Does more disclosure mean better governance?
The Institute’s Corporate Governance Paper Competition is held annually to raise awareness of corporate governance issues among local undergraduates. This year’s competition was held on the theme ‘Corporate governance means more reports and disclosure?’ This first part of the winning paper explores the relationship between corporate governance and disclosure.
In the aftermath of the global financial crisis, it is widely recognised that more comprehensive reporting mechanisms and stringent disclosure requirements are key to abating the severity of the crisis. Although inadequate disclosure did not directly lead to the economic downturn, it did hinder governments from reacting to and resolving the ensuing crisis in a timely manner before the problems grew worse. The importance of disclosure should not be underestimated.
Good disclosure practices enable corporations to attract investments and maintain confidence in capital markets by providing stakeholders with access to more reliable and regular information for making decisions. Corporate governance scandals such as Enron and WorldCom have prompted companies to follow more stringent disclosure requirements. Despite the apparent benefits brought
by disclosure, it is too early to draw the conclusion that more reports and disclosure equate to higher standards of corporate governance. Excessive disclosure could lead to unforeseen problems that might outweigh the benefits.
This study analyses the issues from a general perspective, with a focus on the regulations and rules in Hong Kong, though references are made as appropriate to other jurisdictions for more all-round comparisons. The main argument of this study is that disclosure and reports are necessary for, but not by themselves enough for, good corporate governance.
Disclosure in Hong Kong
The mandatory disclosure requirements in Hong Kong are stipulated by:
- the Companies Ordinance (currently
- Cap 32, but Cap 622 from March 2014)
- Securities and Futures Ordinance (Cap 571)
- Securities (Disclosure of Interests) Ordinance (Cap 396), and
- the listing rules.
Having formalised mandatory disclosure requirements ensures the quality of materials published for the general public and cultivates effective enforcement practices among companies, but over- regulation and excessive government intervention might hinder the free operation of the market. In this respect, it is more desirable for companies to develop a self-disciplinary culture to voluntarily disclose information to investors as a supplement to mandatory disclosure.
Companies can provide information over and above the minimum statutory or regulatory requirements, but this is clearly a self-regulatory practice and there will be differences in the degree to which companies will adopt voluntary disclosure depending on their different managerial philosophies. Essentially, it provides companies the opportunity to describe and explain their investment potential to investors. Some of the most useful voluntary disclosures are the metrics used by companies in their operations management and business strategies. Since disclosure is voluntary, companies are not obliged to continue to make the disclosure in subsequent periods.
Both creditors and investors are able to benefit from informative voluntary disclosure. From the creditors’ perspective, voluntary disclosure can enhance creditability and forge bonds with investors so that they can access financial markets with narrower price changes between transactions. Investors, on the other hand, benefit from the reduced likelihood that companies will misuse or misallocate their capital.
Disclosure to the public can also be performed by information intermediaries, such as financial analysts, industry experts, and the financial press. They engage in information production to unravel any misuse or misallocation of company’s resources by managers. However, the significance of information intermediations may gradually fade away as voluntary disclosure pre-empts analysts’ ability to distribute private information to the general public.
Disclosure and corporate governance
Transparency is a crucial indicator of the level of corporate governance in a corporation or an economy as a whole. The core idea is to disclose material information which serves the purpose of understanding the company’s strategic goals and affects stakeholders’ interests.
According to the OECD Corporate Governance Principles, the ‘corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company’. Hence, the degree of disclosure is a kind of measurement of a company’s corporate governance.
Indeed the Walker Review, Published in the UK in July 2009 in response to the global financial crisis, confirms that quality disclosure is an indispensable criterion to achieving good corporate governance. In order to monitor management, a sufficient degree of disclosure is required for shareholders to spot potential problems with the management or with alleged transactions.
Nonetheless, a transparent company does not necessarily have sound corporate governance. Corporate governance is a broad concept encompassing a wide range of elements, such as equitable treatment of shareholders, roles of other stakeholders, responsibilities of the board, etc. Yet the success of corporate governance is still to a large extent affected by the degree of transparency in the company, measured by the availability of information concerning stakeholders’ interests.
Benefits of disclosure
1. Macro perspective
Promotion of an efficient market. Good disclosure practices have a positive influence on domestic and global financial markets. Annual reports, prospectuses, news clippings, road shows, etc, are communication channels that enable investors to catch a glimpse of the company’s ideology, operation, business prospects, financial strength, etc. In the absence of proper disclosure mechanisms, investors find it almost impossible to obtain useful investment clues and are more likely to make the wrong investment decisions.
The collapses of large banks and corporations such as Lehman Brothers, Merrill Lynch, American International Group (AIG) and Halifax Bank of Scotland (HBOS) during the financial crisis in 2008 are financial debacles that manifest inadequate regulatory efforts and poor conversations between the institutions and their investors.
For financial markets to function efficiently, the share price has to fully reflect the value of the issuing company. The contemporary market takes at most a semi-efficient form since, in reality, private insider information always exists, preventing share prices from fully reflecting the value of the company. As more information becomes available to the public by means of disclosure, there is a tendency towards a strong and efficient market.
Having an efficient market provides a nourishing ground for investors to make informed investment decisions on securities such as stocks, bonds, debentures, etc, based on unbiased prices in reliance on publicly available information.
Protection of investors. Disclosure provides shareholders with information they need to exercise their rights and obligations, such as receiving dividends, voting for directors in shareholders’ meetings, subscriptions to new issues of securities on the same terms as the insiders, etc. Investors can also assess the risks of investments and hedge the investments if necessary. Although having more disclosure does not guarantee that shareholders can fully understand the information, it does give them a choice to utilise the information in whatever way they prefer to protect their interests, for example, hiring an analyst to interpret the information before making investments.
Price stability. As the market price to a large extent reflects the true value of the company, it is more difficult for arbitrageurs to exploit profit opportunities and cause drastic price changes, thereby dampening price fluctuations and providing a more stable investment environment.
Liquidity. Enhanced information publication allows people to be less concerned about any differences between intrinsic value and market value. They are less likely to spend time worrying the core idea is to disclose material information which serves the purpose of understanding the company’s strategic goals and affects stakeholders’ interests about share prices and more likely to inject capital into the market. As a result, liquidity increases in an efficient market.
Avoidance of ‘betting’ behaviour. As mentioned above, arbitrageurs find it hard to make profits in a more efficient market. They therefore provide liquidity to investors who need financial securities for purposes other than ‘betting’.
2. Micro perspective
Increase in company value. Companies’ values are likely to improve where good disclosure practices are followed. Better disclosure encourages companies to pay more attention to their internal management and public image. Moreover, expanded disclosure, from the financial perspective, leads to an upward valuation of the companies’ stock due to a boost in investor confidence. As a result, the firm’s liquidity improves and it arouses the interests of more institutional and individual investors.
Enhanced monitoring abilities. The ability of shareholders and boards to monitor management is improved when more reports are circulated for disclosure purposes. In particular, expropriation of minority shareholders can be stopped since they get the chance to inspect the companies into which they are injecting capital. It is not uncommon to observe that in many listed companies the majority shareholders often take control of the management and sit on the boards. They can easily manipulate voting and pass resolutions in favour of their own interests, depriving minority shareholders of their rights. By allowing more transparency over corporate operations, shareholders possess more information to help them make proper investment decisions, such as reducing the amount of their investment, or even withdrawing shares from the company, if they are concerned about or disapprove of company policies or practices. Shareholders can also resort to legal action in the case of illegitimate oppression.
Lower cost of capital. In financial markets, one party often does not know enough about the other party to make accurate decisions. This phenomenon creates the problems of adverse selection and moral hazard, and undermines the functionality of the financial market. Disclosure is intended to alleviate these problems, reducing the asymmetry of information between those inside the firm and those outside it, and enhancing a firm’s ability to raise capital at lower costs.
Undergraduate Bachelor of Business Administration and Law, University of Hong Kong
SIDEBAR: Meet the author
CSj interviews the author of the winning paper in this year’s Corporate Governance Paper Competition – Tommy Lau, Bachelor of Business Administration and Law undergraduate, University of Hong Kong.
Congratulations on winning the HKICS Corporate Governance Paper Competition – how did you come to hear about the competition and why did you decide to take part?
‘My school sent out an email about the competition and, although the topic was new to me, I was interested in it. Also I wanted to practice my writing skills and of course the prize money was attractive!’
The theme of this year’s competition was ‘Corporate governance means more reports and disclosure?’ Do you think good corporate governance necessarily mean more disclosure?
‘I think good disclosure is a component of good corporate governance. The global financial crisis demonstrated that corporate disclosure requirements were not stringent enough before the crisis, companies were able to find ways to limit their disclosures to the public which contributed to the crisis. But if you have good disclosure you don’t automatically have good corporate governance since corporate governance is about many other things in addition to disclosure.
For example, a major component of corporate governance is the way the board of directors operates. The board is the head of the company so the behaviour of directors must be in good faith and honest and they need to ensure that the company is heading in right direction. But the more research I did for this paper, the more I realised that corporate governance is actually about much more than the way a company is run. You need to look at the relationships between different stakeholders of the company and the way the company balances their interests.
In some cases this will be obvious, for example companies need to protect the interests of minority shareholders when planning corporate transactions. But it also goes further than this since companies need to consider the interests of other stakeholders such as employees and customers. There is a global trend for companies to focus more on being socially responsible and this means considering the interests of society as a whole rather than just the shareholders’ profits.’
Do you think your generation takes these ideas of the social responsibility of companies and stakeholder inclusiveness more seriously?
‘Yes. In my business course we cover corporate social responsibility and the need for companies to care about issues like environmental protection and income disparity for example. Companies cannot afford to be solely focused on profit. I think my generation has more knowledge about these issues and cares more about them than the older generation.’
Your paper highlights the many advantages of good disclosure and makes the point that companies should go beyond the statutory minimum mandatory disclosure – would you like to add any comments on that point?
‘I think it’s important to remember that the mandatory disclosure requirements set out in law are only minimum requirements and there are many benefits if companies are willing to disclose more to stakeholders. The most obvious benefit is that this will boost investor confidence in the company – not only will it mean that investors have a better knowledge of the company but also a good record on disclosure will indicate a well-run company.’
Your paper also makes the point that companies should avoid too much disclosure?
‘When I started my research for this paper I assumed that more disclosure can only be beneficial, but I came to recognise that too much disclosure can be a disadvantage. Firstly, if you disclose too much it might be hard for investors to digest all the information – particularly where the disclosure relies on technical financial terms that will be hard to understand. Secondly, companies are understandably reluctant to let their competitors know too much about their business model.’
What are your career plans for the future – would you like to be involved in corporate governance work?
‘I’m not sure yet what career I will choose, I am still looking at this. I would like to work in the legal field but I am also interested in working in business. I am interested in corporate governance – the issue of how companies are run and how they should be run is very important topic. But writing this paper has broadened my understanding of what corporate governance means. I understood it to be about the management of the company, and it is about that, but my research made it clear that there are many different aspects to this subject.’
One final question – do you think the HKICS Corporate Governance Paper Competition is a good way to promote the awareness of corporate governance among undergraduates in Hong Kong?
‘Yes, I think it is. To write a paper on a corporate governance theme means you have to do a lot of research to understand the issues. Also, after writing the paper, you can compare your work with the other contestants’ papers, so you can share ideas and understand how other people are thinking about the topic.’