This article looks at the experience of three jurisdictions with different board structures to assess what influence board structure has on governance outcomes.
While global business is becoming increasingly intertwined, due to historical and cultural reasons the basics of board structure are not harmonised but differ in different countries. The authors, who come from Hong Kong, Germany and Japan, explain the single-tier, dual-tier and hybrid board structures found in these jurisdictions, respectively, and the corresponding directors’ roles and responsibilities thereto. The analysis will give directors an understanding of the considerations applicable to different board structures in these jurisdictions, as well as their specific roles in such environments, and it will shed some light on the elusive quest of which board structure is better for good governance.
Hong Kong: a single-tier board structure
In Hong Kong, the shareholders are collectively regarded as owners of a Hong Kong company and they appoint the directors (who act for the company but not any individual shareholder in general). Aside from the requirement for directors to be aged over 18 and above, for there to be at least one natural person director for a privately held company and for all directors to be natural persons for listed companies, there is little in terms of qualification requirements for the appointment as directors to a Hong Kong company. The board structure may therefore be said to be flexible in Hong Kong, albeit with a requisite degree of personal responsibility given that a company with only corporate directors is no longer permitted, following enactment of the new Companies Ordinance (2014), as a measure of good governance.
As Hong Kong adopts the single-tier board structure (as with most common law jurisdictions including Australia, Singapore, the UK and the US), all directors belong to one board. This structure is often seen as typical for a ‘shareholder-driven’ governance system, especially in the UK and the US. While in practice certain directors can be designated as independent, non-executive or executive directors, or known by any other titles, they remain indistinguishable in terms of their responsibilities. For example, listed companies must have at least one third (and not less than three) of their directors as independent non-executive directors on the board. But the imposition of the independence requirements does not distinguish the accountability of the director from any other directors.
The major function of the board is to oversee the execution of company strategy, while the shareholders, subject to the constitutional documents, perform an overall empowerment and monitoring role over the board of directors for the interests of shareholders collectively. As such, the power of appointments, except for filling in casual vacancies at the board of directors, vests with the shareholders’ meeting. This board system works well, as the roles and responsibilities are well defined under the constitutional documents and the Companies Ordinance. With the prevalence of family and Chinese state ownership of major listed companies, concentrated ownership means that many boards reflect the interests of these major shareholders. Research on the topic of concentrated ownership has shown that, because of the long-term views adopted by the company and its management, minority shareholder investment returns do not necessarily suffer and at times can be higher than diversified ownership companies.
All directors owe the same duties to the company to which they are appointed. That is, they must consider the best interests of the company in their dealings for the company to a standard commensurate with what a reasonable director in their position would do, or in the case of specialised directors with higher knowledge, to a standard commensurate with the skills and knowledge they possess. In short, directors have a high degree of responsibility and cannot hide under any title given to them. Further, at law there are limitations to indemnities, ratification and directors’ and officers’ insurance that can be purchased to cover directors’ exposures to personal liabilities.
This means that directors must be well versed in law and good governance practices as risk mitigation prior to taking any appointments as directors for Hong Kong companies, especially listed companies. There are additional obligations imposed under Hong Kong’s listing rules and securities law, and the Securities and Futures Commission (SFC) is taking a front-loaded and direct enforcement approach against directors’ misfeasance, including breaches of directors’ duties. With the possibility of shareholder derivative actions under the new Companies Ordinance and the recent stance of the SFC towards listed issuers, the authors would rank director duties and responsibilities as serious.
Germany: a dual-tier board structure
In Germany, shareholders are collectively regarded as owners of a company. Germany adopts a dual-tier board structure for stock corporations, known as Aktiengesellschaft (AG). Countries with similar dual structures include China, Indonesia, Russia and South Africa. In addition to the powers reserved to the shareholders’ meeting, the day-to-day powers in a German AG are split between an executive board or management board (Vorstand) and a supervisory board (Aufsichtsrat). The latter is appointed by the shareholders (except for the employee representatives therein) – a structure often seen as a prototype of stakeholder orientation. No person (for example the CEO or CFO) can be a member of both the management and supervisory boards – with the management board members being roughly equivalent to the executive directors, and the supervisory board members similar to non-executive directors. There are no independent directors required for either of the boards.
The management board consists of at least one member. It has the role to independently manage and represent the company. It has full responsibility for the day-to-day business and its powers are only restricted by existing law, the Articles of Association and rules of procedure. Its members are jointly responsible for the management of the company. Even when they are assigned specific functions or business sectors, each member of the management board remains accountable for the management of the entire company. Management board members have to exercise general control in the interest of the company, including the duty to also inquire in areas assigned to colleagues (for example, the CEO). They cannot excuse themselves by purely focusing on their assigned duties. Also, the management board’s authority as representative of the company towards third parties cannot be limited. Specifically, its members cannot be given any direct instructions by shareholders except for certain consents required for matters like mergers and acquisitions and budgets through the supervisory board where the shareholders have an influence.
The supervisory board, with a minimum of three members, appoints, supervises and advises the management board. The supervisory powers include supervision over financial statements, management actions and reports, audit matters and the calling for extraordinary shareholder meetings where required. Also, investments over certain thresholds typically require supervisory board approval. The board’s work can be organised in committees, and typically large companies would at least have a nomination and an audit committee. All supervisory board members are fully responsible for committee acts and decisions whether they are committee members or not. The supervisory board also represents the company in all legal issues against the management board, but it otherwise does not take on a representative role. For example, the chairman of the supervisory board of a German AG will not directly engage with investors – this is left to the management board members, normally the CEO and CFO.
There are no specific requirements regarding the qualifications and selection of management board members beyond their ability to observe the duties of care and loyalty of a diligent and prudent business person. Under Germany’s ‘business judgement rule’, decisions made by the management board shall be for the benefit of the company. For the supervisory board, a proportion of one third or one half of the seats is allocated to employee, representatives for companies above 500 or above 2,000 employees, respectively, and special voting rights can be given to the chairman.
There is no statutory-backed corporate governance code for listed companies, as in Hong Kong. Rather, a voluntary and widely followed code for listed companies (Deutscher Corporate Governance Kodex) exists with the intention of convergence to wider international standards. Germany follows a ‘comply or explain’ regime where misrepresentations, including for disclosures made, can have legal consequences. Under German jurisdiction, liability towards the company, whether listed or not, is generally unrestricted and unlimited for both the management and supervisory board members, and current practice sees more and more activity in this field. The authors would therefore rank director duties and responsibilities as increasingly serious.
Japan: a hybrid board system
In Japan a joint-stock company, known as kabushiki kaisha (KK), is the most common type of corporate form. While there are varieties of governance structures available for KK, all types of KK must have a shareholders’ meeting and at least one director. The directors are appointed by the shareholders’ meeting. All directors must be natural persons, and apart from certain limited disqualification causes (for example having a criminal record), there are no statutory requirements relating to director qualifications, while all directors of a KK can be foreign nationals or residents. Each director owes the duty of care as a good manager and the duty of loyalty to the company, and is liable to the company for damages caused by its breach thereof, with the business judgment rule being applicable. The liability of non-executive directors may be limited by a contract with the company.
All large public companies must have a board of directors consisting of at least three directors, out of which the board must appoint a representative director who represents the company. The role of the board of directors (of the traditional model) stipulated by law is to make decisions on business execution and to monitor the execution of business (both management and monitoring roles), while the execution of business itself is effected by the representative director and other executive directors appointed by the board of directors. Traditionally, it has been typical for Japanese companies to have most members of the board as executive directors usually internally promoted from the employees, which makes it more of a management-focused board rather than one focused on monitoring. In order mainly to strengthen the monitoring and supervisory role of the board, new rules requiring external or independent directors, along with the new board structures stated below, have been introduced in recent years.
In contrast to Hong Kong and Germany, Japan provides multiple options for the board structure, and for large public companies there are now three options available for the board:
- the board of statutory auditors model
- the three committees model, and
- the audit and supervisory committee model.
The ratio of each model among listed companies is: (1) 79.8%, (2) 2%, and (3) 18.2%, according to Tokyo Stock Exchange (TSE) research (see Tokyo Stock Exchange Listed Companies White Paper on Corporate Governance 2017, available online at: www.jpx.co.jp/english/news/1020/b5b4pj000001nivy-att/2017.pdf).
The board of directors with the statutory auditors (kansayaku) model is the traditional and most common structure for large public companies. This model requires, in addition to the board of directors, that there be a board of statutory auditors. The board of statutory auditors consists of three or more statutory auditors appointed by the shareholders’ meeting, of which more than half must be external statutory auditors. Although there are two boards, this is quite different from the German dual-tier board structure. The major role of the statutory auditors is to audit the performance of the directors, covering both business and financial auditing, and each statutory auditor is to perform the role independently. They must report to the shareholders’ meeting on the outcome of the audit, while they have the right to investigate the company’s business and assets and must attend the board of directors’ meetings and express their opinion when necessary. If the statutory auditors find a violation of law or the articles of incorporation by the directors, they must report it to the board of directors and may seek a court order to stop it if such violation is likely to cause significant damage to the company. Unlike the German supervisory board, the statutory auditors do not have rights to appoint or remove the representative and other executive directors.
The board of directors with the three committees model was introduced in 2003. This requires the nomination, audit and remuneration committees under the board of directors to have three or more directors, of whom more than half must be external directors. Under this model, the execution of business is carried out by executive officers appointed by the board and the main role of the board is monitoring their performance. However, unlike a typical supervisory board in other jurisdictions (for example Germany), this model allows the directors to be appointed as the executive officers concurrently. Only a small number of listed companies have adopted this model (around 2%). A major reason is said to be the reluctance to include external directors’ significant involvement in the nomination and remuneration of the directors under this model.
The final model of the board of directors is the audit and supervisory committee model, introduced in 2015. This requires an audit and supervisory committee consisting of three or more non-executive directors, of whom more than half must be external directors. The role of the committee is similar to that of the statutory auditors, except that it is also required to give its opinion on the nomination, removal and remuneration of the non-member directors and may express this opinion at the shareholders’ meeting. This model allows the board to delegate a significant portion of its decision-making to the representative and other executive directors for more timely and efficient decision-making, and to focus more on monitoring and supervising thereof, which is said to be one of the major reasons for its status as the second most popular model and is the incentive to adopt this model over the conventional model.
As to the external director requirement, a statutory ‘comply or explain’ rule was introduced in 2015, which requires a listed company without any external director to explain the reason for this. Additionally, the TSE rule requires a listed company to have more than one independent director or statutory auditor and, with the introduction of the corporate governance code in 2015, a company listed in the first or the second section of TSE is required to explain the reason if it does not have more than two independent external directors. The scope of ‘independent’ by definition is more limited than that of ‘external’.
Conclusion: contextual models
While it is often argued that the cross-border application of corporate governance requirements drives much of the convergence visible today, the authors offer a different perspective. Although there is indeed a substantial development of both regulatory frameworks and practices going on, different backgrounds seem to shape the respective paths taken by different jurisdictions. The structure of boards in different regions is a mere reflection of this.
Thus, it is no surprise that academic reviews and empirical studies find only limited evidence of convergence in governance across countries, and then mostly in form rather than substance. Still, some forces behind the development of corporate governance seem the same – such as a quest for greater governance efficiency and legitimacy towards capital markets. This complex and dynamic environment makes the role of the director both challenging and interesting – and it should ensure that studying cross-country governance will remain a captivating and instructive field.
Mohan Datwani FCIS FCS(PE), Senior Director and Head of Technical & Research
The Hong Kong Institute of Chartered Secretaries
Junko Dochi, Attorney at Law (Japan and California)
DOCHI Law Office
Kai-Uwe Seidenfuss, Deputy Managing Director
Lei Shing Hong Ltd