To motivate independent directors, put them in the spotlight

The importance of independent directors in enhancing corporate governance is clear, but practice tells a different story. In China, public oversight can encourage them to raise the bar

Featured faculty: George Yang
Written by Putro Harnowo

Many countries require listed companies to have independent directors on their boards. These directors have no ties to the company, are not part of the executive team, and do not participate in daily operations. Their role is to support ethical management, balance stakeholder interests, and protect shareholders. However, several challenges can prevent them from fulfilling these responsibilities effectively, raising important questions about corporate governance best practices.

Among many possible reasons, controlling shareholders often immensely influence the nomination of independent directors, who receive meagre compensations, giving them less motivation to exert monitoring efforts. A lack of expertise could also be the cause, as many independent directors are industry outsiders with little business experience. Regardless, their oversight function is vital in ensuring corporate governance.

George Yang, Professor of the School of Accountancy at The Chinese University of Hong Kong (CUHK) Business School, investigates how public oversight can strengthen independent directors’ roles. His research examines China’s “sunshine enforcement”, in which regulators use public enforcement mechanisms to encourage independent directors to improve their monitoring efforts. By increasing transparency and public visibility, this approach aims to strengthen accountability and compliance—important elements of effective corporate governance best practices.

In a study titled Public enforcement through independent directors, Professor Yang and his co-authors, Li Xiaoxi and Rao Pingui of Jinan University, as well as Yue Heng of Singapore Management University, examined the role of independent directors in responding to a comment letter, a publicly shared inquiry from regulators regarding companies’ filings, disclosures, or compliance with regulations.

Specifically, the researchers look into certain transactions between companies and parties with pre-existing relationships. Such transactions, known as related-party transactions, are particularly concerning in emerging markets like China as they can lead to expropriation, an unfair practice where controlling shareholders take advantage of their position to benefit themselves at the expense of minority shareholders.

“Using data from China, we find that firms receiving comment letters concerning related-party transactions from stock exchanges significantly reduce their related-party transactions in subsequent years,” says Professor Yang. “Managers, including independent directors, particularly care about their ‘face’. They would be ashamed if they received sanctions from the market regulators, which would result if the issues in the comment letters were not properly resolved.”

Independent directors are also more likely to dissent or resign if their firms fail to fix the issue after receiving comment letters, especially when their reputation is at stake, signifying that the reputation concerns can be utilised to enhance public enforcement.

Rules regarding related-party transactions and independent directors

Companies are often more comfortable dealing with familiar parties, and some are inclined to do business with entities or individuals with prior relationships, either through family ties, business partnerships, or shareholding interests. Although legal, such related-party transactions may create conflicts of interest, which is why public companies in many countries are required to disclose them.

To protect shareholders’ interests, the China Securities Regulatory Commission (CSRC) issued guidelines that clearly require certain related-party transactions, including those exceeding three million Chinese yuan or five per cent of the firm’s net asset value, to be approved by independent directors before being submitted to the board for discussion.

“Managers, including independent directors, particularly care about their ‘face’. They would be ashamed if they received sanctions from the market regulators.”

Professor George Yang

The Division of Corporation Compliance and Disclosure of each Chinese stock exchange is responsible for reviewing various filings of listed firms at least once every three years and will send comment letters to relevant firms. The firms are required to reply within five business days. Under the sunshine enforcement mentioned above, these letters and the firms’ responses are published simultaneously on the exchanges and CSRC’s websites.

Several rounds of correspondence may be needed before a resolution is reached. Unsatisfactory responses could lead to detrimental consequences, such as restrictions on bond issuances, seasoned equity offerings, stock-financed acquisitions in the following 36 months and even suspension of trading.

As the person tasked to review related-party transactions, independent directors would be held accountable if the commented transactions turn out to have violated securities regulations. Being charged by the CSRC for negligence would seriously undermine a director’s future career and essentially bar them for life. From 2002 to 2018, the researchers found that 37 per cent of sanctions against independent directors were related to related-party transactions.

Reputations and careers matter for independent directors

The researchers collected more than 1,100 comment letters issued by the Shanghai and Shenzhen stock exchanges from 2014 to 2017. Additionally, they also extracted financial information related to related-party transactions from the China Stock Market and Accounting Research Database, then collected information to measure independent directors’ reputations from the Chinese Research Data Services Platform database. Almost half of the comment letters explicitly discuss issues about related-party transactions, and 90 per cent of the listed firms in the sample reported related-party transactions.

“We find that firms decrease their related-party transactions by 16.4 per cent after receiving a related-party transaction comment letter,” says Professor Yang.

After measuring independent directors’ reputation and career concerns using media mentions, number of directorships, age, and membership in the audit committee, the researchers found that the reduction effect of comment letters becomes stronger when the independent director has a higher reputation or career concerns. This result appears primarily in non-business-related-party transactions, which means the transactions were not closely related to the core business operations and, therefore, more likely to be for expropriation purposes.

As Chinese society places a high value on social image, the negative exposure from the CSRC comment letters would also damage independent directors’ social reputations. Taken together, when the comment letters increase regulatory risk and threaten their reputations and career prospects, independent directors would be eager to confront controlling shareholders and management. The study found that there is an increasing 10 per cent chance that independent directors will either dissent or resign if the firms do not improve after receiving related-party transaction comment letters.

“Playing friendly toward controlling shareholders becomes a lower priority to independent directors when regulatory risk suddenly increases,” says Professor Yang. “Independent directors worry about their reputation largely because it affects their career prospects, and it could also impact their social image, friendships, or even the well-being of their family members or those otherwise tightly connected to them.”

The study shows how public comment letters can encourage independent directors to strengthen their monitoring efforts and help limit self-dealing activities. These findings offer valuable insights into corporate governance best practices, particularly the role of transparency, regulatory oversight, and individual accountability in protecting shareholders.

To improve the effectiveness of corporate governance, Professor Yang suggests “lay responsibility on specific people, especially those who do not directly benefit from potential frauds but are involved in the governance and monitoring process.”