The Role of Independent
Directors in Corporate Groups
The Corporate Governance of Group Companies
Korea Development Institute
A.C. Pritchard
University of Michigan Law School
1 November 2004
Separation of Ownership & Control
™Insider domination ™Independent
directors
¾Information
Asymmetry
¾Discretion
¾Access to
information
¾Power to curtail
discretion
2
Crisis & Reform
Financial crisis
of 1997-1998
Accounting scandals
of 2001-2002
3
Chaebol
™ Enormous separation of ownership and
control
¾ 75% voting > 13% cash flow (Kim & Sung 2004)
4
Consequences
™Manipulation of ownership interest by
controlling shareholders
¾Controlling shareholders benefit from
acquisitions (Bae, Kang, & Kim 2002)
¾Controlling shareholders allocate ownership
interests to most profitable members of the
group (Kim & Sung 2004)
¾Controlling shareholders limit exposure to
members of group with high risk (Chang 2003)
5
Reform in Korea
™Explicit fiduciary duties
¾More easily enforceable via law suit
™Independent directors
¾Board majority
¾2/3 of audit committee
6
Dispersed public ownership
™Managers, not controlling shareholders,
are the concern
¾Few shareholders with more than a small
percentage of shares
¾Independent directors overcome collective
action problem
7
Role of independent directors
™No correlation with profitability
™Important role at salient times
¾Takeovers
—Greater premia
—Less hubris
¾Replacement of poor-performing CEOs
™Mixed evidence that independent directors
enhance accuracy in disclosure
8
Reform in the U.S.
™ Focus on enhancing the accuracy of financial
statements
¾ Relationship with auditors central focus
™ Audit committees must be exclusively
independent directors
¾ Auditors must report to audit committee
™ Majority independent directors on board
¾ Independent nominating committee
¾ Independent compensation committee
9
Korea v. U.S.
Korea
United States
Board
> 50 % independent
> 50 % independent
Audit
Committee
Required
67 % independent directors
Required
100 % independent directors
“Financial sophistication” or “financial literacy”
Auditors must report to audit committee
Nominating
committee
Required for outside directors
Required
100% independent directors on committee or
>50% of all independent directors
Compensation
committee
Not required
Required
100% independent directors or
> 50% of all independent directors
Related-party
transactions
Board approval required
Independent directors’ approval required
(otherwise subject to legal challenge)
Cumulative
voting
Required if no opt out in
charter; most firms have opted
out
Permissible, but not required and not common
10
More reform for Korea?
Korea
United States
Board
> 50 % independent
> 50 % independent
Audit
Committee
Required
67 % independent directors
Required
100 % independent directors
“Financial sophistication” or “financial literacy”
Auditors must report to audit committee
Nominating
committee
Required for outside directors
Required
100% independent directors on committee or
>50% of all independent directors
Compensation
committee
Not required
Required
100% independent directors or
> 50% of all independent directors
Related-party
transactions
Board approval required
Independent directors’ approval required
(otherwise subject to legal challenge)
Cumulative
voting
Required if no opt out in
charter; most firms have opted
out
Permissible, but not required and not common
11
Too much reform for U.S.?
Korea
United States
Board
> 50 % independent
> 50 % independent
Audit
Committee
Required
67 % independent directors
Required
100 % independent directors
“Financial sophistication” or “financial literacy”
Auditors must report to audit committee
Nominating
committee
Required for outside directors
Required
100% independent directors on committee or
>50% of all independent directors
Compensation
committee
Not required
Required
100% independent directors or
> 50% of all independent directors
Related-party
transactions
Board approval required
Independent directors’ approval required
(otherwise subject to legal challenge)
Cumulative
voting
Required if no opt out in
charter; most firms have opted
out
Permissible, but not required and not common
12