In contrast to the Revised Corporate Governance (CG) Code for Public Companies (PCs) which refers only to the role of independent directors in exercising independent judgment as against “management,” the CG Code for Publicly Listed Companies (PLCs), in defining an independent director clearly delineates between “management” and “controlling shareholder,” thus:
Independent director — a person who is independent of management and the controlling shareholder, and is free from any business or other relationship which could, or could reasonably be perceived to, materially interfere with his exercise of independent judgment in carrying out his responsibilities as a director.
In essence, the CG Code for PLCs cascades the duty of independent directors “to exercise independent judgment” into three scenarios: (a) vis-à-vis with Management; (b) vis-à-vis with the controlling shareholders; and (c) in all situations that would put the interest of the company in conflict with his personal, professional or business interests. It fuses together the distinct role of independent directors in widely held companies and controlled companies.
In a “widely held company,” where there is no controlling stockholder as a result of its shares being widely dispersed among scattered shareholders, professional management, i.e., the Board and Senior Officers, tend to act independently based on their own mandate, and, controlling the corporate resources, they are able to machinate the proxy-solicitation process to ensure obtaining the necessary voting power to perpetuate themselves in office. In such companies, the tendency is for Management, headed by a strong CEO, to run the show before a rubber-stamping Board. Consequently, in “widely held companies,” the primary governance concern is to prevent the professional managers from behaving opportunistically at the expenses of the public investors.
In developed economies, it was in the case of widely held companies that the system of independent directors was first adopted, to provide a check against the majority members of the Board who are practically handpicked by Management and who therefore cannot be expected to exercise independent judgment when Management takes a position that serves their interests more than that of the stockholders. In fact, even under the Sarbanes-Oxley regime in the United States, there exist rules in the NYSE and Nasdaq that exempt listed companies from independent directors dominance in nominating, compensation and audit committees, where it can be shown that it is a “controlled company” in which more than 50% of the voting power rests with an individual, a family or another group of shareholders who vote as a block.
On the other hand, in Publicly Held Companies (PHCs) where a block of stockholders have controlling interests — referred to as “controlled companies” — where the controlling stockholders may use their power to divert value at the expense of the public investors who invariably constitute the minority stockholders, the primary governance concern is to protect the public investors from the controlling stockholders’ opportunism and value diversion. The primary role therefore of independent directors in controlled companies is to protect the minority stockholders who are the public investors from the propensity of the controlling stockholders to divert value from the company to their private interests, which may take many forms, including selling (or purchasing) assets, goods or service to or from the company on favorable terms; acquiring equity at below-market prices; or paying themselves excessive compensation.
In both scenarios, corporate law requires or encourages the use of independent directors, not to take management control away from the professional managers or the controlling stockholders acting through the Board, nor their ability to set the company’s strategy, but rather to vet self-dealing transactions and other conflicted decisions.
As is well apparent, most of the PHCs in the Philippines are “controlled companies,” since most of them grew from original family-owned companies that have remained within family control even when some of them went to be listed with the Philippines Stock Exchange (PSE). The primary role therefore of independent directors in Philippine jurisdiction where the overriding PHCs are controlled companies is to protect the minority stockholders who are the public investors from the propensity of the controlling stockholders, acting through key positions in Management, and through majority membership in the Board, to divert value from the company to their private interests.
Such primary role of independent directors in PHCs can be termed “oversight function against corporate opportunism” by the controlling shareholders, who operate through majority membership in the Board, as well as holding senior positions in the Management. The efficacy of such oversight role of independent directors is critical within the framework of corporate governance reform, since, when properly exercised, the decision of the independent directors would carry a “chilling effect” on attempts by the controlling shareholders to engage in self-dealings; whereas, when improperly exercised, the actuations of independent directors could provide a “cleansing effect” on the improper actuations of the controlling stockholders to the investing public and the regulatory agencies.
Yet this primary role of independent directors seems to have been preempted by the designation of “non-executive directors” — which includes independent directors — as having the primary duty to exercise independent judgment on corporate affairs.
Under the heading “The Board’s Governance Responsibilities,” the CG Code for PLCs provides that “The Board should be composed of a majority of non-executive directors who possess the necessary qualifications to effectively participate and help secure objective, independent judgment on corporate affairs and to substantiate proper checks and balances.” It explains that “The right combination of non-executive directors (NEDs), which include independent directors (IDs) and executive directors (EDs), ensures that no director or small group of directors can dominate the decision-making process. Further, a Board composed of a majority of NEDs assures protection of the company’s interest over the interest of the individual shareholders. The company determines the qualifications of the NEDs that enable them to effectively participate in the deliberations of the Board and carry out their roles and responsibilities.”
In other words, the CG Code for PLCs seems to promote majority NED in PLC Boards as the main deterrent against corporate opportunism by the majority shareholders.
Unlike the Revised CG Code for PCs which provides that “Independent directors should always attend Board meetings. Unless otherwise provided in the by-laws, their absence shall not affect the quorum requirement. However, the Board may, to promote transparency, require the presence of at least one independent director in all its meetings.” The CG Code for PLCs no longer contains such express “duty to attend Board meetings,” for independent directors. Instead, the CG Code for PLCs “foster[s] commitment” on the part of all the members of the Board, thus: “To show full commitment to the company, the directors should devote the time and attention necessary to properly and effectively perform their duties and responsibilities, including sufficient time to be familiar with the corporation’s business.”
In addition, under the heading “Reinforcing Board Independence,” the CG Code for PLCs provides that “The NEDs should have separate periodic meetings with the external auditor and heads of the internal audit, compliance and risk functions, without any executive directors present to ensure that proper checks and balances are in place within the corporation. The meetings should be chaired by the lead independent director.” The CG Code explains the underlying reason to be as follows:
“NEDs are expected to scrutinize Management’s performance, particularly in meeting the company’s goals and objectives. Further, it is their role to satisfy themselves on the integrity of the corporation’s internal control and effectiveness of the risk management systems. This role can be better performed by the NEDs if they are provided access to the external auditor and heads of the internal audit, compliance and risk functions, as well as to other key officers of the company without any executive directors present. The lead independent director should lead and preside over the meeting.”
Such rationale pertains to widely held companies which are prevalent under the United States situation, where the conceptual issues of agency problem, asymmetry of information and high transaction cost prevail, as has been explained by Prof. Limlingan in the following manner:
The agency problem occurs when the principal and agent are not the same person or entity. In the American economic system, especially among listed companies, the principals (shareholders) are different from the agents (management). Under this situation, the agency problem is confronted when the principal has to ensure that the agent acts in the principal’s interests and not his own.
To complicate matters, the agent usually has greater access to information and so places the principal at a disadvantage. The shareholder or principal could, of course, seek to obtain more information to overcome the asymmetry of information — the bias towards management in terms of knowing what is going on in the firm — and, after analyzing it, act on its base. But doing this would incur high transaction costs on the part of the principal. On the other hand, transaction costs for the agent are shouldered by the agent’s employer, thus adding insult to injury.
Our PHC sector, which as noted earlier is composed almost entirely of controlled companies, does not suffer from these governance flaws — for indeed the controlling stockholders themselves dominate the Board and key officer positions in the company. Therefore, the delineation between non-executive directors (other than independent directors) and executive directors does not really make that much of a difference, for most, if not all of them, represent the controlling stockholders, or more precisely the controlling families in PHCs.n
The article reflects the personal opinion of the author and does not reflect the official stand of the Management Association of the Philippines or the MAP
Cesar L. Villanueva is the vice chair of the CG Committee of the MAP, the founding partner of the Villanueva Gabionza & Dy Law Offices, and the former Chair of the Governance Commission for GOCCs (GCG).