Ownership structure, power separation and the supervisory effectiveness of independent director system

Abstract

We develop a theory to explain that the paradoxical ineffectiveness of China's independent directors stems from a failure to achieve separation of powers. Using a game-theoretic model, we show that in dispersed ownership economies, this separation arises naturally, creating an incentive-compatible equilibrium where monitoring is effective. In contrast, China's concentrated ownership structure leads to a consolidation of powers, where the controlling shareholder acts as both principal and agent, simultaneously controlling operations, supervision, and sanctions. This power consolidation structurally neutralizes independent directors, rendering them captured monitors. This power-based framework explains two key puzzles: why governance mechanisms fail when transplanted from Type I to Type II agency environments, and why enhancing de jure board powers is futile when de facto power is not reallocated. We show that meaningful reform must reinstate power separation by externalizing the sanctioning mechanism and realigning nomination rights away from controlling shareholders.