Board Independence as Panacea to Tunnelling? An Empirical Study of Related Party Transactions in Hong Kong and Singapore

In this article, we examine a general question: is the legal transplantation of corporate governance rule effective in curtailing agency costs? Entering into the 21st century, we have seen reforms of corporate governance standards in the Far East since the Asian Financial Crisis in 1997, including in Hong Kong and Singapore. These reforms built on the Anglo-American model of corporate governance in the UK and US supported by broad academic literature of connecting better corporate governance with firm value and identifying the association of tunneling or wrongdoings with poor corporate governance practices. The idea is also to provide more checks-and-balances and monitoring corporate management and insiders to protect the interests of shareholders and to prevent controlling shareholders from extracting the company’s resources into their own pocket. Among various corporate governance regimes, one important tool is to improve board independence, which has seemed to become the panacea of corporate governance problems by policymakers.

Our research question then is whether higher board independence really has the desired effect of reducing tunneling (in particular tunneling through related party transactions (RPTs)) by corporate management or controlling shareholders in East Asian countries. We use RPTs as a benchmark, because independent directors play a key role in vetting RPTs. In addition, controlling shareholders are able to obtain private benefits of control through RPTs. These are also a crude way for controlling shareholders or management to divert resources into their own pockets. In East and Southeast Asia, many corporate scandals or failures are more or less caused by or connected with transactions with controlling owners. Therefore, higher board independence is expected to have the effect of reducing harmful self-dealing and tunneling by corporate insiders. 

However, because Asian companies commonly have a significant beneficial owner pulling strings in front of or behind the scene, it is too naïve to believe that beneficial owners (who often also control management) would voluntarily yield more power to independent directors. With the ability to elect and/or remove directors, beneficial owners might also have some means to control independent directors. Even if an independent director is truly independent, it is also questionable at times whether he has received sufficient information to make appropriate judgments or is willing to raise his voice in board or committee meetings. Those factors might compromise an independent director’s function to monitor the management.

In this article, we present our findings of a sample of 254 companies listed in the Mainboard of the Stock Exchange of Hong Kong (SEHK) between 2009 and 2015 and a sample of 103 companies listed in the Mainboard of Singapore Exchange (SGX) during the same time span, as both Hong Kong and Singapore share the same common law heritage, while thriving as international financial centers in East and Southeast Asia. Our data shows that higher board independence does negatively correlate with the volume of related party transactions (RPT), indicating that better corporate governance might have the effect of reducing tunnelling through RPTs. However, we find no causal effect of Hong Kong’s imposition of a minimum board independence threshold in 2012 on reducing tunnelling by comparing a group of companies which changed board composition due to the reform with other firms which have complied with the standards from the outset. Our data also shows that a controlling shareholder having larger ownership stakes does not necessarily mean more tunnelling, while state-owned enterprises (notably Chinese state firms) have a much larger volume of RPTs than other firms. Overall, this research lends support to the existing literature on the role of better corporate governance in addressing agency costs. However, our research shows that there could be limited effect on reducing on tunnelling, if regulators simply kept raising corporate governance standards incrementally. In other words, it is not a panacea to address problems of tunnelling by keeping raising board independence standards as a policy response to corporate scandals and unfair related party transactions. It requires further empirical studies to understand the real effect of corporate governance reforms (and subsequent reforms) on reducing agency costs.  

Christopher Chen is Associate Professor of Law, Wai Yee Wan is Associate Professor of Law and Wei Zhang is Assistant Professor of Law at Singapore Management University.