Corporate governance in emerging economies role of the independent director

CORPORATE GOVERNANCE IN EMERGING ECONOMIES:
ROLE OF THE INDEPENDENT DIRECTOR









UMAKANTH VAROTTIL

(B.A., LL.B (Hons.), National Law School of India University, Bangalore;
LL.M, New York University School of Law)








A THESIS SUBMITTED FOR THE DEGREE OF PH.D. IN LAW

FACULTY OF LAW

NATIONAL UNIVERSITY OF SINGAPORE

2009











[This dissertation is current as of 25 June 2009]

i
ACKNOWLEDGMENTS
I owe immense gratitude to a number of institutions and individuals without
whose support it would not have been possible for me to undertake this work in a
timely manner. While I endeavour to list all of their names here, I may be excused
if I have inadvertently omitted to mention any of them. Needless to say, any errors
in this work are mine alone.
I thank the Faculty of Law, National University of Singapore (NUS) for

admitting me into the PhD programme and for providing an extremely conducive
environment for research of the present kind. The excellent resource base in the
libraries of the University, both physical and online, seemed to cater comfortably
to my relentless pursuit of information from various sources. At no stage during
my research did I feel crippled by the lack of research materials. I am also
thankful to the many individuals who were generous with their time and ideas
when I interviewed them during my field work.
I am particularly grateful to my supervisor Professor Hans Tjio for his
advice and guidance throughout my tenure in the PhD programme. My
discussions with him helped shape the scope of the project, and his inputs on
drafts of this dissertation have been invaluable. Without his encouragement, I
could well have taken a longer period of time to complete this dissertation. More
so, he set an example by demonstrating his own commitment to this project,
which always received his utmost priority.
I express my sincere thanks and appreciation to the panel of examiners
consisting of Professors Stephen Girvin, Richard C. Nolan and Tan Ng Chee for
their time and effort in reviewing the dissertation despite their busy schedules and
for providing valuable comments and suggestions.
Several other professors at the NUS Law Faculty have had a part to play in
this work. I thank Alexander Loke and Michael Ewing-Chow for reviewing my
research proposal and for providing comments and suggestions during my
doctoral candidate qualifying examination (DCQE) that helped fine-tune the
research. Andrew Simester not only taught me the intricacies of legal research in
the Graduate Research Seminar course, but was also kind enough to meticulously
go over my research proposal and provide extensive feedback when I presented
the proposal in the class. I have also tremendously benefited from my discussions
with Stephen Phua and Dan Puchniak, whose passion for the field of corporate
governance in particular and business law in general always amazes me. Words of
encouragement or even general enquiries about my progress from several other
professors on the Faculty, who are numerous to be named individually, have

always gone to boost my morale.
I am grateful to the administration at the Law Faculty. Vice-Dean Alan
Tan gladly ensured my seamless qualification and dissertation process, while
Dean Tan Cheng Han assured me on the very first day of the programme that the

ii
door to his office was always open in case I faced any obstacles, which was
always a source of comfort for me, although the occasion to take up his invitation
never arose. Normah and Zana at the Graduate Division Office tirelessly
answered my constant bombardment of queries about some administrative matter
or the other.
I sincerely thank NUS as well as the Lee Foundation for conferring a
generous scholarship that supported me financially as I worked on my PhD.
I have also enjoyed the support and camaraderie of several fellow
candidates in the graduate programme at NUS, which made an otherwise lonely
journey so lively. They include Tan Lay Hong, Jason Bonin, Abhik Majumdar,
Lin Lin, Vincents Benjamin, Tan Hsien-Li and several others.
My special thanks are due to Mr. Cyril Shroff, colleagues and many
friends at my (first and only) employer of 11 years, Amarchand Mangaldas, where
I received limitless opportunity to witness real-world corporate activity at close
quarters that has stood me in good stead for my research. I also owe my
foundations in corporate law to the National Law School of India University
(NLSIU), particularly Professor M.P.P. Pillai. The NLSIU has also been kind in
publishing in the latest issue of the National Law School of India Review my
article “A Cautionary Tale of the Transplant Effect on Indian Corporate
Governance” that contains some of the foundational ideas propounded in this
dissertation.
Many friends and well-wishers have played an important role in this
mission. I am thankful to Arun Thiruvengadam for being generous with his
advice, counsel and guidance from the time I embarked on my path in academia.

Srikanth, Nandini and Mayura extended their benevolence in ensuring that my
family and I settled well into Singapore. Other friends at various locations never
failed to provide their constant encouragement and moral support – Saikrishna,
Aparna and R.V. Anuradha, just to name a few.
Finally, words cannot describe my appreciation for my wife Swapna and
son Aditya who have stood firmly by me through all my endeavours. Swapna’s
open-heartedness allowed me to pursue a somewhat unconventional career path—
one that meant my giving up a stable job by daring to live my dreams. Although it
involved a great amount of risk and uncertainty to us as a family, she helped in a
smooth transition by handling it with great poise. Aditya too had to be uprooted
from his family and friends to move to another country, which he did with ease;
nevertheless, he does not cease to be amused by the idea that his father was a
student for three years, much like him, and at the same time that he was one. I
cannot forget the encouragement I have always received from my mother, late
father and my extended family.
iii

TABLE OF CONTENTS
SUMMARY viii

LIST OF TABLES x


1.

INTRODUCTION 1

1.1

Introduction to the Chapter 1

1.2

Background to the Research 1

1.3

Problem, Hypothesis and Questions 11

A.

Problem 11

B.

Hypothesis 11

C.

Key Questions 12

1.4

Relevance and Importance of the Research 13

1.5

Methodology and Research Approach 20

A.

Theoretical Component 20

B.

Comparative Study 21

C.

Analytical Component 24

D.

Normative Component 27

1.6

Conclusion to the Chapter 27


2.

COMPARATIVE CORPORATE GOVERNANCE: SETTING THE TONE
28

2.1

Introduction to the Chapter 28

2.2

Different Models of Corporate Governance 30

A.

The Outsider Model of Corporate Governance 30

B.

Constituents of the Outsider Model 35

C.

The Insider Model of Corporate Governance 38

D.

Constituents of the Insider Model 44

1.

China 45

2.

India 53

E.

Summary 63

2.3

Reviewing the Models in Context of the Agency Paradigm 64

2.4

Driving Forces Behind the Different Models 68

A.

The “Law Matters” Explanation 68

B.

Other Explanations 73

C.

Impact of Explanations on Models of Corporate Governance 76

2.5

A Review of the Convergence vs. Divergence Debate 77

A.

Factors for Convergence 77

B.

Divergence; Path Dependency 79

C.

The Relevance of the Debate to Independent Directors 82

2.6

Transplant Effect 83

2.7

Conclusion to the Chapter 86


3.

INDEPENDENT DIRECTORS IN OUTSIDER SYSTEMS: ORIGIN AND
EVALUATION 88

3.1

Introduction to the Chapter 88

3.2

Theoretical Foundations for the Origin of Independent Directors 90

iv

A.

Berle & Means Study 90

B.

Economic Analysis of the Agency Problem 92

3.3

Emergence of Independent Directors in U.S. Corporate Practice 98

A.

Changing Board Composition; The Voluntary Phase 99

B.

Emergence of a “Monitoring Board” 101

C.

Judicial Reliance on Board Independence 105

1.

Self-Dealing Transactions 106

2.

Derivative Suits 110

3.

Defensive Measures Against Hostile Takeovers 112

D.

Regulatory Prescriptions on Board Independence 114

E.

Independent Directors and the Stakeholder Theory 120

3.4

Emergence of Independent Directors in U.K. Corporate Practice 127

A.

Various Committees Culminating in the Combined Code 128

B.

Non-executive Directors and the Stakeholder Theory 133

3.5

Effect of Independent Directors in Outsider Systems 137

A.

Qualitative Studies 138

B.

Quantitative Studies 146

1.

Board Composition and Corporate Performance in General 146

2.

Board Composition and Specific Tasks 148

3.6

Conclusion to the Chapter 156


4.

ADOPTION OF INDEPENDENT DIRECTORS BY EMERGING
ECONOMIES: LESSONS FROM CHINA AND INDIA 158

4.1

Introduction to the Chapter 158

4.2

Evolution of the Independent Director Concept in the Insider Systems
160

4.3

Norms Governing Independent Directors in China 163

A.

Evolution of Corporate Governance Norms 163

B.

Rationale for Corporate Governance Reforms 166

C.

The Independent Director Opinion 169

1.

Basic Requirement 169

2.

Independence 169

3.

Qualifications of Independent Directors 172

4.

Nomination and Appointment 173

5.

Tenure 178

6.

Allegiance of the Independent Directors 179

7.

Role of Independent Directors 181

8.

Effectiveness of the Independent Director Opinion 187

4.4

Norms Governing Independent Directors in India 189

A.

Evolution of Corporate Governance Norms 189

B.

Rationale for Corporate Governance Reforms 194

C.

Clause 49 and Independent Directors 199

1.

Basic Requirement 199

2.

Independence 200

3.

Nomination and Appointment 203

4.

Allegiance of the Independent Directors 206

v
5.

Role of Independent Directors 207

6.

Effectiveness of Clause 49 212

4.5

Independent Director Norms: China and India Compared 214

A.

Chronological Survey 214

B.

Comparison of Key Features 219

4.6

Conclusion to the Chapter 221


5.

EFFECTIVENESS OF INDEPENDENT DIRECTORS IN CHINA AND
INDIA 223

5.1

Introduction to the Chapter 223

5.2

Independent Directors in China: Empirical Survey 226

A.

Effect on Corporate Performance 226

B.

Number of Independent Directors 229

C.

Nomination and Appointment 230

D.

Competence 231

E.

Incentives and Disincentives 233

F.

Role of Independent Directors 236

5.3

Independent Directors in China: Case Studies 238

A.

Effectiveness 238

B.

Legal Liability 242

5.4

Independent Directors in India: Empirical Survey 244

A.

Effect on Corporate Performance 245

B.

Number of Independent Directors 249

C.

Nomination and Appointment 251

D.

Competence 253

E.

Incentives and Disincentives 254

F.

Role of Independent Directors 256

5.5

Independent Directors in India: Case Studies 262

A.

Compliance with Clause 49 262

B.

Effectiveness of Independent Directors: The Satyam Episode 264

1.

Satyam: The Company and its Board 264

2.

The Maytas Transaction 267

3.

Fraud in Financial Statements 271

4.

Lessons from Satyam 274

C.

Legal Liability 282

5.6

Conclusion to the Chapter 285


6.

CONSTRAINTS FACING INDEPENDENT DIRECTORS IN THE
INSIDER ECONOMIES 287

6.1

Introduction to the Chapter 287

6.2

Structural Constraints 288

A.

Appointment of Independent Directors 291

B.

Role and Allegiance of Independent Directors 295

1.

Role of Independent Directors: Strategic and Monitoring 296

2.

Independent Directors and Their Constituencies 300

6.3

Legal Constraints 304

vi
A.

Legal Characteristics of Corporate Structures 305

B.

Robustness of the Legal System for Enforcement of Independent
Director Norms 310

C.

Market Regulation Versus State Regulation 315

6.4

Cultural Constraints 319

6.5

Political Constraints 330

6.6

Perceptional Constraints 336

6.7

Conclusion to the Chapter 340


7.

FUTURE PROSPECTS FOR INDEPENDENT DIRECTORS IN
EMERGING ECONOMIES 342

7.1

Introduction to the Chapter 342

7.2

Revisiting the Concept 344

7.3

Alternate Structures for Appointment of Independent Directors 346

A.

Nomination Committee 347

B.

Minority Shareholder Participation in Independent Director Elections
351

1.

Cumulative Voting 357

2.

Voting by “Majority of the Minority” 362

3.

Evaluation of Options for Minority Shareholder Representation 363

C.

“Public Interest” Directors 367

D.

Government Director 369

7.4

Crystallising the Role of Independent Directors 370

7.5

Other Relevant Considerations 376

A.

Defining Independence 376

B.

Competence and Qualifications 377

C.

Commitment 378

D.

Cadre of Independent Directors 380

E.

Incentives 381

F.

Disincentives 383

G.

Other Supporting Factors 385

H.

Performance Evaluation 386

7.6

Role of the Law and Other Factors 387

7.7

Conclusion to the Chapter 389


8.

CONCLUSION: THE WAY FORWARD 391

8.1

Summary and Conclusions 391

8.2

Contributions to Knowledge 394

8.3

Guidance for Further Research 397


BIBLIOGRAPHY 400


APPENDICES 427

Appendix 1 427

List of Persons Interviewed 427

Appendix 2 429


vii
Questionnaire 429

Appendix 3 432

Comparison between Independent Director Opinion (China) and Clause 49
(India) 432

viii

SUMMARY

Modern corporate governance recognises independent directors as
“monitors” of managers so as to protect the interests of the
shareholders of companies. Although the concept of “independent
directors” originated in the United States (U.S.) in the 1950s
voluntarily as a good measure of corporate oversight, it has now
become a mandatory requirement of corporate law, at least in the case
of public listed companies. Gradually, the phenomenon has been
imbibed into the United Kingdom (U.K.). Over the turn of the century,
several other jurisdictions have embraced independent directors as an
integral part of their corporate governance codes. These include
emerging economies such as China and India.
The U.S. and the U.K., which have been at the vanguard of the
independent director movement, follow the classic “outsider” model of
corporate governance, with dispersed shareholding. This gives rise to
agency problems between managers and shareholders arising out of
the separation of ownership and control. The institution of independent
directors has seemingly been introduced as protection for shareholder
interests against actions of managers in public companies with
dispersed shareholders. However, other jurisdictions (to which the
independent director concept was transplanted) follow the “insider”
model of corporate governance where ownership and control are
relatively closely held by cohesive groups of insiders. Companies here
are controlled by family groups or the state, and they do not face the
classic agency problem between managers and shareholders; indeed
they face a different agency problem – one between the controlling

shareholders and minority shareholders. Furthermore, under these
“insider” systems of corporate governance, there is a greater role that
corporate law plays to protect the interests of the non-shareholder
constituencies.
This research analyses the implications of legal transplantation of the
independent director concept from the outsider system to the insider
system of corporate governance and examines whether or not such
transplantation of a corporate governance mechanism that works to
address one type of agency problem would work at all to address
altogether different types of agency problems. The findings of the
research indicate that the effect of independent directors in the insider
systems of China and India is different from that in the outsider
systems. The transplantation of the concept does not take into account
the intrinsic differences between these two types of systems, and this is
evident from a survey of the corporate governance norms in these
jurisdictions as well as an analysis of the available empirical evidence.
ix
There are several reasons due to which such a position ensues.
Specifically, it is due to the admixture of several constraints –
structural, legal, cultural, political and perceptional – that prevent
effectual institutional change in the insider systems so as to enable the
independent director concept to seamlessly blend into their own
systems. Therefore, what is required is a complete overhaul of the
independent director norms as well as practices in China and India.
This dissertation contains some normative measures required to
embolden independent directors in these systems.
x
LIST OF TABLES

Table 1: Summary of BSE 100 and BSE 500 Shareholding Data
Table 2: Summary of Promoter Data in BSE Top 100 Companies
Table 3: Comparative Regulatory Timeline
Table 4: Characteristics of Independent Directors in China
xi










“In proposing to apply the juristic rules of a distant time or country
to the conditions of a particular place at the present day regard must
be had to the physical, social, and historical conditions to which that
rule is to be adapted.”
1



1
Srinath Roy v. Dinabandhu Sen 42 I.A. 221, 241, 243 (Privy Council) cited from M.P. Jain,

Outlines of Indian Legal History, 5th ed. (Agra, India: Wadhwa & Co., 1990) at 441.

xii
1

1. INTRODUCTION
1.1 Introduction to the Chapter
1.2 Background to the Research
1.3 Problem, Hypothesis and Questions
1.4 Relevance and Importance of the Research
1.5 Methodology and Research Approach
1.6 Conclusion to the Chapter

1.1 Introduction to the Chapter
This dissertation begins with an introduction to the concept of an independent
director in corporate governance. Although the concept emerged in the developed
economies of the U.S. and the U.K., it was transplanted to several other corporate
law systems over the turn of the century. This Chapter identifies the problems
involved in transplantation of the concept to the two emerging economies of
China and India, sets out the hypothesis this dissertation seeks to address, and
outlines some key questions for consideration. After setting out the importance of
this research, it details the methodology adopted for accomplishing the research.
1.2 Background to the Research
I begin by outlining the importance of corporate governance in modern business
and the role of the board of directors in general and independent directors in
particular. Corporate governance relates to the “system by which companies are
2
directed and controlled”.
2
It is also pertinent to note that corporate governance
extends beyond just managing the business well and earning handsome profits; it
represents the set of checks and balances within the corporate structure that helps
create long-term value enhancement for stakeholders in a company.
3
In that sense,

good governance is more than mere good management. While good management
may make a business profitable, good governance ensures that the commercial
benefit derived by a corporate entity is directly reflected in the value to the
stakeholders of the entity. Delving a bit deeper into this aspect, we find that
corporate governance, in its simple terms, “concerns the relationships between a
company’s owners, managers, board of directors (BOD), and other
stakeholders.”
4
The study of the inter-relationship among these four
constituencies strikes at the heart of corporate governance. In the ultimate
analysis, no single constituency (for example, management) ought to extract value
for itself at the cost of other constituencies (for example, shareholders).

2
U.K., Financial Reporting Council, Report of the Committee on the Financial Aspects of
Corporate Governance, online: European Corporate Governance Institute
< at para. 2.5(1992) [Cadbury Committee
Report]. It is also defined to mean the way in which businesses are run. See Jonathan P.
Charkham, Keeping Good Company: A Study of Corporate Governance in Five Countries
(Oxford: Clarendon Press, 1993) at 1.
3
See Robert A.G. Monks & Nell Minow, Corporate Governance, 3rd ed. (Malden, Mass.:
Blackwell Publishing, 2004) at 2 (observing that “[i]n essence, corporate governance is the
structure that is intended to make sure that the right questions get asked and that checks and
balances are in place to make sure that the answers reflect what is best for the creation of
long-term, sustainable value”).
4
Ferdinand A. Gul and Judy S.L. Tsui, “Introduction and Overview” in The Governance of
East Asian Corporations: Post Asian Financial Crisis (New York: Palgrave MacMillan,
2004) at 3. The authors observe:

Agency theory provides a theoretical perspective in which to discuss these relationships.
Specifically, in order for owners to get what they want (i.e., increased value of their
investment), they must contract with non-owner managers to run the company, and with
the BOD to oversee the management of the company. … The development of corporate
governance is an attempt to oversee these relationships, …, to regulate behavior so as to
achieve the desired outcome and appropriate rewards for all parties involved.
3
Among the tetrarchs described above, the board of directors plays a
ubiquitous and indispensable role in a company’s governance.
5
The board is that
organ of the company which holds the principal authority for a company’s
governance, and hence the structure and composition of the board would
necessarily have an impact on the manner in which the company is governed.
Among the various structural changes that have occurred in recent years to
improve the way in which companies are governed, the introduction of the
concept of an independent director occupies a prominent position.
6
As an
important aspect of legal reform in the field of corporate governance, policy
makers are increasingly pinning hope as well as responsibility on independent
directors to ensure that companies demonstrate high levels of corporate
governance.
7


5
See John Carver, Boards That Make a Difference, 3rd ed. (San Francisco: John Wiley & Sons,
2006) at 1. The author notes: “It is virtually impossible to escape contact with boards. We are
on boards, work for them, or are affected by their decisions. Boards sit atop almost all

corporate forms of organisation—profit and non-profit—and often over governmental
agencies as well.” See also, Margaret M. Blair, Ownership and Control: Rethinking
Corporate Governance for the Twenty-First Century (Washington DC: The Brookings
Institution, 1995) at 77 [Ownership and Control] (noting that “[i]n principle, the board of
directors is the single most important corporate governance mechanism. … Directors have the
legal authority to perform almost every function that even the most strident advocates of
corporate governance reform would like to see”).
6
See Donald C. Clarke, “Three Concepts of the Independent Director” (2007) 32 Del. J. Corp.
L. 73 at 73 [Three Concepts] (observing that “[i]ndependent directors have long been viewed
as a solution to many corporate governance problems”). See also Laura Lin, “The
Effectiveness of Outside Directors as a Corporate Governance Mechanism: Theories and
Evidence” (1996) 90 Nw. U. L. Rev. 898 at 899-900 (finding that in response to highly
publicised allegations of corporate governance problems, reformers have identified
independent outside directors as a possible solution); Colin B. Carter & Jay W. Lorsch, Back
to the Drawing Board: Designing Corporate Boards for a Complex World (Boston, Mass.:
Harvard Business School Press, 2004) at 44 [Back to the Drawing Board].
7
Victor Brudney, “The Independent Director – Heavenly City or Potemkin Village?” (1982) 95
Harv. L. Rev. 598 at 599 (where Professor Brudney notes that of the “panoply of structural
changes being discussed, few come with such broad support as the notion of the “outside” or
“independent” director”).
4
That brings me to the threshold question: who exactly are independent
directors? Independent directors are those members of the board of directors who
are not executives of the company (at present or in the recent past), and are
otherwise independent of management and free from any business or other
relationship which could materially interfere with the exercise of their
independent judgment.
8

Such directors should not have any material relationship
with the company or its management, other than in their capacity as directors or
members of any of the board committees. This is to encourage the independence
of thought and judgment of such directors.
9
The fact that directors should not be
beholden to any constituency other than the shareholders is enunciated in
Professor Donald Clarke’s definition as follows:
… “independent director”: one who has no need or inclination to stay in
the good graces of management, and who will be able to speak out, inside
and outside the boardroom, in the face of management’s misdeeds in order
to protect the interests of shareholders.
10

The concept of independent directors was ushered into the corporate system
voluntarily as a good measure of governance, and was initially not something that
was mandated by law. The history of independent directors can be traced to the
1950s in the United States (U.S.) when certain directors who were not part of the

8
Cadbury Committee Report, supra note 2 at para. 4.12.
9
Blair, Ownership and Control, supra note 5 at 81 (stating that “[t]he idea behind adding more
outside and independent directors is that they are likely to be objective critics of
management”).
10
Clarke, Three Concepts, supra note 6 at 84. In other words, a director who is truly
independent will possess unhindered powers to govern and take decisions on behalf of the
company in an objective manner. See Jay W. Lorsch & Elizabeth MacIver, Pawns or
Potentates: The Reality of America’s Corporate Boards (Boston, Mass.: Harvard Business

School Press, 1989) at 13 [Pawns or Potentates].
5
company’s management were appointed to the board.
11
Gradually, the number of
independent directors on corporate boards began to increase.
12
Director
independence assumed greater importance when the judiciary and regulatory
authorities began deferring to judgments of independent boards. On the judicial
front, Delaware courts placed reliance on decisions of disinterested independent
directors in legitimising several actions pertaining to self-dealing transactions,
derivative suits and demand futility claims, and defensive measures against
hostile tender offers.
13
In addition, stock exchanges began to look at companies
favourably when they had established board independence, as the listing manuals
of the key stock exchanges exhorted companies to have boards with independent
directors.
14
Eventually, independence of directors acquired the status of a

11
Jeffrey N. Gordon, “The Rise of Independent Directors in the United States, 1950-2005: Of
Shareholder Value and Stock Market Prices” (2007) 59 Stan. L. Rev. 1465 at 1473 [The Rise
of Independent Directors].
12
Ibid. at 1478.
13
For a detailed discussion, see infra Chapter 3, Section 3.3(C). See also Lin, supra note 6 at

904-910. It is to be noted, however, that there is a difference between “disinterestedness” of
directors and “independence” of directors; a disinterested director is one who has no interest
in the transaction in question, but an independent director is one who is not otherwise
affiliated to the company (in addition to being disinterested in the transaction in question).
While disinterestedness is concerned primarily with a particular transaction in question,
independence is a wider concept that governs board structure as a whole. However, this
difference is not altogether relevant for this present analysis, which focuses on independent
directors rather than disinterested directors.
14
The New York Stock Exchange [NYSE] and Nasdaq Stock Exchange [NASDAQ] have
emphasised the importance of independent directors on boards of listed companies. See
NYSE, “Listed Company Manual (2003)” [NYSE Listed Company Manual], online: NYSE
< NASDAQ Stock Market, Inc., “Market Place Rules
(2003)” [NASDAQ Rules], online: NASDAQ
< />1_4_2&manual=%2Fnasdaq%2Fmain%2Fnasdaq-equityrules%2F>.
6
mandatory provision contained in a statute. This occurred with the enactment of
the Sarbanes-Oxley Act of 2002 in the U.S.
15

The phenomenon of independent directors was not confined to the U.S. It
occurred in the United Kingdom (U.K.) too, but more recently than in the U.S. In
the U.K, the trend towards independent directors was set in motion in 1992 with
the Cadbury Committee Report.
16
This report forms the basis of corporate
governance in the U.K.
17
Now, board independence has become an integral part
of corporate governance in the U.K. by virtue of the Combined Code on

Corporate Governance.
18
Although the Combined Code is not mandatory, it
follows the “comply or explain” approach whereby companies are required to
comply with the provisions of the Combined Code, or alternatively explain their
governance approach. Since the Combined Code imposes disclosure obligations
on companies with reference to corporate governance compliance, it persuades
companies to comply with corporate governance norms (such as the appointment
of the requisite number of independent directors), rather than invite the

15
See Sarbanes-Oxley Act of 2002, s. 301. Although the Sarbanes-Oxley Act does not stipulate
independence requirements for the entire board, it requires that members of the audit
committee be independent. This postulates that at least such of the directors as are on the audit
committee should satisfy the requirement of independence.
16
Supra note 2 at para. 4.11. The Cadbury Committee required all boards to have a minimum of
three non-executive directors, with two of them being independent.
17
Furthermore, the broad principles laid down in the report have also been used as the
foundation for developing corporate governance norms in other jurisdictions as well. See R.P.
Austin, H.A.J. Ford & I.R. Ramsay, Company Directors: Principles of Law and Corporate
Governance (Chatswood, NSW: LexisNexis, 2005) at 14.
18
See Financial Services Authority, The Combined Code on Corporate Governance [Combined
Code], Para. A.3.2 (providing that at least half the board, excluding the chairman, should
comprise non-executive directors determined by the board to be independent).
7
displeasure of shareholders as the companies explain their failure to comply with
those requirements.

At this stage, it may be useful to examine the reason for considering the
U.S. and U.K. for this part of the present research. It is pertinent to observe that
not only have the U.S. and U.K. been at the vanguard of the evolution of the
institution of independent director, but that both these jurisdictions possess a
unique characteristic in that they follow the classical “outsider” model of
corporate governance.
19
These regimes are dominated by companies with
dispersed equity holdings with large institutional ownership.
20
They follow the
idea of separation of ownership and control of companies, which was originally

19
See Stilpon Nestor & John K. Thompson, “Corporate Governance Patterns in the OECD
Economies: Is Convergence Under Way?”, online: OECD
<
20
Nestor & Thompson, ibid. at 5-9. See also Brian R. Cheffins, “Putting Britain on the Roe
Map: The Emergence of the Berle-Means Corporation in the United Kingdom” [Putting
Britain on the Roe Map] in Joseph A. McCahery, Piet Moerland, Theo Raaijmakers & Luc
Renneboog, eds., Corporate Governance Regimes: Convergence and Diversity (Oxford:
Oxford University Press, 2002) at 151, where the author states as follows:
An important corporate governance link between the US and the UK is that the two
countries share an ‘outside/arm’s length’ system of ownership and control. In Britain, as
in the US, the ‘outsider’ terminology is appropriate because share ownership is widely
dispersed.
This position has received wide support from other commentators as well. See Lucian Arye
Bebchuk & Mark J. Roe, “A Theory of Path Dependence in Corporate Ownership and
Governance” (1999) 52 Stan. L. Rev. 127 at 133 [Path Dependence] (concurring that “[a]t

present, publicly traded companies in the United States and the United Kingdom commonly
have dispersed ownership, whereas publicly traded companies in other advanced economies
have a controlling shareholder”); John C. Coffee, Jr., “The Future as History: The Prospects
for Global Convergence in Corporate Governance and its Implications” (1999) 93 Nw. U.L.
Rev. 641 at 641 [The Future as History] (adding that “contemporary empirical evidence finds
that, even at the level of the largest firms, dispersed ownership is a localized phenomenon,
largely limited to the United States and Great Britain”); Troy Paredes, “A Systems Approach
to Corporate Governance Reform: Why Importing U.S. Corporate Law Isn’t the Answer?”
(2004) 45 Wm. & Mary L. Rev. 1055 at 1056 (acknowledging that the Anglo-American
pattern of finance is characterised by “dispersed share ownership and the separation of
ownership and control in the United States and the United Kingdom”).
8
propounded by Berle and Means.
21
Dispersal of shareholding in public companies
results in the collective action problem,
22
preventing shareholders from taking
active part in key decisions involving the company that are otherwise within the
shareholders’ domain under corporate law, and also impeding their basic
decision-making power of electing the directors who are delegated management
rights by the shareholders. This creates a conflict in the form of an agency
problem between the shareholders and the managers.
23
The role of corporate law
in the outsider systems is primarily to address this agency problem, and in that
context, the institution of independent directors has seemingly been introduced as
protection for shareholder interests against actions of managers in public
companies with dispersed shareholders.
24

The evolution of the independent director institution did not remain
confined to the economies of the U.S. and the U.K. where it originated. Owing to
the corporate governance wave that emerged in response to the corporate
governance scandals of the last decade, it witnessed rapid proliferation to other

21
Adolf A. Berle & Gardiner C. Means, The Modern Corporation and Private Property (New
York: Macmillan, 1940 [c1932]) at 66.
22
Collective action problems exist “whenever it is in individuals’ self-interest not to contribute
to a group activity even though all of the individuals would be better off if everyone were to
contribute. In a resulting irony, each individual is made worse off by pursuing her own self-
interest”. Christopher R. Leslie, “The Significance of Silence: Collective Action Problems
and Class Action Settlements” (2007) 59 Fla. L. Rev. 71 at 72-73.
23
For a detailed discussion on the concept of the agency problem in a company, see Michael
Jensen & William Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs, and
Ownership Structure” (1976) 3 J. Fin. Econ. 305 at 310 [Theory of the Firm].
24
Reinier R. Kraakman, et al., The Anatomy of Corporate Law: A Comparative and Functional
Approach (Oxford: Oxford University Press, 2004) at 50 [The Anatomy of Corporate Law]
(envisioning independent directors as trustees to protect shareholders against opportunistic
managers).
9
economies as well.
25
Among the countries to which the concept was transplanted,
there are jurisdictions that follow the “insider” model of corporate governance.
These regimes are dominated by companies where ownership and control are

relatively closely held by identifiable and cohesive groups of insiders who have
longer-term stable relationships with the company.
26
These include emerging
economies such as China and India, where companies have historically been
largely controlled (by virtue of high shareholding levels) by business families or
the state. Such a shareholding pattern continues even in publicly listed companies,
although there are some rare exceptions where companies in insider systems have
gradually moved to an outsider model of corporate governance.
27
This presents a
different agency problem altogether. As there is no dispersion of shareholding, the
agency problem between shareholders and managers is much less important.
However, this regime exacerbates the agency problem between controlling
shareholders and minority shareholders. Controlling shareholders are usually in a
position to shape the composition of the board of directors, in that all directors
owe their allegiance to the controlling shareholders as their appointment,

renewal
and continuance in office (without removal) are subject to the wishes of the

25
Eddy Wymeersch, “Convergence or Divergence in Corporate Governance Patterns in Western
Europe?” in McCahery, et. al, supra note 20 at 238 (stating that the appointment of
independent directors is among the “most conspicuous instruments advocated in most
systems” when it comes to corporate governance). For a somewhat detailed account of the
manner in which the independent director concept has been embraced in various jurisdictions
around the world, see Tong Lu, “Development of System of Independent Directors and the
Chinese Experience”, online: <
[Independent Directors and Chinese Experience].

26
See Rafael La Porta, Florencio Lopez-de-Silanes & Andrei Shleifer, “Corporate Ownership
Around the World” (1999) 54 Journal of Finance 471 at 474 [Around the World].
27
Since the exceptions are only rare, and companies still continue to be dominated
predominantly by family groups or the state, China and India are considered to be insider
systems.

10
controlling shareholders. These powers of controlling shareholders extend to the
appointment, renewal and removal of independent directors as well.
These circumstances have resulted in a curious position whereby the
concept of independent directors that was devised in the context of outsider
systems for the purpose of protecting the shareholders from managers has been
directly transplanted to an entirely different corporate system, being the insider
system where the agency problem is distinct (being one between controlling
shareholders and minority shareholders). It is not clear what the theoretical
underpinnings of such transplant are, or whether the proliferation of the concept
to various countries is merely an over-reaction to corporate governance failures
around the world (such as Enron, WorldCom, Parmalat and the like).
28

Furthermore, there is no clarity on what the benefit of an independent director in
an insider system would be in the shadow of the dominance of a controlling
shareholder. It is precisely this anomaly that the present research seeks to unravel,
as we shall see in greater detail.

28
To be sure, this is not the first instance of transplantation involving directors of companies.
There have been other instances that are the subject matter of studies at varying levels of

detail: (i) Japan’s importation of the directors’ duty of loyalty from the U.S., Hideki Kanda &
Curtis Milhaupt, “Re-examining Legal Transplants: The Director’s Fiduciary Duty in
Japanese Corporate Law” (2003) 51 Am. J. Comp. L. 887; and (ii) China’s importation of a
directors’ duty of diligence, again primarily from the U.S., see Donald Clarke, “Lost in
Translation? Corporate Legal Transplants in China”, The George Washington University Law
School Public Law and Legal Theory Working Paper No. 213, online:
< at 14-16 [Lost in
Translation]; Rebecca Lee, “Fiduciary Duty Without Equity: “Fiduciary Duties” of Directors
Under the Revised Company Law of the PRC” (2007) 47 Va. J. Int'l L. 897.

11
1.3 Problem, Hypothesis and Questions
A. Problem
The concept of independent directors has originated in the context of outsider
systems of corporate governance. These systems are affected by the agency
problem between managers and shareholders, and the institution of independent
directors has seemingly been introduced to address that agency problem.
However, the concept has been transplanted to insider systems. In insider systems,
companies are dominated by controlling shareholders, and these systems suffer
from a different agency problem, viz., that between controlling shareholders and
minority shareholders.
B. Hypothesis
Principal Hypothesis
The appointment of independent directors on boards of companies in the insider
systems (that suffer from the agency problem between controlling shareholders
and minority shareholders) will entail a result or effect that is different from the
result or effect of their appointment on boards of companies in the outsider
systems (that suffer from the agency problem between managers and
shareholders).