STRATEGY
A Search for True Independence in Asia
January 27, 2010
Lee Kha Loon and Angela Pica

CFA Institute recently published a report that reviews the effectiveness of independent non-executive directors (INEDs) in the Asia-Pacific region. Family-owned businesses, with concentrated ownership structures and controlling shareholders, dominate the Asia-Pacific market, and their ability to control the board of directors can lead to abuse of minority shareholders.

Corporate Governance and the Role of INEDs
CFA Institute believes that good corporate governance systems and practices are fundamental to investor confidence and market integrity. Shareholders elect and appoint a board that is responsible for the company’s strategy and direction, and the board then elects and appoints the CEO and management responsible for operations. CFA Institute believes these boards should consist of a majority of INEDs, who have high ethical standards and the ability to act objectively on all board matters, protect minority shareholders’ rights, and make sure they are not expropriated. In order to create an appropriate balance of power, the chairman should be an independent director and separate from the CEO.

Majority independent boards are common in some countries. The average percentage of INEDs on corporate boards in the United States is 75 percent, in Australia 72 percent, and in Canada 71 percent. In contrast, the average proportion of independent directors on corporate boards in India is less than half (46 percent), and the average number in Hong Kong is slightly more than one-third (35 percent). The main reason for the disparity is the presence of a controlling shareholder in most Asian corporations. The requirement of INEDs on boards also is relatively new in the Asia-Pacific region—it was introduced in the aftermath of Asia’s 1998 financial crisis.

The role of INEDs is threefold. First, they serve in an advisory role and bring technical or financial expertise to the board and management as accountants, lawyers, engineers, or IT experts. Second, they serve as watchdogs, whereby they are required to chair or sit in on audit, nomination, and remuneration committees of the board as required by their respective exchanges’ listing rules or corporate governance codes. Third, they are responsible for approving all related-party transactions (business deals or arrangements between two parties who are joined by a special relationship prior to the deal), which frequently occur in family-owned companies and state-owned enterprises.

Were the Independent Directors Independent?
Family control of companies listed on exchanges dominates the Asia-Pacific region, with around 70 percent of companies being family owned in Hong Kong, Indonesia, Malaysia, and Thailand. Typically, this means families own a controlling stake in the company. In some cases, however, the family owns less than 10 percent of the shares but controls the board—and therefore controls how the company is run. In some cases, institutional ownership is collectively larger than the family stake.

This was evident in the case of Satyam Computer Services, one of India’s largest providers of software services, which is listed on the New York Stock Exchange. Chairman and major shareholder Ramalinga Raju controlled the board. When he proposed buying two related companies, Maytas Infrastructure and Maytas Property, for $1.6 billion in December 2008, only the board’s, and not the shareholders’, approval was required—a weakness in India’s system. Despite five of the nine directors on the board being INEDs, the purchase was approved at the board meeting. Investors were confused by the business move and sold Satyam immediately after the deal was announced at an investor’s briefing on the same day. The share price of Satyam fell sharply in the following weeks, resulting in margin calls of shares pledged by directors and further selling of shares. As a result, three INEDs resigned, and in January 2009, Raju also resigned. He was later arrested, along with his brother, on charges of forgery and fraud. This example shows that INEDs do not always protect minority shareholder rights but appear to succumb to pressures from the controlling shareholder. Satyam had a majority INED board, but without an effective nomination and election system, these individuals were far from independent.

Subhed: Codes and Practices in the Asia-Pacific Region
The four countries in the CFA Institute report have corporate governance codes and listing rules to promote best practices. Table 1 highlights the level of compliance with local regulations. It is evident that in Hong Kong and the Philippines only 70 percent of companies comply with stated rules on the number of INEDs, which leaves the system open to abuse. The table also indicates that in India it is “not common” for companies to have a nomination committee, which is essential for voting independent members onto company boards.

Table 1
Corporate Governance in Practice

Nomination and Election of Directors
There has been much debate and discussion on the effectiveness of INEDs, and some countries are reviewing their regulations and codes. Currently, controlling shareholders can effectively control the nomination and election of all directors, including INEDs.

This problem is not confined to Asia. In Chile, a bill has been proposed to the senate that requires all corporations with a net worth in excess of $38million, and relevant minority shareholder interest of at least 12.5 percent, to elect at least one independent director. Therefore, one group of shareholders is allowed to elect a representative who must be independent in judgment and have no conflicts of interest with the corporation or its subsidiaries, management, or controllers.

As part of its 2005 regulatory reform, Italy adopted a method for appointing board members that allows minority shareholders to propose an alternative list of directors. The candidate with the highest number of votes—and who is in no way related to the majority slate—must be appointed as an INED. This method helps ensure minority shareholder representation and independence among directors.

Currently, if you own a 5 percent stake in a company in Singapore, Hong Kong, or Malaysia, you are able to put forward proposals at shareholder meetings, including proposals for directors to be voted on at annual general meetings. CFA Institute believes one method for improving the existing nomination and election process is to lower the threshold of percentage holdings to nominate directors for election. This change would prevent the nomination committee from fully controlling the slate of directors to be elected.

Cumulative voting also should be introduced because it allows a shareholder to accumulate his or her votes for one candidate on the nomination slate, thus theoretically increasing the shareholder’s chances of electing his or her desired candidate. Therefore, if five directors are up for a vote, instead of just giving one vote to each director, you can accumulate all five of your votes for one director, thereby increasing your chances of electing your desired candidate.

Further Recommendations
The report recommends that better-quality biographical information on nominees be disclosed before any elections take place and that a thorough definition of independence for management and controlling shareholders be produced.

The report notes that exceptions to the rules on “independence” should not be allowed and that all directors must meet the defined guidelines on independence. New directors must have a high level of training, and the report recommends that a regional director certification program be established. Perhaps most importantly, companies in the Asia–Pacific region should have a majority independent board, and this should be considered best practice.

Lee Kha Loon, CFA, is head of the CFA Institute Asia-Pacific office, and Angela Pica, CFA, is a policy analyst for CFA Institute.

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