Director selection and performance – Can Hong Kong learn from the UK experience?
Gordon Jones FCIS FCS, author and Hong Kong’s former Registrar of Companies, looks at the corporate governance reforms implemented in the UK in response to the global financial crisis of 2007–2008, with particular reference to director selection and performance, and finds that the UK now imposes significantly higher governance standards in these areas than Hong Kong
The financial crisis of 2007–2008 subjected the boards of major banks and companies to an unparalleled degree of stress and testing. The UK, which was very badly affected by the financial crisis, initiated an immediate high-level corporate governance review of banks and other financial institutions (BOFIs). One of the most important documents to emerge from this review was the ‘Walker Report’ which reviewed the corporate governance arrangements in BOFIs. Sir David Walker’s final report was published on 26 November 2009. In comparison with the knee-jerk reaction in the US during the Enron crisis, there was, however, no call for overreaching and draconian legislation similar to the Sarbanes-Oxley Act 2002. The review found that the UK’s Combined Code (now renamed the Corporate Governance Code) remained fit for purpose but made 39 recommendations to further enhance the governance of BOFIs.
The Walker Report
The Walker Report’s recommendations concerned five main issues: board size, composition and qualification; the functioning of the board and evaluation of performance; the role of institutional shareholders; governance of risk; and remuneration. This article will focus on the first two issues, with particular reference to director selection and performance. A very brief summary of the Walker Report’s recommendations in these areas is outlined below.
Board size, composition and qualification. In order to improve the contribution of non-executive directors, they should: (1) receive a substantive personalised approach to induction and training (to be reviewed annually); (2) attend regular thematic business awareness sessions; and (3) be provided with dedicated support. The nonexecutive directors on BOFI boards would also be expected to commit more time than has been normal in the past, with a suggested minimum commitment of 30 to 36 days for those on the boards of major banks.
Functioning of the board and evaluation of performance. As part of a unitary board, non-executive directors should be ready, able and encouraged to challenge and test proposals on strategy put forward by the executive. The board of a BOFI should undertake a formal and rigorous evaluation of its performance with external facilitation of the process every second or third year.
The ICSA Report
Subsequently, it was agreed that the Institute of Chartered Secretaries and Administrators (ICSA) would contribute to the review by conducting research on ‘appropriate boardroom behaviours’. The findings of the ICSA’s research were also shared with the UK’s Financial Reporting Council (FRC) which was concurrently reviewing the operation of the UK Corporate Governance Code. The resulting report – Boardroom Behaviours (June 2009) – exposed a number of weaknesses in the composition and practices of boards that had been exposed by the financial crisis, including the balance of executives and non-executives, board diversity and board evaluation.
Balance of executives and nonexecutives. The report suggested that the trend to decrease the number of executive directors attending board meetings might be detrimental to board competence, and the balance between executive and non-executive directors might need to be reviewed. It considered the UK Corporate Governance Code’s requirement (other than for small companies) that the board should comprise a majority of independent non-executive directors had led to a decrease in the number of executive directors attending to just two – the CEO and the CFO – in order not to increase board size. ‘This has led to a situation of information flow through two or sometimes three executive directors who, with the best will in the world, will be unable to master the whole corpus of the company’s objectives and operations,’ the report states.
Board diversity. The report also highlighted the benefits of having a diverse board membership, precisely because diversity encourages the kind of truly independent challenges and questioning which is needed on the boards of companies encountering difficulties. ‘It is evident that boards do not currently contain a sufficiently wide range of skill sets, experience and background – including those recruited from academia, the public and not-forprofit sectors,’ the report states.
Board evaluation. The report considered that high standards of rigorous and occasionally independent evaluation are needed to increase boards’ effectiveness. Further emphasis should be placed on the means for ensuring accountability in the areas of individual director and whole board performance. Directors should be assessed, inter alia, against expectations relating to boardroom performance and behaviours and, where appropriate, their remuneration arrangements should reflect those aspects. At the moment, many executive directors appear to face a potential conflict because they are remunerated on the basis of the way in which they manage the business to maximise short-term value rather than pursuing the goal of a sustainable business model. Generally, these remuneration arrangements seem to place little emphasis on their behaviours as directors in the boardroom working on behalf of shareholders’ long-term interests.
Comparing the codes
The UK’s FRC undertook to implement the recommendations of the Walker and ICSA’s reports which it considered should apply to all listed companies in the UK. These recommendations were incorporated in the UK’s Corporate Governance Code which was published in June 2010. At around the same time, Hong Kong Exchanges and Clearing (HKEx) was reviewing Hong Kong’s Code on Corporate Governance Practices (now renamed the Corporate Governance Code). The Consultation Paper on Review of the Code on Corporate Governance Practices and Associated Listing Rules was issued in December 2010 and the subsequent Consultation Conclusions in October 2011.
A comparison of the two codes in the areas of board appointments and diversity, directors’ time commitments and training and board evaluation is illuminating as it indicates the differences between the two jurisdictions and the extent to which good corporate governance practices in the areas under discussion, which have been accepted in the UK, still continue to be opposed by many listed issuers in Hong Kong.
Balance of executives and nonexecutives
The UK. The main principle under section A.4 states quite categorically that: ‘as part of their role as members of a unitary board, non-executive directors should constructively challenge and help develop proposals on strategy’. Under section B.1, the main principle is that: ‘The board and its committees should have the appropriate balance of skills, experience, independence and knowledge of the company to enable them to discharge their respective duties and responsibilities effectively.’ This is underpinned by the supporting principle that: ‘The board should include an appropriate combination of executive and non-executive directors (and, in particular, independent non-executive directors (INEDs)) such that no individual or small group of individuals can dominate the board’s decision taking.’ Furthermore, under Code Provision (CP) B.1.2 : ‘Except for smaller companies, at least half the board, excluding the chairman, should comprise non-executive directors determined by the board to be independent. A smaller company should have at least two independent non-executive directors.’
Hong Kong. Section A.4 of the UK code regarding the fundamental role of nonexecutive directors has no equivalent in the Hong Kong code. This is a serious omission as it is not unknown for INEDs to be appointed to listed company boards merely as ‘window dressing’ and they are not seriously expected to question the decisions of the majority shareholders. If they do, they should expect to part ways with the company very swiftly!
Furthermore, the equivalent provisions in the Hong Kong code are not as comprehensive as those in the UK, although there is a clear emphasis on independence. Under section A.3, the principle is that: ‘The board should have a balance of skills and experience appropriate for the requirements of the issuer’s business… [however, there is no mention of knowledge of the company]. It should include a balanced composition of executive and non-executive directors (including independent non-executive directors), so that there is a strong independent element on the board which can effectively exercise independent judgement. Non-executive directors should be of sufficient calibre and number for their views to carry weight.’
The Hong Kong listing rules mandate that every board of directors of a listed issuer must include at least three INEDs (Rule 3.10). However, as a listed company board will have fewer INEDs than in the UK, it is essential to ensure that their quality, in terms of ability, experience, knowledge and personality, compensates for their lack in numbers. This is why the role of the nomination committee is so important.
The UK. Under section B.2 of the UK code, the main principle is that: ‘There should be a formal, rigorous and transparent procedure for the appointment of new directors to the board’. This is underpinned by the supporting principle that: ‘The search for board candidates should be conducted, and appointments made, on merit, against objective criteria and with due regard for the benefits of diversity on the board, including gender’. Furthermore, under CP B.2.2: ‘The nomination committee should evaluate the balance of skills, experience, independence and knowledge on the board and, in the light of this evaluation, prepare a description of the role and capabilities required for a particular appointment’.
Hong Kong. As nomination committees have now become a code provision requirement for all listed companies (CP A.5), it is likely that more listed companies will establish such committees. However, unlike the UK provisions, there are no main and supporting principles outlining the philosophy behind the procedure and criteria to be adopted by nomination committees in identifying potential directors. Furthermore, there is no requirement to prepare a description of the role and capabilities required for a particular appointment. In other words, the Hong Kong approach is far less systematic than that in the UK.
There may, however, be some changes in this respect. On 7 September 2012, HKEx released a consultation paper to collect views on a proposal to require listed companies to ensure that they have a more diverse board representation on their boards – that is, the need to have more women as opposed to middle-aged men. The paper drew attention to the fact that women comprise only 10.3% of the boards of listed companies and 40% of listed companies do not have any female directors. As the proposed change to Hong Kong’s Corporate Governance Code would be a code provision, companies not adopting the principle of board diversity would have to explain their reasons for doing so. The consultation period is due to end on 9 November 2012.
Directors’ time commitments
The UK. Under section B.3 of the UK code, the main principle is that: ‘All directors should be able to allocate sufficient time to the company to discharge their responsibilities effectively’. Furthermore, CP B.3.2 states that: ‘…The letter of appointment (of non-executive directors) should set out the expected time commitment. Non-executive directors should undertake that they will have sufficient time to meet what is expected of them. Their other significant commitments should be disclosed to the board before appointment, with a broad indication of the time involved and the board should be informed of subsequent changes’. In other words, directors are left with no uncertainty over the time which the board expects them to spend on their duties.
Hong Kong. By comparison, the Hong Kong requirements are by no means as robust. Initially, HKEx proposed that there should be new code principles (CP A.5.2 (e) and (f)) enabling the nomination committee to, inter-alia, regularly review the time required from directors to perform their duties to the issuer and whether they are spending sufficient time as required. However, in the light of widespread opposition, this requirement has now been given the status of a highlevel principle under which the board should regularly undertake such reviews. In practice, this means that compliance will vary very widely.
The UK. Under section B.4 of the UK code, the main principle is that: ‘All directors should receive induction on joining the board and should regularly update and refresh their skills and knowledge’. This is underpinned by the supporting principle that: ‘The chairman should ensure that the directors continually update their skills and the knowledge and familiarity with the company required to fulfil their role both on the board and on board committees’. Under CP B.4.1: ‘The chairman should ensure that new directors receive a full, formal and tailored induction on joining the board’. As part of this, directors should avail themselves of opportunities to meet major shareholders. Furthermore, under CP B.4.2 ‘The chairman should regularly review and agree with each director their training and development needs’.
Hong Kong. At present, directors should participate in a programme of continuous professional development to develop and refresh their knowledge and skills (see CP A.6.5). HKEx originally proposed that there should be a new code principle requiring directors to receive at least eight hours of training in each financial year. However, as a result of widespread criticism that an eight-hour training period was too prescriptive, HKEx has deleted the time requirement from the new code provision. However, a note to CP A.6.5. will require directors to report on what training they have received in the course of a year.
The UK. Under section B.6 of the UK code: ‘The board should undertake a formal and rigorous annual evaluation of its own performance and that of its committees and individual directors’. This is underpinned by the supporting principles that: ‘The chairman should act on the results of the performance evaluation by recognising the strengths and addressing the weaknesses of the board and, where appropriate, proposing new members be appointed to the board or seeking the resignation of directors’. In parallel, individual evaluation should aim to show whether each director continues to contribute effectively and to demonstrate commitment to the role (including commitment of time for board and committee meetings and any other duties). This is underpinned by CP B.6.1: ‘The board should state in the annual report how performance evaluation of the board, its committees and its individual directors has been conducted’.
Hong Kong. By comparison, board evaluation is hardly ever undertaken in Hong Kong although it is a natural and logical consequence of adopting a more systematic approach to appointing directors through nomination committees. The most recent HKEx Analysis of Corporate Governance Practices Disclosures in 2009 (September 2010) indicated that only one issuer (Standard Chartered Bank) had undertaken a board evaluation in 2009.
As the commercial environment within which companies operate changes all the time, it is essential that the board’s membership comprises the right skill sets, experience and expertise to ensure that the company is capable of meeting existing and future challenges. This can only be achieved if boards submit to some form of evaluation which, if it is to be genuinely objective and hence effective, will have to be undertaken by a third party.
In order to remedy this very unsatisfactory situation, HKEx proposed to add a new Recommended Best Practice (RBP) B.1.8 that issuers conduct a regular evaluation of its own and individual directors’ performance. However, notwithstanding the fact that it was only a RBP as opposed to a CP, in the context of the consultation exercise, the proposal was opposed by over two thirds of responding issuers, but gained majority support from market practitioners and professional bodies. Many respondents said that they would support the proposal if HKEx omitted the evaluation of individual directors from the RBP. In view of this, HKEx has adopted a new RBP recommending evaluation of the board but not of individual directors. The consequence is that Hong Kong has a far less robust system in place for determining the continuing effectiveness and efficiency of listed company boards.
Unlike North America and Western Europe, Hong Kong, together with other East Asian jurisdictions was largely shielded from the worst aspects of the financial crisis, for example there were no bank collapses. In retrospect, this may have been a ‘bad thing’ from the corporate governance angle as it tended to remove the need and pressure for reform. As a consequence, it is not unsurprising that the most recent reforms of Hong Kong’s Corporate Governance Code are less far reaching and robust than the reforms of the UK Code.
The ICSA Boardroom Behaviours report considered that, if better guidance to directors had been available and, more importantly, observed, some of the consequences of the financial crisis might have been less severe. It also argued that the prevention of a recurrence of the events of 2008 would at least be dependent upon more robust guidance on boardroom behaviour being incorporated into the UK’s Corporate Governance Code. However, while this has been done in the UK, there have been no parallel reforms in Hong Kong.
Regrettably, the global history of major regulatory and governance reform indicates that the usual catalysts for such reforms are major economic and corporate crises. In Hong Kong, it took the global crisis of ‘Black Monday’ on 19 October 1987, before the government undertook to reform the hitherto totally inadequate regulation of the securities market, leading to the establishment of the Securities and Futures Commission. Will reforms regarding director selection and performance have to await another such crisis?
Gordon Jones FCIS FCS
Author and former Registrar of Companies, Hong Kong.
Mr Jones was a panellist in session one of the Corporate Governance Conference 2012.