Courtesy calls for reciprocity: Appointment of uncertificated independent directors in China

• Published date: 01 July 2021
• Author: Yanlin Li,Jiawei Liu,Gary Gang Tian,Xin Wang
• Date: 01 July 2021
• DOI: http://doi.org/10.1111/corg.12366

ORIGINAL ARTICLE

Courtesy calls for reciprocity: Appointment of uncertificated

independent directors in China

Yanlin Li

1

| Jiawei Liu

2

| Gary Gang Tian

1

| Xin Wang

3

1

Department of Applied Finance, Macquarie

University, North Ryde, New South Wales,

Australia

2

Dongwu Business School, Soochow

University, Suzhou, China

3

School of Accounting, Southwestern

University of Finance and Economics,

Chengdu, China

Correspondence

Xin Wang, School of Accounting,

Southwestern University of Finance and

Economics, No. 555 Liutai Avenue, Wenjiang

District, Chengdu 611130, Sichuan Province,

China.

Email: yourwangxin@163.com

Funding information

National Social Science Fund of China,

Grant/Award Number: 16CJY005

Abstract

Research Question/Issue: Using regulatory qualification requirements for being an

independent director in China, we examine the effect of explicit norms of reciprocity

between uncertificated independent directors (UIDs), who are not qualified at the

beginning of their appointment, and insiders.

Research Findings/Insights: We find that UIDs are less likely to cast dissenting votes

after their appointment, especially after they are qualified, and that firms with UIDs

exhibit more expropriation and information opacity. Our main results are robust to

alternative explanations and endogeneity tests.

Theoretical/Academic Implications: Our study contributes to the literature on

reciprocity theory by presenting a new reciprocity norm under the rules of ID

qualification and documenting that independent directors who highly value board

appointment reciprocate with less independence.

Practitioner/Policy Implications: This study offers insights to policy makers regarding

how to effectively establish and enhance regulations for qualification for indepen-

dent directors throughout the world.

KEYWORDS

Corporate governance, board appointment, board voting, qualification test, rookie

independent directors

1|INTRODUCTION

Many studies have investigated the factors that influence the inde-

pendence of board directors and how independence adds value for

shareholders. Fama and Jensen (1983) demonstrated that reputation

for independence enables directors to perform their duty of monitor-

ing firm management, but some studies, such as Adams, Hermalin, and

Weisbach (2010), have documented that it is common for indepen-

dent directors to merely act as “rubber stamps.”Many studies have

conjectured that the low independence of board directors is caused

by mutual rent-seeking under a norm of reciprocity between

insiders and independent directors (Boivie, Bednar, & Barker, 2015;

Brick, Palmon, & Wald, 2006; Fich & White, 2005; Fiss, 2006; O'Reilly,

Main, & Crystal, 1988),

1

which is more likely to occur in the

nomination process (Coles, Daniel, & Naveen, 2014; Khanna, Kim, &

Lu, 2015). Independent directors who are appointed after the insider

assumed office are more likely to assign their loyalty to the insider in

repayment for the appointment, which can lead to weak board moni-

toring, higher chief executive officer (CEO) compensation, lower

turnover–performance sensitivity, and a higher likelihood of corporate

fraud (Coles et al., 2014; Khanna et al., 2015; Ma & Khanna, 2016;

Main, O'Reilly, & Wade, 1995; Park, Westphal, & Stern, 2011; Stern &

Westphal, 2010; Wade, O'Reilly, & Chandratat, 1990). However, there

is no direct evidence indicating whether the appointment is an impor-

tant favor from insiders to independent directors in reciprocity in

which both parties realize an interest exchange. More evidence is nec-

essary regarding how reciprocity between independent directors and

insiders is established in the director appointment process.

Received: 11 June 2020 Revised: 8 January 2021 Accepted: 9 January 2021

DOI: 10.1111/corg.12366

352 © 2021 John Wiley & Sons Ltd Corp Govern Int Rev. 2021;29:352–380.wileyonlinelibrary.com/journal/corg

Chen and Keefe (2020) documented that rookie independent

directors are more independent because of weaker connections with

firm insiders. However, minority shareholders and external investors

in the market lack background information on rookie directors' inde-

pendence and monitoring ability. Considering the results following

the 2010 change in the investment advisor qualification exam in the

United States, Kowaleski, Sutherland, and Vetter (2020) documented

that an effective way to alleviate the agency problem is to establish

a qualification exam that increases practitioners' understanding of

conduct and labor market activity. To improve the knowledge and

independence of candidates, since 2005, the China Securities Regu-

latory Commission (CSRC) has required all independent director can-

didates to obtain official qualification before their first appointment

by taking a training class held by the Shanghai and Shenzhen stock

exchanges and passing an exam. However, listed firms apply to

CSRC for uncertificated independent directors (UIDs) to complete

the qualification soon after their appointment, if they miss the class

because of registration limits or for other reasons. Firms that hire

UIDs must disclose the UIDs' qualification status to the public, and

they face monitoring pressure from officials and the market. We

use the Chinese setting to explore whether such appointments are

significant favors to UIDs and whether they help to build reciprocity

between UIDs and insiders. In addition, unique voting data are avail-

able from Chinese samples that are not available in other countries.

Since 2004, the CSRC has required all listed firms to release the

voting records of all directors in board meetings. This information

can be used to access the black box

2

of board information and

investigate how UIDs' voting behavior is influenced by norms of

reciprocity with insiders.

We use reciprocity theory to explain UID appointments and

propose that UIDs follow norms of reciprocity with insiders. With the

use of empirical tests, we investigate the impact of rookie indepen-

dent directors' uncertificated status on their governance behavior.

We find that compared with their counterparts, UIDs cast fewer

dissenting votes and attend fewer meetings after being admitted to

the board by insiders. This result is more pronounced in firms operat-

ing in weak internal (higher concentrated ownership) and external

governance environments. In addition, we confirm that the presence

of UIDs is positively associated with a higher ratio of other receivables

in total assets and more related-party transactions, suggesting greater

expropriation by insiders. Furthermore, the presence of UIDs is

positively correlated with information opacity as measured using

earnings management.

We rule out two alternative explanations that may drive our main

results: the abilities of independent directors and their social ties with

insiders. Our additional tests reveal that the reciprocity norm persists

after UIDs have passed the official qualification training course. Our

findings remain robust even when subsample analyses are performed

and endogeneity concerns are addressed using an instrument variable

test and a propensity score matching (PSM) test. The results of our

empirical analyses thus support the reciprocity argument that UIDs

play a weak monitoring role in return for receiving valuable board

seats from insiders.

Our paper makes several contributions to the corporate gover-

nance literature. First, our findings contribute to the growing body

of literature on how the reciprocity norm between independent

directors and insiders affects director independence. Researchers

have found that reciprocity can be reflected by the CEO interlock

(Fich & White, 2005; Lorsch & Young, 1990), the positive correla-

tion between increasing CEO compensation and greater director sal-

aries (Boivie et al., 2015; Fiss, 2006), and the positive association

between directors' cash compensation and the magnitude of earn-

ings management (Ye, 2014) after the appointment of directors.

Other studies have found that independent directors are easily cap-

tured by CEOs or board chairs with significant influence over their

appointment, leading to lower board independence (Ma &

Khanna, 2016; Main et al., 1995; Park et al., 2011; Stern &

Westphal, 2010; Wade et al., 1990). However, appointment is not

always regarded as a favor by independent directors, and the effect

of appointment on board independence depends on how indepen-

dent directors value their appointment. Our paper documents a new

type of reciprocity norm between independent directors and

insiders under the rules of ID qualification. It provides substantial

evidence that UIDs highly value being appointed by insiders when

they lack official qualification and that they reciprocate with

reduced monitoring intensity.

Second, our paper extends the literature on the appointment of

rookie independent directors. Chen and Keefe (2020) documented

that rookie independent directors are more independent because they

are less likely to be connected with firm insiders. However, rookie

directors are also less likely to be appointed because less information

or signals regarding their working ability and monitoring experience

can be provided to firms and the market. Our paper complements

prior studies with the finding that rookie directors who are not

officially qualified are grateful for their first appointment, which leads

to reciprocity between UIDs and insiders that makes UIDs less

independent.

Third, our paper complements the literature on board indepen-

dence and its changes under external regulations. The U.S. Securities

and Exchange Commission has mandated that a nomination commit-

tee must consist entirely of independent directors to prevent CEOs

from exercising authority over the nomination process. Nevertheless,

board independence still suffers from the appointment of indepen-

dent directors who are socially connected with senior executives

(Balsam, Kwack, & Lee, 2017; Hwang & Kim, 2009). A new form of

reciprocity between independent directors and insiders may have

arisen because of flaws or exceptions in regulatory requirements. Our

study provides additional evidence that UIDs can prompt mutual rent-

seeking with insiders under the exceptions to China's independent

director qualification requirements.

Fourth, our paper contributes to policy making by shedding light

on how to design and implement qualification requirements for

independent directors. Kowaleski et al. (2020) were the first to find

that rules and ethics training and exams positively affect conduct

and labor market activity in the financial sector. Similarly, the estab-

lishment of qualification rules by officials can support the

LI ET AL.353