The Institute’s corporate governance paper competition is run biennially in tandem with the Institute’s corporate governance conferences. This month, CSj publishes the second and final part of the winning paper in this year’s competition which, like the conference itself, set itself the tough but crucial task of troubleshooting the 21st-century board.

In 2008, the UK Institute of Directors published An effective board which gives a highly useful definition of board effectiveness. ‘An effective board has the following characteristics: it is efficient, allows a respectful conflict of ideas, is simple, is focused, is integrated and synergistic, has good outcomes, preserves community assets, and leads to enjoyment and personal reward for the individual board members.’

Reaching this ideal, however, is not always easy. Last month we highlighted some common weaknesses that undermine board effectiveness. In this second and final part of our article, we make practical recommendations on how to boost board effectiveness.

Independence and diversity

An independent board is an essential element for sound corporate governance. It is important to ensure that there are no actual or perceived conflicts of interest between the board members and management. This will help the board become more effective in supervising and, where necessary, challenging the activities of management. In addition, the board will be capable of assessing the performance of managers with an objective perspective. Therefore, the majority of board members should be independent of both the management team and not have any commercial dealings with the company.

The first step to ensuring an independent board is to recruit a sufficient number of independent directors. According to the Hong Kong listing rules, the board of directors of a listed company should have at least three independent non-executive directors (INEDs). Genuine independence, however, is not merely a matter of the number of INEDs on the board – quality is more important than quantity when it comes to independence. One way companies can achieve quality independence is to ensure that there is a good diversity of perspectives on the board.

Diversity refers not just to gender and age; it also covers matters such as experience, ethnicity and the countries where people have worked. Diversifying the board leads to more thought-provoking and rewarding discussions and ultimately to better decision-making. A great deal of research shows that nondiverse boards are in much greater danger of descending into ‘groupthink’ than boards with a good mix of perspectives. The following provides recommended directions for diversifying the board.

Professional diversity

For boards to be effective they need to recruit members from heterogeneous backgrounds.

Traditionally, boards tend to look for skills and expertise in areas such as finance, accounting, auditing, law and regulation, risk management and asset management. In the 21st century, boards will need to adopt a more diversified approach by recruiting members with experience in community relations, stakeholder engagement, environmental management, reputation management and communications.

• Boards with a diverse and broad knowledge base will be in a better position to look at the challenges the company faces from different perspectives. This diversity of perspectives can also overcome the biases of individual directors.

• Boards with directors from varied professional backgrounds will also have a more diverse social and professional network base, both inside and outside the entity’s boundaries. A wide network base can be highly useful to companies and can help mitigate the information asymmetry problem (see ‘information asymmetry’ on page 29), since it can provide independent sources of information and prevent the board from becoming too reliant on management disclosures.

Ethnic/ national diversity

Globalisation has become a fact of modern life. Increasing economic integration with the global economy has meant that a business in Hong Kong is rarely simply doing business with Hong Kong people anymore. The business world is encouraging convergence.

Some major Hong Kong companies have a truly global strategic outlook. They serve worldwide markets with production facilities and added-value chains that are not regionally dependent and they raise finance from various international sources. Unfortunately, this is seldom reflected in the composition of their boards of directors. The proportion of ‘foreign’ directors (that is, not nationals of the home country) is typically very small. Therefore, one of our recommendations is to increase national diversity on the board. There are several benefits to be gained from this.

• Gaining an international perspective. Directors from different national backgrounds offer different cultural perspectives on the issues the board addresses. This helps the board brainstorm for creative and innovative ideas.

• Increasing the confidence of international investors. If a significant number of shareholders are foreigners, this should be reflected in the composition of the board. This is especially important for companies cross-listed on major international stock exchanges. This adds to the global image of the company in the eyes of potential investors and employees.

• Supporting international operations. If a company is oriented towards international operations, the board needs to have directors who are well-experienced internationally and who can provide the relevant support.

Although foreign directors can bring good ideas to the boardroom, there might be some potential drawbacks to increasing the national diversity of the board. In particular, there will be substantial costs involved in hiring foreign directors (especially if they are independent directors) from distant countries as it becomes more difficult and timeconsuming to have onsite visits and board meetings. This discourages an independent director’s incentives to gather information and closely monitor top management.

Gender diversity

Increasing female representation in the boardroom will be a trend for 21stcentury boards. Many recent academic studies point out the advantages of women’s involvement in the boardroom. Furthermore, governments and businesses all around the world are actively promoting gender diversity on corporate boards. Gender diversity on boards has three key dimensions:

1. Improving performance. Women bring different perspectives and voices to boardroom debates. They often take their non-executive director roles more seriously and are better prepared for board meetings.

2. Accessing the widest talent pool. Women are becoming more highly educated, which implies that there is now a wider pool of highly-qualified talent that companies can choose from. In Europe, approximately six out of every 10 university graduates are women. In the UK, women represent almost half the labour force.

3. Achieving better corporate governance. The more genderbalanced boards are more likely to ensure better communication and focus on additional non-financial performance measures, such as: employee and customer satisfaction, sustainability, and corporate social responsibility. They are also more likely to have new director induction programmes and close monitoring of board accountability and authority.

In some countries it is mandatory to include women in the boardroom. For instance, Spain passed a gender equality law in 2007 obliging public companies and IBEX-quoted firms with more than 250 employees to reach a minimum of 40% representation of women on boards by 2015. France passed a law in 2010 requiring French boards to have 20% female composition within three years and 40% by 2016.

In the context of this international trend towards tougher requirements on gender diversity, boards in Hong Kong need to show that they can learn from their international peers by recruiting more women directors. While these quotas for gender representation on boards overseas have brought about a marked change rapidly, the key issue is whether companies see the intrinsic value of board diversity. Shareholders should also be more pro-active in promoting diverse boards.

Information asymmetry

We discussed in part one of this article the problem of the information asymmetry between non-executive directors on the board and management. We highlighted the dangers of non-executive directors relying too heavily on management disclosures without making any attempt to verify those disclosures independently. This can prove disastrous where management is filtering or even withholding relevant information regarding the entities’ operations from the board.

David Nadler, in his article ‘Building better boards’ published in the Harvard Business Review (May 2004), shared his views on how the board can be kept in the dark. ‘One is to provide them with too little information. The other, ironically, is to provide too much’.

These problems were addressed in the US, in the wake of the Enron, HealthSouth, WorldCom, Global Crossing and Adelphia scandals, by the passage of the SarbanesOxley Act (SOX) in 2002. SOX attempts to legislate for better transparency and accuracy of information reaching the board, but the legislative route is just one of the possible solutions to reduce information asymmetry. We mention above, for example, the benefits of professional diversity in mitigating this problem. A broader network and knowledge base is the key for an effective board so that it is not the last group to hear of trouble when catastrophe strikes.

Social responsibility

The role of the board is to act in the best interests of the company’s shareholders and stakeholders. It is not enough, therefore, to be solely focused on maximising profit. Companies should maximise their financial performance by strategically managing their economic, social, environmental and ethical performance. Incorporating sustainable business strategies into the company’s outlook helps define its long-term value. Sustainable strategies include reputation management, cost control, competitive positioning and revenue opportunities. Sustainability can create business value by building reputation, enhancing employee morale and strengthening competitiveness. The board can provide supervision and accountability for corporate sustainability practices. The following methods can help to implement the sustainability concept:

• Diversify directors’ backgrounds. Apart from achieving the advantages discussed above, a diversified board can also help in incorporating sustainable strategies. The board can include people who are experts in sustainability practices who can then share their experience with the other directors.

• Start sustainability from the boardroom. A board should create an atmosphere that is conducive for sustainability not only for top management but also the entire company. Directors need to ensure that their organisation views corporate sustainability as more than just good corporate citizenship; it must be an integral component of its overall business strategy. In this process, the board plays an important role in setting up the right environment, which is the foundation for all other components of internal control, providing discipline and structure.

• Improve education and training. Development and training of directors can make the board become more effective. The board is primarily responsible for good governance practices and directors are always asked to contribute in terms of new areas of knowledge and skill sets. Continuous improvement of the individual director is becoming more and more important. Directors can attend training courses and seminars related to corporate sustainability, which can help individual board members gain insights into the current leading environmental ssues, climate change and its impact, and the newest sustainability business model.

• Establish a sustainability committee. Companies can set up a specific sustainability committee or expand the role of existing committees to include sustainability. The committee should be responsible for overseeing the incorporation and effectiveness of sustainable business activities. It should also set targets and strategies, review the performance regarding these activities, and communicate this information with top management.

A company should not initiate sustainable activities with a financial motive. The board must understand the core value of sustainability and corporate social responsibility. It must ensure that a company encourages social activities on a purely non-profitable basis and it should set up relevant policies in an ethical way and provide resources to give effect to these policies. The actual benefit from being socially responsible may not be directly evident to the company, but society as a whole certainly benefits.

Conclusion

Modern corporate boards face not only higher expectations from the public, but also increasing legal responsibilities. This article has shared some insights into the challenges for 21st-century boards and makes some recommendations to improve board effectiveness. Some of these recommendations include having more diversity on the board and setting a sustainable corporate strategy. Directors with a better network within and outside the company help to provide a better picture of the challenges the company faces and help make the board more independent of management. Having access to independent sources of information is crucial to avoid overreliance on management disclosures. All these factors can work together to improve the operation of corporate boards so that they can become more efficient and effective in the 21st century.

Ken Chan Wai Kit and Sardonna Wong Ka Yi, Department of Accountancy,

City University of Hong Kong

The first part of this article was published in the November 2012 issue of CSj (see pages 36-38). Photos of this year’s Corporate Governance Paper Competition and Presentation award ceremony can be found on the HKICS website at www.hkics.org.hk.

 

SIDEBAR: Gender diversity in Hong Kong

According to the 2012 Women on Boards survey by Governance Metrics International (GMI), women make up just 9.4% of Hong Kong directors. About 40% of Hong Kong companies do not even have a single female director. Out of the 48 constituent companies of the Hang Seng Index (HSI), 20 do not have any women directors.

According to the Women on Boards League Table 2012, published by Community Business (www. communitybusiness.org), which analyses the representation of women on the boards of Hang Seng Index (HSI) companies, the top three companies for female board representation are all in the financial sector. In Hang Seng Bank Ltd, five of the 16 board members (31.3%) are women. Four of them hold non-executive directorships and one holds an executive directorship. Bank of China Ltd comes in second place, with four of its 15 board members (26.7%) being women, all of whom are non-executives. HSBC Holdings Plc is ranked third, with 23.5% female board directors. The four women on its board of 17 all hold nonexecutive director positions.

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