David Graham, Chief Regulatory Officer and Head of Listing, Hong Kong Exchanges and Clearing Ltd, outlines the meaning of ‘compliance’ in a principles-based regulatory regime.

The purpose of corporate governance regulation is to facilitate effective and prudent management that can deliver the sustainable success of a company over the long-term. Regardless of the size of a company, good corporate governance is a key component of a positive corporate culture and can give a company a competitive edge over its peers. A strong corporate governance framework helps promote good management, integrity and better internal control, which can, in turn, improve a company’s performance, enhance its reputation and ultimately render it more attractive to both customers and investors.

Studies have shown that there is a positive correlation between a company’s stock returns and the quality of its corporate governance practices (See ‘Corporate governance and equity prices’, The Quarterly Journal of Economics, 118(1), 2003; and ‘Do investors really value corporate governance? Evidence from the Hong Kong Market’, Hong Kong Institute of Monetary Research Working Paper No 22, 2005). Investors value and reward companies with strong corporate governance cultures.

Good corporate governance not only benefits companies, but also contributes significantly to financial market stability, investment and economic growth. It is one of the primary factors determining where investment money flows. Investors have far more confidence in markets that respect the core principles of corporate governance, including fairness, openness and transparency, accountability, board oversight, and respect for the rights of shareholders and the role of key stakeholders.

For the Hong Kong market in particular, good corporate governance is critical to maintaining its long-term relevance, viability and competitiveness. Hong Kong’s corporate governance standards have been commonly cited as one of the main attractions for Mainland Chinese companies to list here. A Hong Kong listing helps Mainland Chinese companies build their brand internationally and signals a vote of confidence to their investors.

Role of the Exchange

Developing a strong corporate governance culture and continuing to improve the standards of corporate governance in Hong Kong takes the commitment of numerous stakeholders, including regulators, practitioners and investors in addition to the companies themselves.

The Securities and Futures Commission, Financial Services and the Treasury Bureau and other governmental bodies all play a part in upholding high standards of corporate governance. Key corporate governance requirements are codified in Hong Kong law, such as fundamental shareholder rights and directors’ duties under the Companies Ordinance, and the prohibition of insider dealing under the Securities and Futures Ordinance.

Whilst Hong Kong’s corporate governance regime for listed companies contains some mandatory requirements, the Stock Exchange of Hong Kong (the Exchange) mostly adopts a principles- based approach. This non-prescriptive method aims to improve corporate governance standards without micromanaging companies’ affairs and stifling their business activities and recognises the diversity and individuality of listed companies.

The Exchange’s Corporate Governance Code (Appendix 14 of the Main Board listing rules and Appendix 15 of the Growth Enterprise Market listing rules) sets out principles of good corporate governance and two levels of recommendations for achieving those principles – Code Provisions, with which a company must ‘comply or explain’, and Recommended Best Practices. The aim of this framework is to give companies the room to find their own ways to fulfil the ‘spirit’ of the Code. This recognises, by design, that companies may be able to adopt different measures to those set out in the Code and achieve equally good results.

Companies often prefer clearly prescribed rules and to be told exactly what they have to do to avoid breaching those rules. Prescriptive rules also make the regulator’s job easier as determining compliance is more straightforward. However, it is recognised globally that dictating a corporate governance solution may prevent companies from determining the best one for their own circumstances. While the Exchange can provide tools for companies to develop strong corporate governance practices, monitor companies’ compliance, and give guidance or make recommendations for improvement, the quality of corporate governance ultimately depends on the commitment and voluntary conduct of companies and their boards.

The purpose of a ‘comply or explain’ approach

The ‘comply or explain’ approach is a framework that allows companies to put together the best possible corporate governance regime for their own circumstances. Companies can adhere to the Code’s Principles by choosing between complying with Code Provisions or adopting alternative measures so long as they disclose clearly and thoroughly their reasons for choosing the latter. To this end, the Corporate Governance Code encourages companies to consider their own individual circumstances, the size and complexity of their operations, and the nature of the risks and challenges they face to determine the most suitable and appropriate solution.

What does compliance with a Code Provision mean?

It is common practice amongst listed companies to make blanket statements in their corporate governance reports to the effect that they have complied with all the Code Provisions except for ‘A, B and C’. However, it is important for companies to ensure that they have carefully considered whether they have complied with each and every part of a Code Provision before making such a statement. Issuers are reminded that non-compliance with any part of a Code Provision, without giving considered reasons, constitutes a breach of the listing rules.

The Exchange spot-checks compliance

The Exchange conducts spot-checks of companies’ compliance with the Corporate Governance Code from time to time as part of its ongoing monitoring activities. It came to our attention recently that, in some cases, companies had confirmed compliance with a Code Provision, but upon closer inspection of their corporate governance reports, this turned out not to be the case.

For example, Code Provision A.5.6 states that the nomination committee (or the board) should have a policy concerning the diversity of its board members, and should disclose the policy, or a summary of it, in its corporate governance report. A number of companies failed to comply with both limbs of this Code Provision. Whilst nearly all companies whose corporate governance reports we examined stated that they had complied, a number of them neither made the required disclosure, nor gave reasons for this departure from the Code Provision. To bring this to the attention of listed issuers, the Exchange has reminded all issuers that only compliance with all aspects of a Code Provision amounts to compliance (see the Exchange’s letter to listed issuers ‘Re: Guidance on Compliance with the Corporate Governance Code’, 2 July 2014 available online at: www.hkex. com.hk/eng/rulesreg/listrules/listletter/ Documents/20140702.pdf).

Not ‘box ticking’

Corporate governance compliance is not a ‘box-ticking’ exercise. The aim of the Corporate Governance Code is to achieve the substance of good corporate governance, not just the form. Again we can take Code Provision A.5.6 as an example, the Note to which states: ‘Board diversity will differ according to the circumstances of each issuer. Diversity of board members can be achieved through consideration of a number of factors, including but not limited to gender, age, cultural and educational background, or professional experience. Each issuer should take into account its own business model and specific needs, and disclose the rationale for the factors it uses for this purpose.’

During our spot-checks, we found many companies disclosing their board diversity policies in identical language to the Note of the Code Provision. While this may constitute compliance in form, it may not necessarily constitute compliance in substance if the company has in fact never considered the issue seriously. The Note is there to serve as a prompt for companies to carefully consider the substance of their board diversity policy.

Disclosure on how companies have complied with Code Provisions

Companies in full compliance with the Code Provisions should nonetheless fully disclose how they have complied with the Code Provisions in practice. The Exchange found in its Analysis of Corporate Governance Practice Disclosure in 2012 Annual Reports (published in November 2013) that many companies offer little by way of explanation on their method of compliance.

Is explaining an inferior solution to complying with a Code Provision? The underlying philosophy of the Corporate Governance Code is that ‘one size does not fit all’, which recognises the reality that all companies are different, and accordingly, their corporate governance solutions may also differ. Companies should look at their own circumstances when contemplating whether to adopt a particular Code

Provision or to opt for a more suitable alternative. The Corporate Governance Code reminds shareholders that these alternative solutions are not breaches. This is as long as the company’s explanation gives clear and considered reasons for adopting an alternative solution and illustrates how its actual practices are consistent with the relevant Principle and contribute to good corporate governance.

Adopting a boilerplate approach and merely quoting commonly used reasons for deviations from the Code Provisions is not helpful to shareholders. Companies should bear in mind when preparing corporate governance reports that their explanations should be as full as is necessary to meet the Exchange’s expectations and those of their shareholders.


Hong Kong’s financial market has enjoyed tremendous success over the years, due in no small part to the transparency and fairness of its regulatory and legal system. Hong Kong has been recognised for its strong corporate governance in various international surveys. For example, the World Bank’s Doing Business 2014 ranked Hong Kong third in the world for investor protection (see Doing Business 2014 – Hong Kong SAR, China, the World Bank and International Finance Corporation, page 58). The Asian Corporate Governance Association’s CG Watch 2012 awarded Hong Kong the top spot in Asia for enforcement, and ranked Hong Kong second for corporate governance rules and practices as well as overall corporate governance culture (CG Watch 2012: Market Rankings, Asian Corporate Governance Association, September 2012).

To strengthen Hong Kong’s corporate governance regime even further will take commitment and determination. Many of our listed companies already have strong corporate governance procedures and practices in place. However, we wish to emphasise the importance of ‘substance over form’. This applies to all listed companies, regardless of their individual circumstances and characteristics. To collectively achieve a higher level of corporate governance, it will be essential for each company to focus on the quality and comprehensiveness of its disclosures and explanations relating to corporate governance.

David Graham, Chief Regulatory Officer and Head of Listing, Hong Kong Exchanges and Clearing Ltd

David Graham will be speaking in session four of the Corporate Governance Conference 2014 on ‘Trends in ESG reporting’. His biography is available in the Conference Guide section of this month’s journal (see page 29).


SIDEBAR: Trends in ESG reporting

Companies increasingly realise that reporting on ESG helps ensure their long-term competitiveness, as investors now incorporate ESG criteria into their valuations and investment strategies, and consumers consider with greater scrutiny the environmental and social impact of the products and services they purchase and consume. Further, ESG reporting helps to strengthen companies’ risk management and control, enhance their reputation and brand, reduce costs and foster ESG best practice in suppliers.

Moving from voluntary to mandatory

Another important driver of the ESG reporting trend is the evolution of regulatory requirements in this area. Many regulators in the world are now imposing requirements for mandatory ESG disclosure. A 2013 study of global developments in policy and regulation for sustainability reporting found that, from 2006 to 2013, the percentage of mandatory ESG reporting policies in the countries reviewed increased from 58% to 72% (see Carrots and Sticks: sustainability reporting policies worldwide – today’s best practice, tomorrow’s trends, UN Environment Programme, the Global Reporting Initiative, KPMG and the Centre for Corporate Governance in Africa, 2013 Edition). Some recent examples of these mandatory measures are set below.

  • In the European Union (EU), the EU Parliament adopted on 15 April 2014 the Directive on disclosure of non-financial and diversity information by large companies and groups. Once the Directive comes into force (that is, once it is adopted by the EU Member States in Council and published in the EU Official Journal), large listed companies (with more than 500 employees) will be required to disclose in their management reports information on their policies, risks and results in respect of environmental matters, social and employee- related aspects, respect for human rights, anti-corruption and bribery issues, and diversity on boards of directors.
  • In the United Kingdom (UK), as a result of the Climate Change Act 2008, all UK quoted companies (that is, those that are (a) incorporated in the UK, and (b) whose equity share capital is (i) officially listed on the Main Market of the London Stock Exchange; or (ii) officially listed in an European Economic Area State; or (iii) admitted for dealing on either the New York Stock Exchange or NASDAQ) have been required under the Companies Act 2006 (Strategic Report and Directors’ Report) Regulations 2013 to report on their greenhouse gas emissions as part of their annual directors’ reports since 1 October 2013.
  • In Singapore, with effect from 22 April 2013, qualifying companies (that is, energy intensive companies in the industry sector that meet a certain energy use threshold amongst other criteria) are required under the Energy Conservation Act to report on energy consumption, greenhouse gas emissions, energy management strategies and conservation plans. The Act details a variety of indicators that must be disclosed.
  • In Mainland China, the government approved on 24 April 2014 broad changes to its Environmental Protection Law for the first time in 25 years. The revised law imposes stricter obligations on companies in respect of pollution prevention and control, and provides for more severe penalties. For example, all companies must apply for a licence for discharging pollutants, and companies that discharge certain key pollutants must make publicly available a wide scope of information on their pollutants and emissions, as well as on the construction and operation of pollution prevention and control facilities. Companies caught polluting the environment outside the bounds of the law will be subject to higher fines and company executives deemed responsible for such pollution may be detained for up to 15 days. The revised law is due to come into force on 1 January 2015.

Another interesting trend noted in the Carrots and Sticks study is that an increasing amount of ESG reporting policy around the world is inspired by, or based on, a ‘comply or explain’ approach. The advantage of this approach, similar to the philosophy underlying our Corporate Governance Code, is that companies are afforded space to develop their practice, decide on the scope of their reporting, focus on areas with material impacts both on their own businesses and on stakeholders, and decide on the best ESG reporting frameworks that best fit their own circumstances. Further, the flexibility of this approach enables companies relatively inexperienced with ESG reporting to develop their competency and practice, with a view to developing their quality and expertise over time.

Integrated reporting

A further trend developing in this space is integrated reporting. Though the concept of integrated reporting is still taking shape, it seems to be gaining traction as a way for companies to disclose their financial and sustainability information in a single report, with the ultimate objective of providing a more holistic, comprehensive picture to investors and other stakeholders of how they create and maintain value over the short, medium and long term. The International Integrated Reporting Council in December 2013 published the International Integrated Reporting Framework in an effort to push this trend forward. We will continue to monitor developments in this area with interest.

Developments in Hong Kong

The Exchange’s Environmental, Social and Governance Reporting Guide (ESG Guide) came into effect for issuers with financial years ending after 31 December 2012. The decision to develop this ESG Guide was largely driven by our recognition that ESG reporting is a growing – and accelerating – global trend. This trend has already begun to have a significant impact on the way companies all over the world do business and disclose information, on the way investors value companies and make investment decisions, and on the choices consumers make. This impact will only continue to grow with time.

The new Companies Ordinance requires that Hong Kong- incorporated companies, for the first financial reporting year beginning on or after 3 March 2014 (when the Companies Ordinance came into effect), must include in their directors’ reports a discussion of their environmental policies and performance, and an account of their key relationships with stakeholders.

Further, the Hong Kong government is preparing for the imminent launch of a dedicated website to provide a Carbon Footprint Repository for Hong Kong listed companies to disclose their carbon audit findings. Although this disclosure will be voluntary initially, the level of obligation may increase in future.

Next steps

ESG reporting is fast becoming a standard practice and the Exchange has an important role to play in urging companies to adopt this practice in order to stay ahead of the curve and maintain their long-term competitiveness. In view of this, we are considering raising the obligation level of some recommended disclosures in the ESG Guide to ‘comply or explain’. To this end, we aim to publish a consultation paper on the proposed upgrades by early 2015, and implement changes to the ESG Guide by late 2015 or early 2016. Any changes to the ESG Guide will only be adopted with the support of the market, and implemented with substantial lead time and additional training to ensure that issuers are fully prepared.