinterested provide fair, impartial evaluations of transactions and management decisions, in turn allowing independent directors with occasional conflicts to serve effectively.³²

Even though China has a surprisingly long corporate tradition, corporate governance in China has developed slowly and the State has been careful not to dive headfirst into adopting Western practices.

B Independent Directors in China: Protectors of the State?

Independent Directors in China "bear the duties of good faith and due diligence toward the listed company and all [its] shareholders. They shall... protect the overall interests of the company, and shall be especially concerned with protecting the interests of minority shareholders from being infringed."³³Before independent directorship was mandated, however, director requirements were not consistent-consequently, use of independent directors was effectively optional.³⁴ Because China had such a large number of State-owned and controlled businesses, corruption ran rampant because it was not possible for the government to monitor so many complex enterprises.³⁵ Today, the Independent Director Opinion mandates that every listed corporation's board comprise at least one-third independent...