ISSN 2282-667XIndependent 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 standards.
National legislations and corporate governance codes often follow this pattern, offering weak definitions of independence, attributing weak powers to independent directors or leaving their role substantially indeterminate, and undervaluing their role in board committees. In the last section of this paper, we suggest possible ways for overcoming this problem in countries that really want to focus on independent directors also in the governance of controlled corporations.
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 reference to financial controls and financial disclosure. In addition, rules about the composition of board committees, particularly the audit committee, give independent directors the power to condition (or determine) some corporate decisions that are likely to result in conflict of interest situations.
To the extent that independent directors constitute the large majority of members, their role tends to overlap with that of the board. In addition to monitoring the managers, they hire the chief executive officer and other top managers, setting their remuneration. They also exercise the managerial functions retained by the board, such as dealing with derivative shareholder litigation, conflict of interests transactions, mergers and acquisitions.[7]
The rise of independent directors also concerned UK corporate governance, where, however, they appeared more recently than in the US. In 1992, the Cadbury Report recommended to appoint at least three non-executive directors to the board, a majority of whom independent from the company (§§ 4.11, 4.12). The main function of non-executive directors was that of monitoring the management's activities and taking decisions about self-interested transactions. In addition, corporations were recommended to establish an audit committee, made up entirely of non-executive directors and including a majority of independent directors, and nomination and remuneration committees, consisting wholly or mainly of non-executive directors (§§ 4.42, 4.30).
After the Enron scandal, the Higgs Report recommended to further increase the proportion of independent directors in boards. According to this Report, boards should include a majority of independent directors, while remuneration and audit committees should consist entirely of independent directors and a majority of the latter should sit in the nomination committee. These principles were included in the 2008 Combined Code on Corporate Governance and reaffirmed in the 2012 version of that Code (§§ B.1.2; B.2.1; C.3.1; D.2.1).
The main purpose behind the rise of independent directors in listed companies was to protect shareholders form the agency costs of managers in the classic Berle & Means context of separation between ownership and control. Furthermore, the notion of independent directors was reconciled with the belief that promoting shareholders' value, as measured by stock market prices, is the main corporate purpose.[8] However, the efficacy of independent directors in monitoring the managers and improving corporate performance was often criticized on the basis of economic analysis. While some early studies show a positive correlation between the presence of independent directors in the board and corporate performance, other studies found no convincing evidence that firms with a majority of independent directors outperform other firms.[9]
Other arguments, suggested in the scholarly debate after the financial crisis, seem to undermine the conventional wisdom about the potential of independent directors in corporate governance. Firstly, current definitions of "independence" are criticized on two different grounds. On the one hand, definitions are considered to be under-inclusive, to the extent that they only focus on the absence of family and business relationships, often ignoring social ties with the managers that could negatively affect directors' independence.[10] Therefore, current standards of independence, albeit stricter than previous ones, are seen as insufficient to ensure that board decisions are taken in the shareholders' interest.[11] On the other hand, strict standards of independence make it difficult for companies to select directors having sufficient expertise and knowledge about the individual firm.[12] Current standards limit the number of eligible directors excluding candidates who have industry expertise but are not independent. Some scholars also advanced the argument that prevalence of independence over competence after SOX contributed to the financial crisis.[13] As a result, current studies on independent directors tend to emphasize the need for firm-specific knowledge and expertise in the relevant fields (especially accounting), rather than independence.[14]
Secondly, scholars criticized the mechanisms for appointing independent directors. To the extent that the top executives still influence the process for recruiting directors, independent directors have poor incentives to conscientiously perform their monitoring tasks.[15] In other words, the co-optation mechanism by which the board is renovated does not assure real directors' independence if the board is not sufficiently independent from the CEO and/or leaves the latter in actual control of the nomination process.
Thirdly, poor performance of independent directors is also explained on grounds of information asymmetry. Independent directors have no direct access to corporate information, which they receive from insiders, i.e. from the same individuals that they should monitor. Information deficits are especially serious in firms with high information costs and affect the independents' capability to effectively perform their tasks.[16]
Fourthly, scholars highlight that independent directors having other occupations, often as CEOs of other companies or non-executive members of other boards, dedicate little time to their role.[17] Moreover, some scholars criticize the mechanisms of independent directors' remuneration for they would result in poor alignment with the shareholders' interest.[18] Also the liability regime of independent directors would not incentivize them enough to spend time and energy in monitoring, given the extensive protection granted to directors under the business judgment rule.[19]
Despite all these limits, which contribute to explain the diffuse frustration about their role in practice, independent directors continue to occupy the large majority of board seats in the US and the UK and their presence is generally recognized as an indispensable feature of modern systems of corporate governance.
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. While US and UK corporate governance follow the one-tier model, countries where concentrated shareholdings are dominant present greater variety. Generally, they follow either a unitary (one-tier) board model or a dual (two-tier) structure consisting of a management board and a supervisory board. This distinction affects not only the role of the board(s) in the corporation, but also that of independent directors. Two-tier systems formally emphasize the monitoring function of the supervisory board, while attributing the management function to a different organ, which only consists of corporate executives. However, the real power of the supervisory board varies across jurisdictions where the two-tier model is in use. In China, for example, the supervisory board plays no significant role, while the management board runs the corporation - under the influence of controlling shareholders.[24]
In the one-tier model, the board is expected to perform both managerial and monitoring functions. However, the difference between unitary and dual systems should not be over-emphasized. Indeed, the delegation of powers to executives is general practice in unitary boards and leads to identify two categories of directors. The executive directors are vested with wide managerial powers and lead the firm's management team, while the non-executive directors are mainly tasked with monitoring functions and often perform the same through participation to board committees, which only consist of non-executive (mostly independent) members. This de facto separation between managerial and supervisory tasks is also reflected by the "executive" sessions of the board, where only the non-executive directors meet to discuss the performance of the managers. Briefly, the internal organization of the unitary board largely reflects the two-tier model and its separation of management and supervisory functions.[25]
The taxonomy of board organization may, however, be more complex. Italian companies, for example, are entitled to choose amongst three governance models: a unitary board (with a mandatory audit committee comprising only independent directors); a dual system consisting of a supervisory board and a management board; and the "traditional" model, consisting of a unitary board (including both executive and non-executive directors) and a board of statutory auditors (vested with control functions).[26] Also, Taiwanese listed companies may be organized along three models, depending on the presence of independent directors: the traditional two-tier model, which assigns monitoring functions to the supervisory board and does not include independent directors; a new two-tier model, which includes a supervisory board and independent directors, both having monitoring functions; and a new one-tier model, including an audit committee, made of independent directors, as an alternative to the supervisory board[27].
Heterogeneity also derives from the definition of corporate goals. Professor Gordon finds a strong correlation between the rise of independent directors in the US and the increasing focus on shareholder value as the ultimate corporate purpose. The concept of a "monitoring board" and the ensuing autonomy of managers at the top support the belief that independent directors serve to protect and promote shareholder value, as measured by stock market price.[29] However, other countries follow a stakeholder orientation, well exemplified by the German rule that the corporation should be run in the "interest of the enterprise", which is defined as a combination of shareholders, employees, and other stakeholders' interest.[30] Consistently with this approach, all main stakeholders (large shareholders, banks and labor) are represented in the supervisory boards of large companies, where the co-determination regime leaves half of the seats to representatives of employees and of the unions.[31]
Similarly in Switzerland the shareholder value approach has never been fully accepted. Rather, maximizing "enterprise value", as a combination of shareholder and stakeholder value, is seen as the main corporate purpose.[32] A like approach is followed in the Netherlands and other North-European countries.[33]Also the Japanese system, despite its incremental alignment to the US model, is not centered on shareholder value, but defines the main corporation's purpose along the German model (which was however influential in the development of Japanese business law). As a result, Japanese corporate governance is focused on the promotion of firm value, which is understood as a mix of shareholders and employees' interest.[34]
However, the distinction between shareholder value and stakeholder approaches should not be overemphasized on comparative grounds, mainly for two reasons. Firstly, this distinction is often more formal than real, for corporate practices do not necessarily conform to the legal statement of corporate goals, but depend on other factors including culture, competitive setting, industry sector, etc. Therefore, a stakeholder orientation of company law does not predict that boards will not adopt a shareholder value philosophy in practice, particularly when institutional investors put pressure on them in that direction. At the same time, boards could follow a stakeholder approach, even in systems led by the shareholder value philosophy, either because of the nature of the firm (e.g. a public utility) or in the case of firms owned by the state. Secondly, the boundaries between shareholder value and stakeholder approach are often blurred, to the extent that the same corporate actions may, in the long run, maximize both shareholder wealth and enterprise value. Indeed, a distinction should rather be drawn between short-term and long-term strategies, while acknowledging that the latter can actually reconcile the shareholders' interests with those of stakeholders.
Nonetheless, the elements of heterogeneity described above (such as legal origins, board structure and corporate goals) may help to explain the organization and functioning of boards, including the role of independent directors, in the various jurisdictions considered in this paper. We shall analyze, in particular, the definition of independence, the specific functions that independent directors are empowered to perform, their duties and liabilities, both with regard to individual jurisdictions or groups of jurisdictions and comparatively. When data are available, we shall also consider the impact, if any, of independent directors on firm performance. As anticipated, our ultimate goal is to analyze the transplant of independent directors from diffuse ownership to concentrated ownership jurisdictions and assess their real or likely impact on corporate governance practices of these jurisdictions.
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 that any material conflict of interest will be properly dealt with (§ 4 extends this recommendation to supervisory boards).
The Preamble to the Recommendation explains flexibility by reference to differences in national legal systems. However, the main reason for it is found in ownership structures, as proven by corporate governance practices in Continental Europe. Controlling shareholders seek board representation at non-executive level particularly when day-to-day management is delegated to outside managers. Moreover, if there is a coalition of controlling shareholders, each of them will try to be represented at board level, which increases the number of seats allocated to the controllers. Indeed, board participation allows monitoring of the managers and offers information about the business of the corporation, enabling blockholders to direct the same at least with respect to strategic and other fundamental decisions. Board participation may also be sought for networking and reputational aims. As a result, the boards of listed corporations in concentrated ownership systems tend to be numerous, particularly in the case of large firms, and include at least two types of non-executive directors, such as those representing the owners and the independents.
All member States were invited to take the necessary measures to promote the application of 2005 Recommendation either by legislation or by best practice codes, resting on the "comply or explain" principle. In 2007, the EU Commission published a report on the application of 2005 Recommendation, showing that all member States required or recommended the appointment of independent directors in the (supervisory) board. However, not all member States reserved to independent directors the main role suggested by the Recommendation - that is, the participation to board committees (primarily audit and remuneration committees) as a means to control potential conflict of interests.[35]
This framework has evolved in the direction suggested by the European Commission. Nowadays, independent directors are foreseen in all EU members States and usually sit in all companies' committees. However, given the flexible approach followed in Europe - based on soft law rather than regulation - some divergences still remain across member States .
Soft law v. hard law
Regulation of independent directors often combines soft law and hard law. In most cases, general company law or special provisions on listed companies provide the basic principles - such as the minimum number of independent directors in the board, the definition of independence, etc. - while a corporate governance code, generally based on the "comply or explain" approach, carries more detailed provisions on independent directors.[36] However, in the Netherlands and Sweden independent directors are only subject to a corporate governance code.[37]
Definition of independence
The definition of "independence" is crucial in the assessment of independent directors as a means to mitigate potential conflicts of interests in a corporation. The EU Recommendation defines independent directors as members of the boards who are «free of any business, family or other relationship with the company, its controlling shareholder or the management of either, that creates a conflict of interest such as to impair its judgment» (§ 13.1). In addition, the Recommendation sets a list of criteria that member States should adopt to assess the independence of directors (annex II).
In most member States "independence" is defined along a similar route. However, in the Netherlands and Belgium, a general definition of independence is lacking. The Dutch Code provides, at § III.2.1, only a list of criteria excluding the independence of directors (mainly, financial and family ties with the members of the management board and with significant shareholders - that is, with shareholders holding more than 10% of the votes). Similarly, the 2009 Belgian Code lists nine classes of impediments to independence, involving the relationship with the main shareholders and management (Annex A), but does not define independence in general terms.
As to the remaining countries, the specific criteria for defining independence found in national corporate governance codes generally mirror those recommended by the Commission,[38] with the exception of Germany. The 2013 German Code (like the previous ones) generically refers to business or personal relationships, with both the management and the company, likely to originate conflicts of interests. No mention is made of business and personal relationships with the main shareholders and also the definition of "conflict of interests" is not very detailed. Rather, conflicts of interests are addressed under the general rules provided in the German Civil Code.[39] This approach is explained by reference to the diffuse reluctance towards independent directors in German corporate governance, which appears more focused on directors' knowledge and expertise than independence.[40]
Even when corporate governance codes are more detailed as to independence, the combination of hard law and soft law and some specific features of national corporate governance systems affect the notion of independence in practice and give rise to divergences amongst member States. National codes of corporate governance follow the EU Recommendation focusing on the absence of business and personal relationships both with management and the corporation and with significant shareholders. However, the definition of "significant shareholder" varies across member States. The French Code, for example, excludes that directors representing majority shareholders may be qualified as independent, unless it is demonstrated that they do not take part in corporate control. Similarly, the 2013 German Code and the Danish one exclude, respectively at § 5.4.2 and § 3.2.1, the independence of directors related to a "controlling shareholder". The Swiss Code refers to "large" shareholders and the Swedish one to "major" shareholders. In some cases, for a shareholder to qualify as "significant", a special threshold is set with reference to voting shares. The Spanish Code defines as "significant" shareholdings above 5% of voting shares (§ 5.5.i), while in Italy, Belgium and the Netherlands more than 10% of voting shares are required.[41]
No doubt, where the main agency problems derive from the behavior of "significant shareholders" and independent directors are expected to monitor the same, differences in the definition of "significant" reverberate on the notion of independent directors and cause divergence between corporate governance systems. A lower threshold to qualify as significant will narrow down the scope of independence, broadening the range of shareholders from which independence should exist.
Things get more complex when different degrees of independence are allowed, as in the Swedish Code contemplating two classes of independent directors. The majority of independent directors should be independent from both the company and the managers, provided that specific impediments to independence mirroring the EU Recommendation do not subsist. For at least two independent directors, also independence from major shareholders (holding more than 10% of voting shares) is required (§ 4.5). The same solution is adopted in the Finnish Code (recommendation 14).
In Austria, independence of directors is defined with reference to personal and business relationships with the managers and the corporation. However, in companies with a free float of more than 20%, at least one independent director should not be (nor represent) a shareholder holding more than 10% of the voting shares. In companies with a free float above 50%, at least two independent directors of this kind are required (§ 53-54).
A similar approach is followed in Italy. Under the Consolidated Financial Services Act (CFSA), the board of directors must at least comprise either one or two independent directors, depending on whether the board members are a maximum of seven or more (Art 147-ter/4). The independence requirements are those set for statutory auditors by Art 148/3 (briefly, absence of family or business ties with the corporation and its subsidiaries). This provision is complemented by soft law, which applies to all independents (including those requested by the CFSA in the number of either one or two). Under the Italian Corporate Governance Code, an adequate number of NEDs should be independent and comply with the independence criteria stated under Art 3.C.1. of the Code (along the EU Recommendation). The Code also specifies that the number and competence of independent directors should be adequate in relation to the size of the board and to the business of the issuer, and sufficient to enable the constitution of committees within the board (Art 3.C.3).[42] Stricter requirements are foreseen for issuers admitted to the Star segment of the Italian Exchange according to the relevant Rules, which make some of the Code provisions mandatory.[43]
Amongst the Corporate Governance Codes, only the Spanish one provides that independence criteria are a necessary condition for a director to qualify as independent (§ 2.10). Otherwise, the possibility for the board to depart from the specific criteria stated in the relevant Code when assessing the independence of a director is acknowledged. The French Code, for example, reserves to the board significant discretion in the assessment of independence. The list of impediments is not binding on the board, so that independence can be found even in the presence of impediments listed in the Code. Conversely, independence may be excluded on special grounds other than those provided in the Code. As a result, about 15% of French independent directors do not fulfill all the requirements listed in the Code. The board therefore enjoys notable discretion, particularly considering that the French system does not explicitly distinguish between executive and non-executive directors, but only between independent and non-independent directors.[44]
Similarly, the Italian Code provides that the board can assess independence through criteria other than those specifically stated by the same, also suggesting that substance should always prevail over form. When departing from the Code's criteria, however, the board should publicly disclose the different criteria applied and explain the reasons of non-compliance.[45]
Proportion of independent directors
Where concentrated ownership dominates, the percentage of independent directors in the board varies, but is generally much lower than in the US and UK, where independent directors are required to be the majority of the board and hold in fact an average of about 80% of board seats.[46] In Europe, national laws and/or corporate governance codes generally provide for a minimum number of independent directors or a given proportion of the same with respect to the other board members. The Italian Code, for example, recommends that listed companies appoint an "adequate number" of independent directors, but no less than two (in the case of the star segment's listed companies no less than one third of all directors) (3.C.3). As a result, the average board of listed companies in 2012 included about 38% of independent members, a proportion that is relatively stable over the time.[47]
The Austrian, Danish and Finnish Codes require a majority of independent directors in the (supervisory) board (respectively at § 53.a, § 3.2.1 and recommendation 14). The Belgian Code requires a majority of non-executive directors of which at least three independent (§ 2.3). The Spanish Code distinguishes between three categories of outside directors: proprietary (owning more than 5% of the voting shares), independent and other (neither proprietary nor independent). Outside directors should account for the large majority of the board, while the percentage of inside directors should be minimal (§ 2.11). Independent directors should cover at least one third of the board seats, with a minimum of two (§ 2.13).[48]
The French Code requires a majority of independent directors in widely-held companies and one third of them in companies with controlling shareholders (§ 8.2). Similarly, the Polish 2002 Code, already in force before the EU Recommendation, required a majority of independent directors in the supervisory board. However, strong opposition from Polish listed companies led to a relaxation of this requirement and the 2010 Code only requires two independent directors in the supervisory board.[49]
Only in Germany the minimum number of independent directors is not specified. The 2013 Code recommends the supervisory board to include «what it considers an adequate number of independent members» (§ 5.4.2). This approach reflects, as already discussed, a general reluctance toward independent directors.
Appointment of independent directors
Independent directors, like other directors, are generally elected by the shareholder meeting under a majority rule. As a result, controlling shareholders (or controlling coalitions) appoint the full board, including independents. However, special appointment rights are provided in some countries to protect minority shareholders. In Poland and Austria cumulative voting ensures proportional representation to different groups of shareholders.[50] In Italy, slate voting is mandatory for listed companies under art. 147-ter Consolidated Financial Services Act, which reserves the appointment of at least one director to the slate winning the highest number of votes amongst those submitted by minority shareholders.[51]
However granting board representation to minority shareholders does not ensure, in itself, higher activism, as incentives for minority shareholders, and for institutional investors, to participate seem to depend more on firms' characteristics (in terms of ownership concentration, size and identity of the ultimate shareholder) than on voting systems[52]. Also, appointment rights reserved to minority shareholders do not necessarily lead to the election of independent directors, as minority shareholders are often more interested in directly participating to board deliberations rather than in appointing third-party independent directors.[53]
Membership of Board Committees
Boards organize their work through committees, which support the decision-making process of the whole group and allow for a more effective monitoring of the firm by reducing information asymmetries. Independent directors typically join one or more committees, potentially contributing their professional expertise and disinterestedness to the relevant activities. However, the role and number of independent directors in committees varies substantially across member States. Also the types and functions of committees vary across European boards, even though the audit, remuneration and nomination committees are generally present.
The audit committee.
Independent directors have an important role to play in audit committees, also in the case of controlled companies. Firstly, participation to the audit committee offers a steady flow of information to independent directors through the internal control system and the internal audit function.[54] Secondly, audit committees have access to the company's resources and documents necessary to monitor the financial statements and their compliance with accounting standards. Thirdly, audit committees have responsibility, today also in Europe, for the selection and monitoring of outside auditors (thus overcoming, partially at least, the problem of controlling shareholders selecting and dismissing the auditors, highlighted by Professor Coffee in his book on Gatekeepers).[55]
This does not mean that, in concentrated ownership systems, independent directors are (or should be) the main barrier against frauds by controlling shareholders. Other institutions, like the gatekeepers and public enforcement, are also and, to some extent, more conveniently relied upon to curb the agency costs of controlling shareholders.[56] The weapons available to independent directors are inevitably weak when it comes to frauds committed by the top managers, and this is true both in concentrated and diffuse ownership. Nonetheless, efficient internal controls make it more difficult to hide financial fraud to the audit committee (and the outside auditors), while independence of the committee's members (and of the outside auditors) works in the same direction.
However, the 2005 European Recommendation does not suggest that all members of the audit committee should be independent. Rather, it foresees that «the audit committee should be composed exclusively of non-executive or supervisory directors. At least a majority of its members should be independent». Also, it provides that all members should have a relevant background in or experience of finance and accounting (art. 11.1).
Directive 2006/43/EC on audit[57] lessens that requirement and provides for the establishment, in all public-interest companies,[58] of an audit committee consisting of non-executive directors and at least one member independent and with specific competence in accounting and/or auditing (art. 41). Requirements of independence and competence are necessary to perform the functions assigned to that committee: monitoring the financial reporting process, the statutory auditors and the effectiveness of company's internal control and risk management systems.
While all member States comply with the Audit directive (with reference to both composition and functions of the audit committee), not all States have followed the EU Recommendation. Therefore, independent directors sit in the audit committees of all European listed companies, but their number in that committee varies. Some Codes (for example, the Belgian and Danish ones) require a majority of independent directors in the audit committee; other codes (such as the French one) require the presence of at least two-thirds of independent directors. In Finland and Sweden, the existence of two categories of independent directors has an impact on audit committees' composition. The Swedish Code requires a majority of directors independent from the corporation and its executive management and at least one director also independent from significant shareholders (2010 Code, § 7.3). The Finnish Code suggests (Recommendation 26) that the audit committee should consist entirely of directors independent from the corporation and at least one director independent also from significant shareholders. In Italy, the Code provides for the internal audit committee to be made up of non-executive directors, with at least a majority of independent directors. However, if the relevant issuer is controlled by another listed company, the audit committee should consist entirely of independent directors (7.P.4).
At the two poles of this patchy European landscape are Switzerland, on one side, and Germany and Austria, on the other. The Swiss Code requires the audit committee to consist of independent directors only and to form a "solid view" of the financial and accounting issues on which conditions the board's decisions are based. According to an informed opinion, the powers of independent directors in Swiss audit committees go beyond the usual preparatory and advisory functions foreseen in the rest of Europe.[59] At the opposite end of the spectrum, the German Code sticks to the minimum requirement foreseen by the Audit directive of at least one independent director in the audit committee, providing in particular that the chairman of the audit committee should be independent (5.3.2). Similarly, the Austrian Code emphasizes knowledge and expertise, rather than independence. Listed companies should establish an audit committee of which at least one member is a financial expert. Both the chairman and the financial expert should comply with some independence criteria (such as not being a member of the management board, an auditor or a manager of the corporation), which are however milder than those applicable to independent directors.[60] Therefore, compliance with the Audit directive is sought through a specific independence requirement for audit committees, rather than by requiring some committee members to be independent directors.
Remuneration and nomination committees
Independent directors also sit in remuneration and nomination committees. In most countries, these committees consist of non-executive directors, with a majority of independent directors (see the French Code, §§ 15.1 and 16.1; the Danish Code, § 3.4.2; the Spanish Code, § 54; the Swedish Code as to remuneration committees;[61] and the Italian and Swiss Codes as to nomination committees).[62] In other countries, the presence of independent directors in nomination and remuneration committees is neither required nor recommended. The German Code, in particular, encourages the establishment of a nomination committee (no reference is made to a remuneration committee) comprising exclusively shareholder representatives (§ 5.3.3). Similarly, in Austria the establishment of remuneration and nomination committees is suggested, but there is no recommendation for companies to appoint independent directors to the same. Rather, once more the emphasis is put on directors' knowledge and experience as to recruitment and remuneration policy (§ 41-43).
However, nomination and remuneration committees are rarely mandatory[63] and, when established, have only preparatory and advisory functions. Moreover, controlling shareholders generally have a say in the relevant areas, particularly with respect to executive remuneration, as the setting of remuneration is an integral part of the hiring process, which is often conducted by controlling shareholders either directly or through their representatives in the board. Consequently, the board's role is often reduced, in practice, to the ratification of pay terms and conditions negotiated in advance between the controlling shareholders and the executives. Similarly, in controlled corporations, nomination committees submit to the board (which will, on its turn, submit to the shareholder meeting) the names of candidates suggested to them by controlling shareholders, who will in the end approve the board proposals in the general meeting.
Independent directors of controlled corporations have an effective role to play in remuneration committees mainly to the extent that conflicts of interest may arise. For example, they might object to the pay package of an owner-manager which includes equity-based incentives by arguing that the manager is already sufficiently incentivized through its stockholding in the company.[64] In nomination committees, the role of independent directors is particularly valuable when the appointment (or replacement) of other independent directors is discussed and potential candidates must be selected.
Vetting of related party transactions
Vetting of related party transactions is generally regarded as a crucial function for independent directors in controlled companies. Independent directors often perform this function in audit committees, given that related party transactions generate delicate compliance issues that are relevant to internal controls. However, their practical involvement in the assessment of related party transactions varies significantly across member States, some of which attribute an important role to independent directors in this area, while others are silent.
Belgium and Italy belong to the first group of countries. In Belgium, Art. 524 of the Companies Code requires related party transactions to be reviewed by a special committee consisting of three independent directors and at least one independent expert.[65] The committee's opinion is not binding on the board, which has the final say on the relevant transaction. However, if the committee's opinion is not followed, the board should publicly disclose the reasons for it. As reported by scholars, this information duty has been effective in deterring deviations from the committee's view.[66]
In Italy, a Consob Regulation is in force providing for a complex regime of related party transactions.[67] Thresholds are fixed for distinguishing between transactions depending on their relevance for the company. There are two types of board approval procedures depending on the relevance of transactions. However, in both procedures independent directors have a role. For the most important transactions, the opinion of a committee composed solely of independent directors is required and is binding on the board, unless a "whitewash" procedure has been adopted by the company in advance, requiring approval of related party transactions by the shareholder meeting whenever the committee issues a negative opinion. For less significant transactions, the prior assessment by a committee consisting of a majority of independent directors is required, but is not binding on the board, which has the final say.[68]
The Spanish Code (Recomm. 8) occupies an intermediate position, as it recommends vetting of related party transactions by the audit committee before the board decides. As a result, independent directors are involved in the assessment of these transactions to the extent that they are members of the audit committee, but the final approval of the same is reserved to the full board (where the interested directors should abstain from voting).
The other countries foresee no specific role (not even advisory) for independent directors as to related party transactions. In France, for example, the related director must inform the board about her potential conflict of interest and the board decides on the transaction with her abstention from voting. Executive compensation is the only area of related party transactions where an involvement of independent directors is sought, to the extent that the prior opinion of the remuneration committee (consisting of a majority of independents) is encouraged.[69]
In the other States, either specific rules on related party transactions are lacking[71]
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 the membership of non-profits organizations that have received significant funds (at least 20% of total donations) from the corporation.[78]
For the rest, the regulation of independent directors varies significantly across Latin America, particularly as to the proportion of independent directors within the board. In Argentina and Peru, [79] the appointment of a "sufficient" number of independent directors for ensuring an effective monitoring is required. In Chile, company law requires boards to include an independent director, while in Costa Rica the corporate governance code recommends at least two independent directors to be appointed. In other States, a general reference is made to the required proportion of independent directors in the board, like in Brazil where the Novo Mercado listed issuers must have boards including at least 20% of independent directors.[80] Higher percentages (25% of members) are required in Columbia and Mexico (where the proportion in practice is about 30%). In Panama, there is no mandatory requirement as to the minimum number of independent directors, but the corporate governance code and sector regulations require a majority of independent directors in all listed companies and at least 20% of them in the boards of banks and mutual funds.[81]
The role of independent directors in board committees and in the assessment of related party transactions is also different. Audit committees are generally present, but their regime and the role of independent directors in them vary significantly. The establishment of an audit committee is mandatory for all listed companies in Argentina, Columbia, Mexico and Chile (where it is named "directors' committee"), while in Brazil it is required only for banks and stock exchanges. In the other countries, the audit committee is recommended by codes of corporate governance.[82]
The organization of audit committees is diverse. Codes recommend the committee to comprise only independent directors in Mexico, Brazil and Columbia, while in Chile and Argentina they foresee a majority of independent directors. In Panama, the relevant Code only suggests that independent directors should select the members of the audit committee.[83]
Nomination and remuneration committees are never mandatory in Latin America. The Brazilian Code recommends the establishment of a "human resources" committee, made entirely of independent directors, with advisory powers on directors' nomination and remuneration policy. Analogously, in Mexico the "corporate practice" committee is made up of independent directors and has a function, amongst others, in the nomination process. In all other countries, the establishment of a nomination committee consisting of a majority of independent directors or including at least one of them is recommended.
Nomination committees are functionally similar to their European homologues, to the extent that they propose candidate directors or suggest procedures to identify them. However, their influence on the selection of directors is practically limited, as - like in Europe - this task is usually performed by controlling shareholders.
Finally, differences also affect the role of independent directors in the review of related party transactions. As a general rule, in Latin America the approval of these transactions is reserved to the board and is covered by the duties of loyalty and care. In some countries (Panama and Costa Rica), specific rules on related party transactions are lacking. In other countries, prior approval or opinion of the audit committee or of independents is required. In Argentina, for example, the board may ask for the audit committee's opinion on this type of transactions, while the corporate governance code suggests a similar procedure to be followed whenever the related party is a majority shareholder. Also the Columbian Code recommends the audit committee to be consulted before the board's approval of related party transactions.[84]
In practice, however, the contribution of independent directors to the protection of minority shareholders against the expropriation by controlling shareholders is negligible. They either lack formal powers or do not play anyhow a role in the assessment of related party transactions.
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 (the latter mainly relating to directors' nomination, executive remuneration and fundamental transactions and combinations).[95]
However, the real impact of independent directors on Japanese corporate governance is lower than expected, for various reasons. Firstly, the functions of independent directors are not well specified. In the one-tier board, the audit committee has substantially the same powers and functions as the board of corporate auditors in the traditional system. It controls the lawfulness of business decisions, brings liability suits on behalf of the corporation against executive and non-executive directors, convenes the shareholder meeting in special cases, etc. In the two-tier model, independent directors are expected to perform monitoring functions, but their role is not clear if compared with the oversight powers of corporate auditors.[96] Secondly, the presence of independent directors is lower than expected. In fact, Japanese corporations rarely opt for the one tier board and the relevant committee structure,[97] while those having the traditional two-tier system in place generally choose to appoint an independent member of the board of auditors, rather than an independent director.[98] The limited number of independent directors helps to explain poor board monitoring over CEOs and other executives, who de facto maintain a stable grip over the board.[99]
No doubt, scholars recognize the possible benefits deriving from the one-tier board and its larger share of independent directors,[100] who are subject to stricter independence criteria than auditors.[101] Moreover, the joint exercise of management and monitoring functions helps to overcome the shortcomings of the two-tier system, which separates these two functions leaving unclear the role of independent directors vis-à-vis that of the board of auditors. In addition, given the mandatory presence of the nomination and remuneration committees in the one-tier model, independent directors could also have a better influence on the hiring and remuneration process.
Poor success of independent directors in Japan is explained by reference to the weight of national legal traditions and reluctance towards the adoption of US-like corporate governance. However, there is also a growing expectation of gradual alignment to the US model, also with respect to independent directors, as stock markets develop.[102]
India
India has a corporate governance system based on concentrated ownership, where controlling shareholders are predominantly families and the State.[103] The current system of Indian corporate governance results from reforms started at the beginning of '90s and aiming at economic liberalization. Also the Indian Securities Market Regulator (SEBI) was established, which contributed to the regulatory reform of listed companies. In 2000, SEBI adopted clause 49 of the Equity Listed Agreement setting the requirements for listed companies' boards.[104] Under these requirements, at least half of the board members should be non-executive, including a variable number of independent directors. If the chairman is an executive director, a promoter or an individual related to a promoter of the company, the independent directors should account for at least half of the board; otherwise, they should cover at least one third of the board seats.[105]
The shareholder meeting elects directors under a simple majority rule, so that the controlling shareholders can nominate or dismiss the entire board. However, companies may include a provision for cumulative voting in their bylaws, allowing minority shareholders to appoint some directors.[106] Given that board elections expose independent directors to the risk of capture by controlling shareholders,[107] the Confederation of Indian Industry and the Ministry of Corporate affairs recently recommended to empower the nomination committee as to the selection of candidates.[108]
Clause 49 also defines "independence" focusing on business and personal ties with managers, promoters, and the corporation. Independence is excluded if the director (i) is related to promoters or companies occupying management positions within the corporation; (ii) is a shareholder owning 2% or more of voting shares; (iii) has been an executive in the last three years; (iv) is a supplier or customer of that company in a way that may hinder his independence. For independent directors sitting in the audit committee also expertise and knowledge requirements are set, in the sense that they must be "financially literate" and one of them must be a professional accountant.[109]
Clause 49 does not precisely define the role of independent directors within the board, apart from specifying the functions of the audit committee, which comprises a majority of independent directors. The audit committee's tasks cover the oversight of financial reporting, the selection of auditors and the consistency of the disclosure concerning related party transactions with the financial statements.[110] No other functions are specifically assigned to independent directors. Moreover, the establishment of remuneration and nomination committees is not mandatory and companies are free to decide about their structure. In addition, independent directors play no significant role in the approval of related party transactions, for the audit committee is only involved in the disclosure of the same, not in their approval.[111] Briefly, independent directors sit in the boards of Indian listed companies, but do not enjoy powers distinguishing them significantly from non-executive directors.
China
The concept of independent directors was imported also into China, after that the Chinese Company law of 1993 and the Securities law of 1998 enacted a modern system of corporate law.[112] Listed companies are required to have three governing bodies: shareholders meeting, board of directors and board of supervisors. Corporate boards are organized according to a two-tier model, where the shareholder meeting appoints both the management board and part of the supervisory board.[113] The Chinese system was no doubt influenced by Japanese and German laws, and requires the supervisory board to consist of at least three members, one third of which are representatives of employees and workers, while the rest are elected by shareholders.[114] Like in other systems, the powers of the management and the supervisory boards are not precisely defined. On the one hand, the supervisory board is generically empowered to monitor the board of directors, but lacks more specific powers to attain this goal and the scope of its monitoring is not specified.[115] On the other hand, the management board runs the corporation and has a variable numbers of members, ranging from 3 to 13 in closely held companies, and from 5 to 19 in public companies. It also includes a number of independent directors.
Independent directors were firstly introduced in China in 1997, when the Chinese Securities Regulation Commission (CSRC) recommended that all listed companies appoint some of them.[116] Independent directors were defined as members of the board having no material relationship with management and being neither employees nor managers of the corporation. The relevant Guidelines, however, did not specify the powers and functions of independent directors.[117] The scenario partially changed in 2001, when the CSRC enacted Corporate Governance Principles, based on the OCDE principles on corporate governance, requiring the appointment of at least one third of independent directors in all listed companies' boards.[118]
Firstly, "independence" is now more precisely defined. Independent directors must not have any familiar, social or financial connection with the corporation, they must have specific knowledge about listed companies and at least five years of experience in either law or economics.[119] Secondly, a few tasks are assigned to independent directors, none of which, however, is particularly relevant. At least half of the members of the audit, remuneration, and nomination committees must be independent. However, the establishment of these committees is not mandatory. Independent directors are entitled to recommend the outside auditor for appointment, but only in an advisory capacity. They also have a limited role in the assessment of related party transactions, on which they should express and disclose their prior opinion without having approval or veto powers. Moreover, independent directors are expected to monitor the management of the firm, but their functions are not clearly defined vis-à-vis the supervisory board.[120] Therefore, like other concentrated ownership systems, Chinese corporate governance, while formally requiring independent directors, in substance leaves a minor role to them.
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 UK).
Secondly, the number of independent directors is, on average, lower when there are dominant shareholders, who tend to occupy the majority of board seats. This also responds to our prediction in theory. However, a minimum number of independent directors is implicitly contemplated when board committees are required to comprise at least a majority of independent directors. Yet, the establishment of committees is not always mandatory, which may contribute to keep the average number of independent directors lower than in the US and the UK.
Thirdly, information asymmetries between the managers and independent directors are similar in concentrated and in diffuse ownership, and the remedies available are also similar. On one side, directors' participation to board committees, particularly to the audit committee, gives them access to a flow of information from sources other than key corporate officers, such as the internal and external auditors, financial and legal advisors, etc. On the other, to the extent that there are efficient and liquid markets for the firm's securities, the prices made in these markets and the reports published by financial analysts with respect to the individual corporation provide independent directors with an additional flow of information, which is vital for the performance of their functions, including the monitoring of corporate strategies. However, a difference could emerge between controlled and widely held corporations if the stock market is less liquid due to the presence of controlling shareholders (or for other reasons), which may aggravate the information asymmetry between the managers and independent directors. Moreover, if provisions about boards committees are only enabling in character, controlling shareholders might choose not to establish them precisely for constraining the information flow to independent directors.
Fourthly, the role of independent directors in controlled corporations is, in principle, different from that played in widely held corporations. Some of the functions that independent directors exercise when shareholders are diffuse, such as hiring and firing the managers, or setting their remuneration, are substantially performed by controlling shareholders. Independent directors are often called essentially to ratify decisions already taken either within the company (by the outside directors representing the controlling shareholders in the board) or outside the same (for example, by the shareholders participating to a shareholder agreement). This ratification function is aimed to protect minority shareholders from the agency costs of majority shareholders. When similar costs are potentially more serious, as in the case of related party transactions, independent directors should have a greater role in assessing the impact of similar transactions from the minority shareholders' perspective. Therefore, the role of independent directors in controlled corporations is for some issues narrower (to the extent that controlling shareholders are expected to do most of the work needed - for example, in the selection of the new CEO) and for other broader, as in the case of transactions between the company and its controlling shareholders.
However, our analysis shows that in many countries the role reserved to independent directors in listed companies is more modest than one would expect in theory. In some cases, the role of independent directors is not even clearly defined. Japanese law, for instance, acknowledges their "monitoring" function without specifying their powers in detail, particularly in the traditional two-tier system and with reference to the board of statutory auditors. Also in the Italian traditional system, it is not easy to distinguish the role of independent directors from that of the other non-executive directors, on one side, and from the role of statutory auditors, who also perform monitoring functions, on the other.
In most countries and especially in Europe, the audit committee comprises independent directors. This reflects our view about the importance of independent directors' participation to the audit committee in controlled corporations. However, the cases in which independent directors also participate to the vetting of related party transactions, either in the audit committee or otherwise, are less frequent, which is difficult to explain given that similar transactions may be a source of agency costs to minority shareholders.
On the whole, the weak regimes applicable to independent directors in many countries, particularly outside Europe, generate the impression that the relevant reforms have often been adopted mainly as a signal to foreign institutional investors that modern corporate governance principles are adhered to also in the jurisdiction concerned. In other words, the mechanism of independent directors is often employed just to accommodate the investors' preference for «western-style corporate governance»[1], rather than to perform a specific function.
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 principle, particularly if there is strong enforcement of this principle and the relevant social rules.[1]
However, in countries where the pressure from markets is less easily felt and reputational mechanisms are ineffective, best practice codes may be insufficient to determine board behavior. Moreover, the "comply or explain" mechanism could have a modest impact in the absence of good enforcement either by a securities regulator or through private litigation. In similar situations, hard law could be needed to enhance the role of independent directors particularly in the presence of controlling shareholders.
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 directors in many countries, particularly outside Europe, generate the impression that independent directors have been introduced mainly to convince foreign institutional investors that modern, western-style corporate governance principles are adhered to also in the jurisdiction concerned.
Limits and weakness in the current treatment of independent directors in concentrated ownership systems around the world can be addressed through a regulatory policy which provides a precise and inclusive definition of independence; adequately defines the role of independent directors vis-à-vis other directors and gatekeepers; requires the establishment of board committees consisting of a majority of independent directors; sufficiently identifies the powers and tasks of independent directors particularly in the areas where conflicts of interest typically arise, such as related party transactions and remuneration issues.
1) This paper was presented at 16th Annual Law & Business Conference - Vanderbilt Law School, Nashville, September 26-27, 2013. A revised version of the same will be published as a chapter in R.Thomas and J.Hill, eds., Research Handbook on Shareholder Power, Edward Elgar Publishing, forthcoming 2014. Sections from 2 to 6 of this paper are attributed to M.Filippelli. This does not affect the joint nature of the work and the shared views of the authors
J.N.GORDON,The Rise of Independent Directors in the United States, 1950-2005: Of Shareholder Value and Stock Market Prices, 59 (2007)Stanford L. Rev.,1465.
On the centrality of shareholder value in US, see K.V.JACKSON, Towards a Stakeholder-Shareholder Theory of Corporate Governance: A Comparative Analysis, 7 (2011) Hasting Bus. L.J., 18-22, 32-34; A.K.SUNDARAM, A.C.INKPEN, The Corporate Objective Revisited, 15 (2004) Organization Science, 350-363.As to data on the extraction of private benefits of control in Latin America countries, see T.NAVOVA, The value of corporate voting rights and control: a cross-countries analysis, 68 (2003) Jour. Finance, 327.
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