November 7, 2012

Corporate Boards in China: Are They Truly Independent?

All eyes are on China as the once-a-decade leadership change takes place.
Who's watching out for investors? Chazen Senior Scholar Wei Jiang uncovers a surprising answer.

Rebecca McReynolds

There are plenty of good reasons for outside investors to be wary of China‘s record on corporate governance and transparency, says Wei Jiang, a Chazen Senior Scholar and professor at Columbia Business School. Most of the country‘s nearly 2,000 listed companies were carved out of state-owned enterprises (SOEs), and the government and its agencies still own controlling blocks of non-tradable stock in those enterprises.

“This has raised the question of who is going to uphold the interests of diversified outside shareholders, such as mutual funds and individuals,” Jiang says. To find the answer, Jiang and her coauthors dug into board of director voting records and found a promising ally for minority shareholders: independent directors.

A Push for Openness

Independent directors have been a mainstay of China’s corporate governance since 2001, when the Chinese Securities Regulatory Commission (CSRC) mandated that listed firms have at least one-third of their boards made up of members with no financial stake in the company. As in the United States, management typically nominates candidates for these positions, and the largest fraction of these seats, 39 percent, are held by academics. Another 19–20 percent are retired government or quasi-government officials.

Even after opening corporate oversight to outsiders, though, there was still speculation on where allegiances lay for these new members, Jiang says. So in an effort to polish the reputation and enhance the transparency of Chinese public companies, the CSRC began publicly reporting individual votes on board proposals in 2004. “Knowing that their votes would be viewed from the outside potentially changed the incentives for the independent director,” Jiang says.

Her recent working paper, “Reputation Concerns of Independent Directors: Evidence from Individual Director Voting,” shows that career concerns motivate independent directors to establish a reputation of being diligent monitors rather than being management-friendly.

Perks and Prestige

The vast majority of proposals voted on by Chinese boards come from corporate management, which typically represents insiders and controlling shareholders. As a result, any dissenting vote tends to be viewed as confrontational and can label the naysayer as someone hard to work with, Jiang says. With the public watching, independent directors are now more interested in enhancing and maintaining their reputations as watchdogs than in sidling up with management, she adds.

Jiang’s research measured the “stock,” or reputation, of independent directors in the study group based on how often they were quoted, in a non-negative way, in China’s top newspapers and magazines and how many other boards they were asked to join. She found that directors with higher reputation stock were more willing to dissent, and that dissenting led to more future opportunities as independent directors in other firms.

That willingness to confront management is strongest among young directors because they have their careers to think about. “Relatively young directors value their reputations more highly because they have the opportunity to serve on more boards and get involved with other companies,” Jiang explains. By raising the value of their personal stock, independent directors can enjoy a lifetime payout in terms of both perks and prestige, she adds.

And once independent directors have earned a strong reputation, they want to hold on to it. In fact, Jiang’s research shows that directors with the best personal reputation stock have a higher probability of dissenting than those without those reputations to protect.

“This is an important finding, because before our study there was a question of whether older and more established board members would use their reputations to ‘cash in’ by catering to management, or would they be more interested in protecting their reputations,” Jiang says. “This shows that these board members have more to lose, and that is the dominant force motivating them.”

Power to the Minority

Of course, a few “no” votes can’t stop managements from moving forward with their proposals, but the power of those dissents is in their public reporting. Jiang’s research also found that when those votes are published, a company’s stock will drop between 1.5 percent and 2 percent in a single day if investors see disagreements from the independent directors.

“That move in the stock market has put constraints on management because now they know they can‘t do whatever they want,” Jiang says. “More importantly, minority shareholders now know that they can rely on independent directors to alert them to any potential wrongdoing inside the company.”

Outside investors can use this research when it’s time to cast their votes for future directors, Jiang says. “When mutual funds are asked for input on nominating independent directors, they often wonder what kind of quality they should look for in the candidates,” she says. “This is a measurement they can use.”

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