Cultivate a market system of independent directors

By an analysis of 2,504 directors from CSI 300 companies, it is recommended to cultivate a market system for independent directors in China.

Since the Kangmei Pharmaceutical fraud case at the end of 2021, there has been a growing consensus in China that serving as an independent director in a Chinese company has become a high-risk profession, and the responsibilities it entails are several times the compensations received, while the “directors liability insurance” does not eliminate all risks for independent directors who fail to do their due diligence. To avoid risk, independent directors delivered a wave of resignations in late 2021, automatically removing some underqualified or incompetent people from Chinese boards.

That said, there is still a significant gap between CSI 300 board needs and what their independent directors can offer. These boards need independent directors with more efficient and practical management and governance experiences to better guide the business. But many existing independent directors bring insufficient experience, and potential candidates with relevant skills are not sufficiently incentivized to join the boards.

The current world is full of uncertainties, and companies increasingly need excellent leaders to bring diverse and flexible strategic guidance to help companies gain the ability to catch up with and even lead the latest market trends. In an uncertain market environment, bridging this gap is crucial for building stronger boards in Chinese companies, as well as guiding their business success to a next level, making the companies more competitive.

To achieve this, the proportion of independent directors on boards needs to be increased in order to make room for attracting independent directors with more diversified backgrounds (taking into account age, gender, digital experiences, ESG expertise, etc.) A diversified board can provide richer insights and guidance on the company's strategy.

Additionally, the selection of independent directors should include a third-party evaluation system to reduce non-objectivity and avoid the influence of nepotism. This will expand the number of candidates and search channels, and use market power to offset the drawbacks of acquaintance referrals.

Russell Reynolds Associates recommends cultivating a market system of independent directors in China. A supply-and-demand equilibrated director market can broaden the search base of independent directors, allowing boards to recruit the right talent for their organizations, attract distinguished, up-and-coming talent, and enable professional directors to be better compensated, hedge independent directors' risks with appropriate compensation.

It does not necessarily mean the existing independent directors on CSI 300 boards will receive a pay raise, but raising the compensation might attract leaders with richer, more diversified experiences onto boards. As Professor Zheng Zhigang of Renmin University of China said, in order for the market mechanism to play a role, "an effective independent director system should be like that, outstanding independent directors are proud to have served excellent companies. Conversely, an excellent company should be proud to hire outstanding independent directors." Also, as observed in this analysis, SOE independent directors brought stronger experiences in either academic backgrounds or business practices and were better paid on average than POE directors.

Another benefit of establishing this market system is that it can apply a reputation-based mechanism onto independent directors: they are compensated not only by their existing experiences, but also by their performance on current board roles. Under transparent observation of the market, it can encourage due diligence of the independent directors, and let them deliver constructive advice to the board. Again, as Professor Zheng Zhigang said, "Independent director compensation is determined more from the degree of due diligence and the degree of risk sharing, rather than the importance of the position you held before you became an independent director."

The characteristics of both incentives and constraints of the market system encourage independent directors to dare to make decisions, take responsibility, encourage action, tolerate failure, and encourage innovation, which can stimulate the enthusiasm of independent directors to serve in a business.

For this market system to work, Chinese companies need to believe that better independent directors and more effective governance will bring positive improvements to their businesses. While it may take time, reciprocal evolving progress between enterprises, regulators, the market, and directors themselves, can advance China’s corporate governance to the next level.