Towards a Credible System of Independent Directors in Controlled Firms

Abstract

In the past years, most jurisdictions around the world have required or recommended public companies to increase the number of independent directors sitting on their boards as a means to protect outside investors from the opportunism of insiders. However, despite the efforts to increase the presence, power and number of independent directors, this paper argues that most countries around the world have failed to create a credible system of independent directors. And they have failed to do so because regulators and policy-makers seem to have omitted the fact that the CEO – in companies with dispersed ownership structures – and the controlling shareholder – in companies with concentrated ownership structures – play a very important role in the appointment, remuneration, and removal of independent directors. Therefore, the influence of corporate insiders in the appointment and removal of independent directors undermines the credibility of these actors to protect outside investors precisely from the opportunism of insiders. In companies with dispersed ownership structures, letting the shareholders decide on the appointment and removal of independent directors may increase the credibility of independent directors. For this reason, this practice – followed by most jurisdictions around the world – makes sense in companies with dispersed ownership structures, as it is the typical case of large corporations in the United Kingdom and the United States. Nonetheless, in companies with controlling shareholders, which are the most common types of firms around the world, leaving the decision to the shareholders’ meeting will mean that the controlling shareholders will have the power to ultimately appoint and remove independent directors. Therefore, outside investors will have reasons to believe that, in those decisions in which the interest of the corporation may differ from those of the controlling shareholders, independent directors will favor the interests of the latter at the expense of minority investors. As a result, regardless of whether such situation of opportunism ultimately exists or not, there will be a reasonable lack of confidence that may harm firms’ access to finance and the development of capital markets. This paper seeks to address this problem by suggesting a new system for the appointment and removal of independent directors that, while preserving the ability of the controller to appoint the majority of the board, provides greater confidence and protection to minority investors in addition to promoting other benefits for the decision-making process in the boardroom.

Keywords: corporate governance, controlling shareholders, independent directors, tunneling, credibility, independence, outside investors, finance, capital markets, economic growth