On July 28, the China Securities Regulatory Commission (CSRC) approved the Measures for the Management of Independent Directors of Listed Companies (the Measures). Prompted in part by a recent financial scandal that sparked director resignations from a number of Chinese boards, the Measures mark the first significant reform of the current independent director system since its formation in 2001.
According to the CSRC, the reform aims to implement a more systematic approach to the selection and management of independent directors, enabling them to better fulfil their duties, and to clarify their responsibilities to better match their rights. The new rules come into effect on September 4, 2023, and corporate issuers will have a one-year transition period to adjust. In this post, we provide background on local governance and oversight, details of what is changing, and the reason for the reform.
Background: China’s Independent Director System
China’s independent director system was officially established in 2001 when the CSRC issued Guidance Opinions Regarding the Establishment of the Independent Directors System in Listed Companies. Following the subsequent revision of the Company Law in 2005, it was legally stipulated that listed companies should have independent directors. Forming part of China’s capital market reforms, the original intent behind incorporating independent directors into listed companies was to adopt aspects of Western best practices to enhance corporate governance standards.
Since 2001 the number of listed companies in China increased from around 1,000 to more than 5,000 and the market evolved significantly, but regulations on independent directors had remained largely unchanged – until the substantial fines imposed on independent directors in a recent financial fraud case triggered a chain reaction, underscoring the urgency of reform.
What is Changing?
The Measures aim to promote a more rigorous board oversight system while also clarifying the limits of independent director liability. Key changes include:
- Mandating that independent directors possess foundational knowledge of listed company operations, be familiar with relevant laws, regulations and rules, and have over five years of work experience in fields such as law, accounting, economics, or other disciplines essential for fulfilling their duties;
- Reducing the cap on the number of directorships a person can hold in domestic listed companies from five to three;
- Requiring independent directors to engage in on-site work for at least 15 days per year;
- Granting independent directors the authority to independently engage intermediary agencies to audit, consult, or review specific matters related to listed companies;
- Specifying that listed companies should provide suitable allowances to independent directors in accordance with their responsibilities;
- Requiring listed companies to provide necessary working conditions and personnel support to enable independent directors to execute their duties, and afford them the same right to information as other non-independent directors;
- Limiting the legal responsibilities of independent directors.
On the one hand, the Measures ask more of independent directors – elevating qualifications by setting more precise experience prerequisites, decreasing the number of allowed directorships after the CSRC found that approximately 20% of independent directors serve on four or more listed company boards, and increasing on-site workdays.
On the other hand, the Measures introduce various safeguards to enable independent directors to execute their responsibilities and clearly define the boundaries of their obligations. While independent directors remain accountable for their breaches, the Measures mentions that if independent directors have fulfilled their fundamental duties and still fail to discover problems prior to document signing, or if listed companies intentionally conceal violations of laws, the independent directors may be exempt from penalties.
What Prompted Reform?
In November 2021, five independent directors at Kangmei Pharmaceutical Co., Ltd. were held jointly liable for the company’s financial fraud, even though they were not directly involved. The court ruled that Kangmei must compensate investors approximately RMB 2.5 billion (equivalent to USD $340 million) due to fraudulent annual reports spanning from 2016 to 2018. Three of the independent directors were required to bear a 10% fine (around RMB 246 million) for endorsing Kangmei’s annual reports over the period. The remaining two independent directors received a 5% fine (around RMB 123 million) for endorsing the company’s 2018 semi-annual report.
This level of liability far exceeded the compensation these directors had been paid for their services. During the fiscal years 2016 to 2018, each Kangmei independent director received an annual fee ranging from RMB 73,900 to RMB 100,800. This is in line with the market — among the 6,700 independent directors in our coverage of Chinese listed companies, annual fees averaged around RMB 80,900, with a median of RMB 73,300, in 2022.
These hefty fines led independent directors across the market to consider their position, and ultimately propelled the reform of the independent director system into the spotlight. Within 15 days of the court’s decision, 39 independent directors had resigned from listed companies. In addition to the discrepancy between job risks and benefits, other issues such as the ambiguous role of independent directors and insufficient support for their supervision duties were the subject of discussion. In response, on April 14, 2023, the CSRC sought public input on the draft of the Measures. Subsequently, the CSRC approved the Measures on July 28.
Challenges Moving Forward
The Measures formalize and clarify the role of independent directors, directly addressing some of the concerns that prompted the recent wave of board resignations. However, there are still some areas of potential improvement.
For instance, regarding board independence, most listed companies only adhere to the minimum regulatory requirement stipulating that at least one-third of the board should be independent. Consequently, independent directors lack majority voting power in board meetings and are unable to veto proposals that require majority approval.
Moreover, while the Measures clearly define the concept of independent directors and the requisites for their independence, in practice, major shareholders or de facto controllers retain significant influence in nominating independent directors. This presents a challenge to ensure that independent directors remain truly independent of major shareholders while fulfilling their duties.
While continued evolution is to be expected in terms of both regulation and market practice, the Measures address certain market concerns that have arisen in the 22 years since the inception of the independent director system. We will continue to monitor how Chinese corporate issuers adjust to the reforms, and how they approach the challenges outlined above.
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