Safeguards against corporate opportunism remains squarely with the independent directors

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Cesar L. Villanueva

M.A.P. Insights

As shown hereunder, it seems clear that ultimately the Corporate Governance (CG) Code for Publicly-Listed Companies (PLCs) places the ability to prevent corporate opportunism squarely on the shoulders of the independent directors (IDs), whether such attempts at corporate opportunism be on the part of the controlling stockholders acting through a majority of the members of the Board, or through Management.

1. Lead Director Must Be an ID. — CG Code for PLCs recommends that “The Board should designate a lead director among the IDs if the Chair of the Board is not independent, including if the positions of the Chair of the Board and CEO are held by one person.”

The CG Code recommends that in cases where the Chair is not independent, or where the roles of Chair and CEO are combined — which engender the abuse of power and authority, and potential conflict of interest — there should be appointed a strong “lead director” among the IDs, who should have sufficient authority to lead the Board in cases where management has clear conflicts of interest, and sets out the functions of this lead director to include, among others, the following: (a) Serve as an intermediary between the Chair and the other directors when necessary; (b) Convene and chair meetings of the non-executive directors; and (c) Contribute to the performance evaluation of the Chair, as required.

2. Key Board Committees Must Be Chaired and Majority Composed of IDs. — The CG Code recommends that “The Board should establish board committees that focus on specific board functions to aid in the optimal performance of its roles and responsibilities.” It explains that “Board committees such as the Audit Committee, CG Committee, Board Risk Oversight Committee and Related Party Transaction Committee are necessary to support the Board in the effective performance of its functions. The establishment of the same, or any other committees that the company deems necessary, allows for specialization in issues and leads to a better management of the Board’s workload.”

The CG Code then recommends that in the key committees, namely, the Audit Committee, CG Committee, Nomination and Remuneration Committee, Board Risks Oversight Committee, and the Related Party Transaction Committee, there should be at least three non-executive/IDs, and that the Committee Chair should be an ID.

It is through the IDs’ chairmanship and majority membership in key Board Committees that the problems of asymmetry of information and high transaction cost are overcome on behalf of the public investors whose interest in PHCs is primarily represented by IDs against corporate opportunism on the part of the controlling stockholders.

3. Material Company Transactions Overseen by IDs. — The CG Code recommends that “The company should make a full, fair, accurate and timely disclosure to the public of every material fact or event that occurs, particularly on the acquisition or disposal of significant assets, which could adversely affect the viability or the interest of its shareholders and other stakeholders. Moreover, the Board of the offeree company should appoint an independent party to evaluate the fairness of the transaction price on the acquisition or disposal of assets.”

It explains that “The disclosure on the acquisition or disposal of significant assets includes, among others, the rationale, effect on operations and approval at board meetings with independent directors present to establish transparency and independence on the transaction. The independent evaluation of the fairness of the transparent price ensures the protection of the rights of shareholders.”

4. Whistleblowing System Should Allow Direct Access to the IDs. — The CG Code supports the proposition that “The Board should establish a suitable framework for whistleblowing that allows employees to freely communicate their concerns about illegal or unethical practices, without fear of retaliation and to have direct access to an independent member of the Board or a unit created to handle whistleblowing concerns. The Board should be conscientious in establishing the framework, as well as in supervising and ensuring its enforcement.”

It explains that “A suitable whistleblowing framework sets up the procedures and safe-harbors for complaints of employees, either personally or through their representative bodies, concerning illegal and unethical behavior. One essential aspect of the framework is the inclusion of safeguards to secure the confidentiality of the informer and to ensure protection from retaliation. Further, part of the framework is granting individuals or representative bodies confidential direct access to either an independent director or a unit designed to deal with whistleblowing concerns. Companies may opt to establish an ombudsman to deal with complaints and/or established confidential phone and e-mail facilities to receive allegations.”

In addition to strict rules on qualifications and disqualifications pertaining to IDs to ensure utter lack of professional, contractual or filial connections with the company, its management and the controlling stockholders, the CG Code for PLCs has adopted certain safeguards that would preserve the ability of IDs to exercise independent judgment in corporate affairs. We shall evaluate the effectiveness of such safeguards in preserving the ability of IDs to exercise independent judgment.

a. IDs Must Have Business Acumen Necessary for the Industry in Which the PLC Operates

Against the criticism that IDs do not possess the personal or professional gravitas to be able act independently against the captains of the industries, the CG Code recommends that “The Board should ensure that its IDs possess the necessary qualifications and none of the disqualifications for an ID to hold the position.” It explains that “IDs need to possess a good general understanding of the industry they are in. Further, it is worthy to note that independence and competence should go hand-in-hand. It is therefore important that the non-executive directors, including IDs, possess the qualifications and stature that would enable them to effectively and objectively participate in the deliberations of the Board.”

The fact that the CG Code places the burden of “ensuring that … IDs possess the necessary qualifications and none of the disqualifications for an ID to hold the position” on the Board, which is majority-composed of representatives of controlling stockholders, tends to ensure that IDs would eventually fall under the spell of the controlling stockholders. As will be discussed hereunder, the true measure of ensuring that IDs would be accountable to the public investors against the corporate opportunism of the controlling stockholders, it is necessary that the public investors must have a certain measure of participation in the election and retention of IDs.

b. Nomination, Election and Retention in the Board of IDs

The CG Code for PLCs recommends that “The Board should have and disclose in its Manual on CG a formal and transparent board nomination and election policy that should include how it accepts nominations from minority shareholders and reviews nominated candidates. The policy should also include an assessment of the effectiveness of the Board’s processes and procedures in the nomination, election, or replacement of a director. In addition, its process of identifying the quality of directors should be aligned with the strategic direction of the company.”

It explains that “It is the Board’s responsibility to develop a policy on board nomination, which is contained in the company’s Manual on CG. The policy should encourage shareholders’ participation by including procedures on how the Board accepts nominations from minority shareholders. The policy should also promote transparency of the Board’s nomination and election process.”

In essence, therefore, the policies and processes for the nomination, election and retention of all members of the Board, including those of IDs, are put under the charge of the Board which is majority-composed by representatives of the controlling stockholders.

The mandatory provisions relating to the nomination and election of IDs can be found in SRC IRR, which provides “The conduct of election of IDs shall be made in accordance with the standard election procedures of the company or its by-laws.”

It should therefore be pointed out that eventually those who become IDs on a PHC must achieve the majority vote from among other candidates through the support of the controlling/majority stockholders. The same is true with ID’s ability to be retained in the Board. In a recent study, it has been demonstrated that when the election and retention of IDs in the Board is dependent upon the controlling stockholders’ support, then they eventually become preempted in their corporate actuations, thus:

Independence requirements strengthen these market incentives by ensuring that directors have no conflicts that could undermine their effectiveness as monitors of management. For example, a director whose livelihood depends on her business ties with the company might fear that refusing to accept the CEO pay demands would provoke retaliation. Many investors and lawmakers, however, believe that such independence alone may not ensure directors’ accountability because management’s influence over the appointment of directors can also undermine the effectiveness of those directors as monitors. Even an ID might fear that adopting a skeptical approach toward the CEO, for example, would reduce her chances of reappointment. Moreover, to the extent that the CEO is involved in appointment decisions, directors may develop a sense of gratitude and obligation to accommodate the CEO’s preferences. These concerns underlie the post-Enron requirement that IDs control the board nomination process, thereby taking from managers the formal power to influence the process — and thus the outcome — of director elections.

The study concludes that “These developments offer two important lessons for controlled companies. First, controllers’ absolute control over the election of IDs undermines those directors’ effectiveness as monitors. Second, enabling public investors to influence the election of IDs would provide these directors with incentives to guard public investors’ interests,” thus:

At controlled companies, IDs are expected to exercise oversight to prevent the controller from expropriating value from public investors. Yet, the same election method that holds directors accountable to public investors at widely held companies currently also holds them accountable to the controller at controlled companies. Controlling shareholders have decisive power over director appointment. Directors at firms with controlling shareholders — including IDs — cannot be elected or reelected following their initial term — unless the controlling shareholder supports their candidacies. Nor will they stay in office once the controlling shareholder decides to end their service on the board.

The study proposes that the better rule of inducing IDs to be accountable to public investors, is by empowering public investors to determine or at least substantially influence the election and/or retention of IDs, such as granting public investors with veto rights over such nomination and/or election of IDs, or allowing the election of IDs to be supported by a majority of the public investors’ voting power.

c. Limiting the Terms of IDs

Against the criticism that eventually IDs lose their independence based on prolonged dealings with the majority members of the Board and Management, i.e., with the controlling stockholders, the CG Code for PLCs recommends that “The Board’s IDs should serve for a maximum cumulative term of nine [9] years. After which, the ID should be perpetually barred from re-election as such in the same company, but may continue to qualify for nomination and election as a non-ID. In the instance that a company wants to retain an ID who has served for nine years, the Board should provide meritorious justification/s and seek shareholders’ approval during the annual shareholders’ meeting.”

It explains that “Service in a board for a long duration may impair a director’s ability to act independently and objectively. Hence, the tenure of an ID is set to a cumulative term of nine years. IDs who have served for nine years may continue as a non-ID of the company. Reckoning of the cumulative nine-year term is from 2012.”

The CG Code further provides that “Any term beyond nine years for an ID is subjected to particularly rigorous review, taking into account the need for progressive change in the Board to ensure an appropriate balance of skills and experience. However, the shareholders may, in exceptional cases, choose to re-elect an ID who has served for nine years. In such instances, the Board must provide a meritorious justification for the re-election.”

The CG Code presumes that nine (9) years is the optimum period that assures that IDs can resist the temptation to begin to in consonance with the controlling stockholders. Nine years is really a long period of time in the life of a PLC against an ID who has lost his independence in just a couple of years that he has acted with in consonance with the ruling of the majority stockholders’ representative in the Board. Yet we can appreciate the need to have long-serving IDs who develop a more intimate workings of the PHC as against a situation of having completely “green horn” IDs every couple of years or so who have yet a long learning curve ahead of them, only to be replaced by a new set when they have developed the skills and competence to exercise their independent judgment.

On the other hand, the perpetual disqualification of IDs after the cumulative nine-year period really does not provide a strong incentive to act independent of Management and controlling stockholders because of the very terms provided for in the CG Code: there are two possible ways by which an ID may remain with the Board, both of which are dependent upon the support of the entire Board (controlled by the majority stockholders) being able to prove that he should remain an ID because of meritorious justification, or by remaining in the Board as a regular director. In either case, there is every incentive on the part of the ID, during his 9-year stint, to be cozy with the controlling stockholders who hold in their power the ability to retain him in the Board.

We conclude this study with the following recommendations.

It is probably time to introduce statutory amendment in the Securities Regulations Code, which is peculiarly applicable to PHCs, to clearly define the role, duties and functions of the IDs to be one primarily set to champion the cause of stakeholders, other than stockholders, to present in all Board proceedings the values promoted under the Stakeholder Theory.

We should study introducing provisions in the SRC that legally empower public investors the right to have a certain legal standing in the nomination, election and retention of IDs in order to ensure direct accountability to such stockholders.

It may well be worth it that the agencies at the forefront of corporate governance development, namely the BSP, the SEC, and the IC, should now begin to put together a full accreditation system for IDs in partnership with leading private sector organizations that allow the proper training and orientation of professional directors that would be made available to covered corporations, each bringing with them a special set of skills for the various fields covered.

Perhaps it should be, in order to preserve the independence of such accredited IDs, that each of the three agencies develop a system of setting up funds within their industries by special levy on their covered corporations, to constitute as the source of remuneration for IDs who shall then be paid by and hence be accountable to, the supervising government agency. Under such a system, IDs would truly become quasi-public officers.

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).