CORPORATE GOVERNANCE IN EMERGING ECONOMIES: ROLE OF THE INDEPENDENT DIRECTOR UMAKANTH VAROTTIL (B.A., LL.B (Hons.), National Law School of India University, Bangalore; LL.M, New York University School of Law) A THESIS SUBMITTED FOR THE DEGREE OF PH.D. IN LAW FACULTY OF LAW NATIONAL UNIVERSITY OF SINGAPORE 2009 [This dissertation is current as of 25 June 2009] ACKNOWLEDGMENTS I owe immense gratitude to a number of institutions and individuals without whose support it would not have been possible for me to undertake this work in a timely manner. While I endeavour to list all of their names here, I may be excused if I have inadvertently omitted to mention any of them. Needless to say, any errors in this work are mine alone. I thank the Faculty of Law, National University of Singapore (NUS) for admitting me into the PhD programme and for providing an extremely conducive environment for research of the present kind. The excellent resource base in the libraries of the University, both physical and online, seemed to cater comfortably to my relentless pursuit of information from various sources. At no stage during my research did I feel crippled by the lack of research materials. I am also thankful to the many individuals who were generous with their time and ideas when I interviewed them during my field work. I am particularly grateful to my supervisor Professor Hans Tjio for his advice and guidance throughout my tenure in the PhD programme. My discussions with him helped shape the scope of the project, and his inputs on drafts of this dissertation have been invaluable. Without his encouragement, I could well have taken a longer period of time to complete this dissertation. More so, he set an example by demonstrating his own commitment to this project, which always received his utmost priority. I express my sincere thanks and appreciation to the panel of examiners consisting of Professors Stephen Girvin, Richard C. Nolan and Tan Ng Chee for their time and effort in reviewing the dissertation despite their busy schedules and for providing valuable comments and suggestions. Several other professors at the NUS Law Faculty have had a part to play in this work. I thank Alexander Loke and Michael Ewing-Chow for reviewing my research proposal and for providing comments and suggestions during my doctoral candidate qualifying examination (DCQE) that helped fine-tune the research. Andrew Simester not only taught me the intricacies of legal research in the Graduate Research Seminar course, but was also kind enough to meticulously go over my research proposal and provide extensive feedback when I presented the proposal in the class. I have also tremendously benefited from my discussions with Stephen Phua and Dan Puchniak, whose passion for the field of corporate governance in particular and business law in general always amazes me. Words of encouragement or even general enquiries about my progress from several other professors on the Faculty, who are numerous to be named individually, have always gone to boost my morale. I am grateful to the administration at the Law Faculty. Vice-Dean Alan Tan gladly ensured my seamless qualification and dissertation process, while Dean Tan Cheng Han assured me on the very first day of the programme that the i door to his office was always open in case I faced any obstacles, which was always a source of comfort for me, although the occasion to take up his invitation never arose. Normah and Zana at the Graduate Division Office tirelessly answered my constant bombardment of queries about some administrative matter or the other. I sincerely thank NUS as well as the Lee Foundation for conferring a generous scholarship that supported me financially as I worked on my PhD. I have also enjoyed the support and camaraderie of several fellow candidates in the graduate programme at NUS, which made an otherwise lonely journey so lively. They include Tan Lay Hong, Jason Bonin, Abhik Majumdar, Lin Lin, Vincents Benjamin, Tan Hsien-Li and several others. My special thanks are due to Mr. Cyril Shroff, colleagues and many friends at my (first and only) employer of 11 years, Amarchand Mangaldas, where I received limitless opportunity to witness real-world corporate activity at close quarters that has stood me in good stead for my research. I also owe my foundations in corporate law to the National Law School of India University (NLSIU), particularly Professor M.P.P. Pillai. The NLSIU has also been kind in publishing in the latest issue of the National Law School of India Review my article “A Cautionary Tale of the Transplant Effect on Indian Corporate Governance” that contains some of the foundational ideas propounded in this dissertation. Many friends and well-wishers have played an important role in this mission. I am thankful to Arun Thiruvengadam for being generous with his advice, counsel and guidance from the time I embarked on my path in academia. Srikanth, Nandini and Mayura extended their benevolence in ensuring that my family and I settled well into Singapore. Other friends at various locations never failed to provide their constant encouragement and moral support – Saikrishna, Aparna and R.V. Anuradha, just to name a few. Finally, words cannot describe my appreciation for my wife Swapna and son Aditya who have stood firmly by me through all my endeavours. Swapna’s open-heartedness allowed me to pursue a somewhat unconventional career path— one that meant my giving up a stable job by daring to live my dreams. Although it involved a great amount of risk and uncertainty to us as a family, she helped in a smooth transition by handling it with great poise. Aditya too had to be uprooted from his family and friends to move to another country, which he did with ease; nevertheless, he does not cease to be amused by the idea that his father was a student for three years, much like him, and at the same time that he was one. I cannot forget the encouragement I have always received from my mother, late father and my extended family. ii TABLE OF CONTENTS SUMMARY . viii LIST OF TABLES x 1. INTRODUCTION 1.1 Introduction to the Chapter . 1.2 Background to the Research . 1.3 Problem, Hypothesis and Questions . 11 A. Problem . 11 B. Hypothesis . 11 C. Key Questions . 12 1.4 Relevance and Importance of the Research 13 1.5 Methodology and Research Approach 20 A. Theoretical Component . 20 B. Comparative Study 21 C. Analytical Component 24 D. Normative Component 27 1.6 Conclusion to the Chapter . 27 2. COMPARATIVE CORPORATE GOVERNANCE: SETTING THE TONE . 28 2.1 Introduction to the Chapter . 28 2.2 Different Models of Corporate Governance . 30 A. The Outsider Model of Corporate Governance 30 B. Constituents of the Outsider Model 35 C. The Insider Model of Corporate Governance . 38 D. Constituents of the Insider Model . 44 1. China . 45 2. India 53 E. Summary . 63 2.3 Reviewing the Models in Context of the Agency Paradigm . 64 2.4 Driving Forces Behind the Different Models . 68 A. The “Law Matters” Explanation . 68 B. Other Explanations 73 C. Impact of Explanations on Models of Corporate Governance 76 2.5 A Review of the Convergence vs. Divergence Debate . 77 A. Factors for Convergence . 77 B. Divergence; Path Dependency 79 C. The Relevance of the Debate to Independent Directors . 82 2.6 Transplant Effect . 83 2.7 Conclusion to the Chapter . 86 3. INDEPENDENT DIRECTORS IN OUTSIDER SYSTEMS: ORIGIN AND EVALUATION . 88 3.1 Introduction to the Chapter . 88 3.2 Theoretical Foundations for the Origin of Independent Directors 90 iii A. B. 3.3 A. B. C. Berle & Means Study 90 Economic Analysis of the Agency Problem . 92 Emergence of Independent Directors in U.S. Corporate Practice 98 Changing Board Composition; The Voluntary Phase . 99 Emergence of a “Monitoring Board” 101 Judicial Reliance on Board Independence 105 1. Self-Dealing Transactions 106 2. Derivative Suits . 110 3. Defensive Measures Against Hostile Takeovers . 112 D. Regulatory Prescriptions on Board Independence 114 E. Independent Directors and the Stakeholder Theory 120 3.4 Emergence of Independent Directors in U.K. Corporate Practice 127 A. Various Committees Culminating in the Combined Code . 128 B. Non-executive Directors and the Stakeholder Theory 133 3.5 Effect of Independent Directors in Outsider Systems . 137 A. Qualitative Studies 138 B. Quantitative Studies 146 1. Board Composition and Corporate Performance in General 146 2. Board Composition and Specific Tasks 148 3.6 Conclusion to the Chapter . 156 4. ADOPTION OF INDEPENDENT DIRECTORS BY EMERGING ECONOMIES: LESSONS FROM CHINA AND INDIA 158 4.1 Introduction to the Chapter . 158 4.2 Evolution of the Independent Director Concept in the Insider Systems 160 4.3 Norms Governing Independent Directors in China 163 A. Evolution of Corporate Governance Norms . 163 B. Rationale for Corporate Governance Reforms . 166 C. The Independent Director Opinion . 169 1. Basic Requirement 169 2. Independence 169 3. Qualifications of Independent Directors 172 4. Nomination and Appointment . 173 5. Tenure . 178 6. Allegiance of the Independent Directors 179 7. Role of Independent Directors 181 8. Effectiveness of the Independent Director Opinion 187 4.4 Norms Governing Independent Directors in India 189 A. Evolution of Corporate Governance Norms . 189 B. Rationale for Corporate Governance Reforms . 194 C. Clause 49 and Independent Directors . 199 1. Basic Requirement 199 2. Independence 200 3. Nomination and Appointment . 203 4. Allegiance of the Independent Directors 206 iv 5. 6. 4.5 A. B. 4.6 Role of Independent Directors 207 Effectiveness of Clause 49 212 Independent Director Norms: China and India Compared . 214 Chronological Survey . 214 Comparison of Key Features 219 Conclusion to the Chapter . 221 5. EFFECTIVENESS OF INDEPENDENT DIRECTORS IN CHINA AND INDIA . 223 5.1 Introduction to the Chapter . 223 5.2 Independent Directors in China: Empirical Survey 226 A. Effect on Corporate Performance . 226 B. Number of Independent Directors 229 C. Nomination and Appointment . 230 D. Competence . 231 E. Incentives and Disincentives . 233 F. Role of Independent Directors 236 5.3 Independent Directors in China: Case Studies 238 A. Effectiveness . 238 B. Legal Liability . 242 5.4 Independent Directors in India: Empirical Survey . 244 A. Effect on Corporate Performance . 245 B. Number of Independent Directors 249 C. Nomination and Appointment . 251 D. Competence . 253 E. Incentives and Disincentives . 254 F. Role of Independent Directors 256 5.5 Independent Directors in India: Case Studies . 262 A. Compliance with Clause 49 262 B. Effectiveness of Independent Directors: The Satyam Episode . 264 1. Satyam: The Company and its Board . 264 2. The Maytas Transaction . 267 3. Fraud in Financial Statements 271 4. Lessons from Satyam . 274 C. Legal Liability . 282 5.6 Conclusion to the Chapter . 285 6. CONSTRAINTS FACING INDEPENDENT DIRECTORS IN THE INSIDER ECONOMIES 287 6.1 Introduction to the Chapter . 287 6.2 Structural Constraints 288 A. Appointment of Independent Directors 291 B. Role and Allegiance of Independent Directors . 295 1. Role of Independent Directors: Strategic and Monitoring . 296 2. Independent Directors and Their Constituencies . 300 6.3 Legal Constraints 304 v A. Legal Characteristics of Corporate Structures 305 B. Robustness of the Legal System for Enforcement of Independent Director Norms . 310 C. Market Regulation Versus State Regulation . 315 6.4 Cultural Constraints 319 6.5 Political Constraints 330 6.6 Perceptional Constraints . 336 6.7 Conclusion to the Chapter . 340 7. FUTURE PROSPECTS FOR INDEPENDENT DIRECTORS IN EMERGING ECONOMIES . 342 7.1 Introduction to the Chapter . 342 7.2 Revisiting the Concept 344 7.3 Alternate Structures for Appointment of Independent Directors 346 A. Nomination Committee . 347 B. Minority Shareholder Participation in Independent Director Elections 351 1. Cumulative Voting 357 2. Voting by “Majority of the Minority” . 362 3. Evaluation of Options for Minority Shareholder Representation . 363 C. “Public Interest” Directors 367 D. Government Director 369 7.4 Crystallising the Role of Independent Directors . 370 7.5 Other Relevant Considerations . 376 A. Defining Independence . 376 B. Competence and Qualifications 377 C. Commitment . 378 D. Cadre of Independent Directors 380 E. Incentives 381 F. Disincentives . 383 G. Other Supporting Factors 385 H. Performance Evaluation 386 7.6 Role of the Law and Other Factors . 387 7.7 Conclusion to the Chapter . 389 8. CONCLUSION: THE WAY FORWARD . 391 8.1 Summary and Conclusions . 391 8.2 Contributions to Knowledge . 394 8.3 Guidance for Further Research . 397 BIBLIOGRAPHY . 400 APPENDICES 427 Appendix 427 List of Persons Interviewed 427 Appendix 429 vi Questionnaire 429 Appendix 432 Comparison between Independent Director Opinion (China) and Clause 49 (India) 432 vii SUMMARY Modern corporate governance recognises independent directors as “monitors” of managers so as to protect the interests of the shareholders of companies. Although the concept of “independent directors” originated in the United States (U.S.) in the 1950s voluntarily as a good measure of corporate oversight, it has now become a mandatory requirement of corporate law, at least in the case of public listed companies. Gradually, the phenomenon has been imbibed into the United Kingdom (U.K.). Over the turn of the century, several other jurisdictions have embraced independent directors as an integral part of their corporate governance codes. These include emerging economies such as China and India. The U.S. and the U.K., which have been at the vanguard of the independent director movement, follow the classic “outsider” model of corporate governance, with dispersed shareholding. This gives rise to agency problems between managers and shareholders arising out of the separation of ownership and control. The institution of independent directors has seemingly been introduced as protection for shareholder interests against actions of managers in public companies with dispersed shareholders. However, other jurisdictions (to which the independent director concept was transplanted) follow the “insider” model of corporate governance where ownership and control are relatively closely held by cohesive groups of insiders. Companies here are controlled by family groups or the state, and they not face the classic agency problem between managers and shareholders; indeed they face a different agency problem – one between the controlling shareholders and minority shareholders. Furthermore, under these “insider” systems of corporate governance, there is a greater role that corporate law plays to protect the interests of the non-shareholder constituencies. This research analyses the implications of legal transplantation of the independent director concept from the outsider system to the insider system of corporate governance and examines whether or not such transplantation of a corporate governance mechanism that works to address one type of agency problem would work at all to address altogether different types of agency problems. The findings of the research indicate that the effect of independent directors in the insider systems of China and India is different from that in the outsider systems. The transplantation of the concept does not take into account the intrinsic differences between these two types of systems, and this is evident from a survey of the corporate governance norms in these jurisdictions as well as an analysis of the available empirical evidence. viii Sarkar, Jayati & Subrata Sarkar, “Large Shareholder Activism in Corporate Governance in Developing Countries: Evidence from India” (2000) 1:3 International Review of Finance 161; “Scandal at Satyam: Truth, Lies and Corporate Governance” India Knowledge@Wharton (9 January 2009), online: ; Schwarcz, Steven L., “Securitization Post-Enron” (2004) 25 Cardozo L. Rev. 1539; Seligman, Joel, “A Sheep in Wolf’s Clothing: The American Law Institute Principles of Corporate Governance Project”, (1987) 55 Geo. Wash. L. Rev. 325; Shah, Ajay, “Getting the Right Architecture for Corporate Governance” Financial Express (13 January 2009); Shankaran, Sanjiv, “Independent Directors Can’t Solve Governance Problems” The Mint (8 April 2009); Shiller, Robert J., “From Efficient Markets Theory to Behavioral Finance” (2003) 17 J. Econ. Persp. 83; Sibao Shen, “China’s New Corporate Governance Measures After Its Accessions into the WTO” (2004) 17 A.J.C.L. 6; Smart, Christopher J., Note, “Takeover Dangers and Non-Shareholders: Who Should Be Our Brothers’ Keeper?” 1988 Colum. Bus. L. Rev. 301; Sobieski, John G., “In Support of Cumulative Voting” (1960) 15 Bus. Law. 316; Solomon, Deborah, “Loophole Limits Independence--Dozens of Firms Use Exemption That Allows Them to Avoid Rules Mandating Board Structure” The Wall Street Journal (28 April 2004) at C1; Sturdy, Herbert F., “Mandatory Cumulative Voting: An Anachronism” (1961) 16 Bus. Law. 550; Subrahmanyam, Vijaya, Nanda Rangan & Stuart Rosenstein, “The Role of Outside Directors in Bank Acquisitions” Fin. Mgmt., Autumn 1997 at 23; Subramanian, Guhan, “Fixing Freezeouts”, (2005) 115 Yale L.J. 2; Sundaramurthy, Chamu, James M. Mahoney & Joseph T. Mahoney, “Board Structure, Antitakeover Provisions, and Stockholder Wealth” (1997) 18 Strategic Mgmt. J. 231; 418 Sundaresan, Somasekhar, “SEBI Should Phase Out ‘Promoter’ Concept” Business Standard (8 October 2007); Sundaresan, Somasekhar, “Year of All-Pervasive Poor Governance” Business Standard (29 December 2008); Sweeney-Baird, Margarita, “The Role of the Non-Executive Director in Modern Corporate Governance” (2006) 27(3) Comp. Law. 67; Tan Cheng Han, “Corporate Governance and Independent Directors” (2003) 15 S.Ac.L.J. 355; Tan Lay Hong & Jiangyu Wang, Modelling an Effective Corporate Governance System for China’s State Owned Enterprises and Challenges in a Transitional Economy, (2007) J. Corp. L. Stud. 143; Tian, Jenny J. & Chung-Ming Lau, “Board Composition, Leadership Structure and Performance in Chinese Shareholding in Companies” (2001) 18 Asia Pacific J. of Mgmt. 245; Tong Lu, “Defects in China’s Independent Director System: A Case Study of Leshan Power Company”, online: [...]... than in the U.S In the U.K, the trend towards independent directors was set in motion in 1992 with the Cadbury Committee Report.16 This report forms the basis of corporate governance in the U.K.17 Now, board independence has become an integral part of corporate governance in the U.K by virtue of the Combined Code on Corporate Governance. 18 Although the Combined Code is not mandatory, it follows the. .. shareholder interests against actions of managers in public companies with dispersed shareholders.24 The evolution of the independent director institution did not remain confined to the economies of the U.S and the U.K where it originated Owing to the corporate governance wave that emerged in response to the corporate governance scandals of the last decade, it witnessed rapid proliferation to other 21... is an effort in furthering the movement of the research in corporate governance as it pertains to emerging economies As I will discuss later, the focus of this dissertation is on two of the largest emerging economies, which not only have significant financial resources at hand but also cater to the lives of a whopping 37% of the people on this planet,44 with the actions of the companies in 42 Douglas... Duties” of Directors Under the Revised Company Law of the PRC” (2007) 47 Va J Int'l L 897 10 1.3 Problem, Hypothesis and Questions A Problem The concept of independent directors has originated in the context of outsider systems of corporate governance These systems are affected by the agency problem between managers and shareholders, and the institution of independent directors has seemingly been introduced... when the controlling shareholder has influence over the appointment or removal of such director? In other words, can independent directors be expected to remain objective when their continuance in that position is dependent on the wishes of the persons (controlling shareholders) that they are required to monitor in the first place? 3 Whose interests are independent directors required to protect in an insider... the role of independent directors in corporate governance is yet unclear, despite being a field which has been occupied for several decades now There is no persuasive (let alone clinching) evidence that independence of directors has been an effective tool in the direction of maximising corporate performance or improving corporate governance There is no uniformity in the definitional aspects of independence... independent directors outside the purview of the controlling shareholders and the managers 37 One significant piece of research that has come to my attention in this field is that of Professor Clarke, see Donald C Clarke, The Independent Director in Chinese Corporate Governance (2006) 31 Del J Corp L 125 [Independent Director in China] However, while his work examines the specifics of Chinese corporate governance. .. importance of this research, it details the methodology adopted for accomplishing the research 1.2 Background to the Research I begin by outlining the importance of corporate governance in modern business and the role of the board of directors in general and independent directors in particular Corporate governance relates to the “system by which companies are 1 directed and controlled”.2 It is also pertinent... in the literature pertaining to independent directors as it does not explicitly address theoretical issues pertaining 34 Clarke, Three Concepts, supra note 6 at 110-11 (noting that jurisdictions already using the institution of independent director should clarify its purpose and adjust legal definitions) See also Li Jingjing, The Independent Director System in China” (2004) 17 A.J.C.L 120 (observing... those economies to deal with issues arising out of the implementation of these principles and practices This research is unique in that it conducts a comparative analysis of the effect of mandating board independence on developed markets on the one hand and emerging markets on the other This is particularly relevant in the context of “westernization” of corporate governance requirements in emerging economies . accomplishing the research. 1.2 Background to the Research I begin by outlining the importance of corporate governance in modern business and the role of the board of directors in general and independent. Role of Independent Directors 181 8. Effectiveness of the Independent Director Opinion 187 4.4 Norms Governing Independent Directors in India 189 A. Evolution of Corporate Governance. Appointment of Independent Directors 291 B. Role and Allegiance of Independent Directors 295 1. Role of Independent Directors: Strategic and Monitoring 296 2. Independent Directors and Their