Changing rules, changing roles – managing it all
The winning paper in this year’s Corporate Governance Paper Competition examines the recent changes brought in by Hong Kong Exchanges and Clearing (HKEx) to corporate governance requirements to raise the overall standard of issuers’ corporate governance, and coordinate HKEx’s Corporate Governance Code and listing rules with international best practice.
Corporate governance is the key to determining the effectiveness and sustainability of a company since it is the framework that guides and directs companies to achieve their goals and objectives in a way that adds value to the company and maximises the interests of stakeholders. It is known to have direct correlation with a company’s share price.
The major aim of the recent changes to the corporate governance requirements introduced by Hong Kong Exchanges and Clearing (HKEx) was to raise the overall standard of issuers’ corporate governance and coordinate HKEx’s Corporate Governance Code (the Code) and listing rules with international best practice.
Issuers and the market as a whole can benefit from more effective and efficient corporate governance. The revised Code and listing rules give rise to better accountability of issuers and directors. The amendments not only improve transparency, but also raise the quality and effectiveness of directors and company secretaries as well as bringing into sharper focus the vital functions of different board committees.
However, the ever-changing and more stringent rules may challenge issuers. It will take time to implement concrete measures to comply with the rules while directors, committees and company secretaries need time to adjust to the new roles.
Although Hong Kong has long been one of the most sustainable and balanced economic environments in the world, board diversity is still an area requiring improvement. In December 2012, investment management fund BlackRock fund analysed 35 blue chip companies and found that 40% of them had no women on their boards. To tackle this issue, HKEx introduced a new Code provision on board diversity in September 2013; this affects more than 1,500 listed companies in Hong Kong.
According to the Board Diversity Policy Statement announced in February 2013, board diversity covers many areas, such as gender, age, educational and cultural background, ethnicity, skills, professional experience, length of service and knowledge.
To evaluate the performance of companies when complying with this policy, the nomination committee monitors, reviews and reports on the board composition annually in the company’s Corporate Governance Report. It also discusses and recommends any revisions to the policy so as to ensure its effectiveness.
The Code says that a balance of skills, experience and diversity of perspectives, which are appropriate to the requirements of the businesses of the issuer, should be found on its board. For example, a balanced composition of both executive and non-executive directors should be included to create a strong independent element on the board and hence exercise independent judgement effectively.
This new provision has brought about tremendous changes to most of the issuers in Hong Kong. The most significant change is the potential for better decisionmaking. By considering a broader range of perspectives, board effectiveness as well as decision-making can both be improved.
A board consisting of like-minded people from similar backgrounds may lead to groupthink, in which the decisions made by them may not be in the best interests of the company as they may not have received enough scrutiny. On the other hand, having a board composed of people from different backgrounds and with differing professional and personal experiences enables the board to approach issues from different angles, allowing the board to come up with more diverse viewpoints and suggestions. This can lead to improved corporate performance.
Extended benefits of board diversity
Board diversity can also enable companies to better manage risks. The board acts as the governing body, which oversees and directs a company’s affairs. Having a diverse board of people with different areas of professional expertise can facilitate greater insights and discussion, even over complicated business and technical matters. This allows the board to anticipate and manage risks, devise wise strategies and make good choices, even if risks are involved.
Board diversity can also create a better public image for companies. Having a wide pool of talent from different genders, ethnicities, ages, races and cultures, produces a competitive advantage while creating a positive and successful impression for the public. Having a diverse workforce enables other stakeholders to foresee many potential benefits of investing in or working with that company. It is therefore easier and more convenient for the company to enter new markets and maintain high customer loyalty as well as boost employee morale.
These positive effects of board diversity can ensure fairness. This is because a broader range of perspectives enables companies to approach and consider more possible ideas and business strategies, so that all the shareholders, including minorities, can be treated equally and fairly. This in turn protects the rights of both shareholders and companies. From this, we can see that the new provision regarding board diversity has driven the corporate governance system to become more comprehensive and complete.
Duties of directors
One of the significant changes to corporate governance has been those relating to directors’ duties. Directors no longer only have a brief idea of the companies whose boards they sit on; they are now expected to be closely involved with the issuer’s Rule 3.08 of the Main Board Rule and GEM Rule 5.01 state that directors are required to take an ‘active interest in the issuers’ affairs’ as well as to ‘obtain a general understanding of its business’. They are obliged to follow up and investigate anything they notice that is untoward. Merely clocking up attendance at formal meetings does not mean that the directors’ duties are satisfied.
The above change reflects greater accountability. Having directors more involved in the issuer’s business gives the board a better understanding of the business, and the company can clarify who is accountable for their decisions and performance, ensuring that power and resources are used appropriately and are aligned with the firm’s best interests. By doing this, organisations can be run more efficiently and effectively.
In fact, recently there have been growing expectations of competence and accountability across the globe. Several examples come from Australia (these include Centro, James Hardie and Fortescue). Seven former non-executive directors, three former executive directors and the company secretary/general counsel of James Hardie Industries Ltd were found to have breached their duties of care and diligence as they failed to read and understand financial reports. According to King & Wood Mallesons, client alerts on Centro on 1 September 2011 and 30 June 2011, as well as those on Fortescue on 8 March 2011 and James Hardie on 13 May 2011, all discussed the recent landmark disclaimers on the duties and liabilities of directors. It is expected that Hong Kong regulators and stakeholders, when considering the standards by which directors in Hong Kong listed companies should be judged, will mention these cases.
Another change to the Code, the new provision C.1.2, requires issuers to provide monthly management updates to directors. These must be ‘sufficient to give directors a balanced and understandable assessment of the issuer’s performance, position and prospects’.
This change will help directors carry out their duties effectively while creating greater transparency. Providing monthly management updates that are balanced and understandable can provide directors with useful information to review and forecast the issuer’s performance. In this way, accurate and timely disclosure of crucial information, including the issuer’s performance and sustainability, can be ensured.
Other amendments to the Code reveal that the board of directors is now expected to evaluate the acceptability of the time directors spend on the company’s affairs, while the board must be notified of all significant changes to time commitments.
Previously, there was a provision obliging directors to attain at least eight hours of training in a financial year. After recent changes, the Code places more emphasis on the disclosure of how directors comply with their training obligations instead of merely requiring them to undertake a certain number of training hours.
This change can help better define and clarify the responsibilities of directors. By attaching more importance to how directors comply with their training obligations, the role of directors has been transformed to ensure a closer connection with the issuer’s affairs. Cooperation between the company and board of directors is encouraged so as to create and enhance value as well as to maintain sustainability.
Directors’ voting rights
One of the noticeable changes in rules is associated with the voting rights of directors, with the removal of the 5% threshold for voting by a director in a situation in which they have personal interests.
In the past, directors with 5% or less interest in issued shares or voting rights of companies were allowed to vote on a board resolution, on the basis that a 5% interest was deemed negligible. However, this exemption has now been removed, while directors are also required to consider whether transactions are material.
This adjustment prevents a conflict of interests when voting, hence ensuring fairness. Stakeholders’ interests are protected, while all shareholders are treated equally. The whole voting process can then become more objective.
Independent non-executive directors
Rule 3.10A, requiring that at least onethird of the board must be independent non-executive directors (INEDs), was amended with effect from 31 December 2012. HKEx now puts more emphasis on facilitating strong INED representation on the board. According to HKEx, the new rule does not impose a heavy burden on issuers since 80% of them need appoint only one additional INED to fulfil the requirement. Another option is to reduce the number of directors.
The growing importance of INEDs in maintaining good corporate governance is demonstrated in further new amendments – as stated in the new Code provision, an INED who has been in his post for more than nine years will continue to serve only with shareholders’ approval, and the issuer will need to clarify the reasons for the INED’s re-election and his/her independence. New Rule 3.25 states that issuers must establish a remuneration committee chaired by an INED and one that has a majority of INEDs as committee members. Meanwhile RBP A.4.4 recommends an issuer establish a nomination committee with a majority the membership being INEDs.
Auditor and company secretary
Shareholders’ approval at a general meeting is required for the appointment or removal of an auditor. To foster transparency, and to ensure shareholders fully understand why an auditor is being removed, an issuer proposing to remove an auditor needs to send a circular to shareholders and the auditor is allowed to make representations to shareholders. An issuer also has to ensure that auditors attend the annual general meeting in order to have full understanding of the company.
To comply with a new Code provision, a company secretary’s selection, appointment or dismissal must be discussed at a physical board meeting, to ensure these events receive proper board attention. New rules regarding qualifications and experience for company secretaries are set out, along with a new section in the Code defining their roles and responsibilities. In particular, a company secretary needs to engage in 15 hours of professional training each financial year in order to comply with a new rule. These measures are to ensure company secretaries have sufficient skills and knowledge to perform their duties.
A new Code provision for the audit committee states that the audit committee should be responsible for arrangements enabling employees to bring up concerns over financial reporting improprieties. Another Code provision states that an audit committee should arrange meetings with the external auditor at least twice a year. This is to ensure the effectiveness of the company’s accounting and financial policies and controls. Recommended best practice is that the audit committee should establish a whistleblowing policy and system.
HKEx has made attempts to enhance the effectiveness of board committees through a set of new measures. For instance, an issuer must form a remuneration committee in which the majority of members are INEDs, with an INED chairman, and clear written terms of reference for the committee must be published. Similar sets of recommended measures also apply to the nomination committee (although the chairman is allowed to be either the board chairman or an INED). HKEx gives flexibility to issuers on either setting up a corporate governance committee or allowing the board to elect to perform this role itself.
Joyce Tang Dik Ying, Department of Accountancy, Lingnan University; and Stacy Wong Hei Yu, School of Accounting and Finance, The Hong Kong Polytechnic University
In the second and final part of this article, to be published in next month’s journal, the authors make recommendations on how to further the goals of HKEx to build better corporate governance in line with international common practice.
SIDEBAR: About the Corporate Governance Paper Competition
The Institute’s Corporate Governance Paper Competition is designed to promote awareness of corporate governance among local undergraduates. The competition is run in tandem with the Institute’s biennial Corporate Governance Conference. Authors of the competing papers also enter a presentation competition and the awardees of both competitions receive their certificates at the Corporate Governance Conference.