19-05-2019

3. Discussion and analysis of jurisdictions studied. 3.6.4 Appointment of independent directors

A basic mechanism that establishes accountability for all directors is the ability of shareholders to vote on their appointment or reappointment. An issue that has attracted particular significance in the jurisdictions studied has been the accountability of INEDs to the shareholders they are intended to represent - the interests of shareholders as a whole as opposed to controlling interests.

The position of independent shareholders underwent a significant development in the UK in 2014 when the FCA established dual voting for independent directors. This requires that the appointment of independent directors is subject to the approval of both (1) the shareholders and (2) independent shareholders. Issuers with a controlling shareholder are required to change their constitutional documents to provide for this, as discussed in Appendix II.1.2. The development in the UK is set against the more sweeping UK CG Code provision that terms of INEDs that are more than six years should be subject to rigorous review.

Neither the United States nor the other jurisdictions studied have implemented a similar approach. The United States has instead been dealing with a different and to some extent unique problem of director appointments arising out of issues attendant on their proxy rules that can work to deprive shareholders of their voice in company meetings (discussed in Section 3.4.2 «Shareholder votes»). One of the particular problems arising out of the proxy rules, germane to the current discussion, is the rise of the independent activist director.

The experience of appointing independent directors in the United States has been notably marked, if not marred, by the actions of activist shareholders. While there is some evidence that shareholder activism is on the rise in the UK, it has not come close to the levels experienced in the United States. The rise of institutional and activist shareholders and proxy advisers as dominant shareholder voices in United States listed issuers has become an important factor associated with a number of current problematic issues with CG culture in the United States, as discussed in Appendix III.1.2. The primary issue is that the interests of such voices, which wield considerable influence, may not align with the strategic or longer-term goals of an issuer or the shareholders as a whole. This has led to some significant anomalies in the development of appropriate executive remuneration packages, as discussed in Section 3.4.3 «Remuneration».

The increased representation of independent directors (see Table 3 in Appendix II.1) has not alleviated the problem owing to the problem that directors independent of management may not be independent of blockholders and may represent shareholder activists seeking short term profits - in one study, over 40% of shareholder activist interventions between 2004-2012 resulted in the appointment of activist directors, and 43% of those appointments were directly employed by a hedge fund activist. As a result, Congress has considered the influence of proxy advisory firms over shareholder voting and the potential conflict of interest that arises because proxy advisory firms also provide consulting services for listed companies and advise on their proxy ballots. The Corporate Governance Reform and Transparency Act of 2017, not yet passed into law, seeks to protect investors by improving the quality of proxy advisory firms by fostering accountability, transparency, responsiveness, and competition in the proxy advisory firm industry. However, this at present looks unlikely to pass into law under the new administration.

In Singapore, although independent directors are now required to be independent of controlling shareholders as well as the company, there is still no requirement that independent directors must be appointed by independent shareholders.

The position is the same in Mainland China. Recent research reveals that independent directors are not effective in preventing frauds - since they are appointed by controlling shareholders they have incentive to side with controlling shareholders (see Appendix V. 7.2). This would suggest that being independent from controlling shareholders itself is not enough; they need to be independently appointed too.

Hong Kong

Procuring the proper undertaking of an INED of its role was a topic of concern in every interview undertaken, and this is more broadly discussed in Section 3.7 Part C «Independent directors».

As regards specific appointment issues, the HK CG Code falls short of the UK CG Code in two regards as regards INEDs. First, in place of a six-year period the HK CG Code provides that serving for a period of nine years «could be relevant to the determination of a non-executive director's independence» and so re-appointment should be made subject to shareholder approval. This also contrasts with the approach taken by the UK CG Code that an independent director serving for more than nine years should be subject to annual review. Second, unlike the UK CG Code, the HK CG Code does not suggest that re-appointment be subject to a «rigorous» review, but merely that the papers sent so shareholders explain why the board considers the INED to remain independent. The question of determining independence is further discussed in Section 3.7.9 «Determination of independence».

The means by which an independent director is appointed was a subject of discussion in a number of our interviews, with mixed reactions. Central to the discussion was whether independent shareholders should appoint independent directors to guarantee their independence, as this has been a topic circulating in the market for some time.

On one hand, the argument made out was that a director couldn't be regarded as truly independent if they are, notwithstanding any independence tests that may be applied, ultimately subject to appointment or removal by a controlling shareholder casting their vote. On the other, concern was expressed that having independent shareholders directly appoint a director may lead to directors on the board that selectively pursue «an agenda» that does not align with the interests of the company as a whole. Neither argument is particularly persuasive. For example, logically, the latter view requires one to put in abeyance the argument that a director subject to appointment by a controlling shareholder may selectively pursue «an agenda» that primarily aligns with the interests of the controlling shareholder rather than the shareholders as a whole.

The UK dual voting model does not provide that only independent shareholders appoint independent directors - the company as a whole must agree as well. There are fewer companies in the UK with controlling shareholders, so the chances of a candidate that is acceptable to shareholders as a whole but not accepted by independent shareholders are smaller, although there have been instances of this happening.303 However, this may not be the case if the system was adopted in Hong Kong, which could lead to difficulties.

Discussion

As the experience in the United States demonstrates, independent directors cannot be understood as a panacea to all possible problems. At the heart of the question is, amongst other things, who are they independent of and whose interests do they understand themselves as being responsible to further. Of course, the profile of shareholders in the UK and the United States stands in high contrast to that seen in Hong Kong in terms of institutional/retail makeup, the frequently seen characteristic of Hong Kong listed issuers possessing a controlling or dominant shareholder or shareholder group and, arising out of that different makeup, the level of shareholder activism, which is rare. These differences should be taken into account when considering the question of the appointment of independent directors.

Based on the foregoing, the arguments for and against introducing special voting arrangements for the appointment of independent directors are largely equivocal. As noted in Section 3.5.1 «Voting rights generally», imposing regulations that establish a different set of voting rights for shareholders based on their independence represents public law overriding rights attaching to shares otherwise enjoyed in the private law context. On balance, it is suggested that in the absence of a clear mandate to impose such an override, no such regulation should be imposed.