On the 30th anniversary of the launch of the UK’s Cadbury Code, which pioneered the ‘comply or explain’ approach to principles-based regulation, CGj looks at the effectiveness and appropriate role of this approach in Hong Kong.

The UK’s Report of the Committee on the Financial Aspects on Corporate Governance, better known as the Cadbury Code, did not invent principles-based regulation. Regulatory regimes, historical and contemporary, have long been faced with the need to find the right balance between the principles-based and prescriptive approaches to rule-making. Nevertheless, the ‘comply or explain’ mechanism pioneered by the Cadbury Code has been hugely influential in the evolution of corporate governance regimes and securities regulation around the world.

Hong Kong signed up to this approach with its Corporate Governance Code (the Code) – first launched in 2005. The Code is non-statutory and non-mandatory in the sense that it requires listed companies to state whether they comply with the provisions of the Code or give reasons for any non-compliance. In addition to the Code, many key regulators have adopted elements of the principles-based ethos in their approach to regulation. But what exactly is the principles-based approach to regulation and how has it fared in the Hong Kong context?

Theory and practice

In theory, the distinction between prescriptive rules and high-level, broadly stated principles seems to be clear cut – the former tell you what you can and cannot do, while the latter set standards by which your behaviour will be judged. Regulators around the world favour different weightings between rules and principles when it comes to drafting their rulebooks, and the relative advantages and disadvantages of these different approaches have been well documented.

One of the reasons the principles-based approach has been so widely adopted by corporate governance regimes around the world is that it enables regulators to draft broadly stated principles that will be relevant and appropriate to the diverse range of companies under their jurisdiction. Such principles will also be less vulnerable than rules to becoming quickly outdated by changes in market dynamics. 

Of most relevance to governance professionals, however, are the putative advantages of the principles-based approach for companies’ compliance and governance frameworks. This approach is ‘outcome-oriented’ in the sense that it puts the onus on companies to reach a desired outcome rather than drafting explicit rules on what behaviour is acceptable. This, however, is both its strength and a potential weakness in that it requires more engagement from companies – they have to reverse- engineer the principles to determine what they mean on a practical level.

For this reason, the effectiveness of the principles-based approach depends heavily on the maturity of the markets it is applied to. Tommy Tong FCG HKFCG, Partner, Herbert Smith Freehills, believes that this approach has had major benefits for Hong Kong – its inherent flexibility has allowed it to cater to businesses facing unique issues and dynamics to make compliance more practical. ‘However, I think the Code is still a work in progress,’ he says. ‘Hong Kong is, compared to the UK, still a less mature market and the backgrounds of listed issuers participating in the market can vary hugely,’ he says. 

Mr Tong believes that this is why a review of whether the principles-based approach is working for Hong Kong is timely. ‘I think we’re at a juncture where questions like this are very relevant. With the changes we’re seeing in the dynamics of the market now, will the regime progressively develop in a way that we have seen in other markets like the UK and Singapore, and others?’ 

One key factor relevant here is the degree to which companies in Hong Kong are subject to institutional investor participation and research coverage. In theory, principles-based regulation relies on investor pressure to drive compliance and governance standards upward, and for those issuers with greater exposure to institutional investors the Code has worked well, Mr Tong says. Nevertheless, the Code and its required disclosures may have less impact for companies that are less sensitive to institutional pressure. 

‘I think there will be areas where we will become more prescriptive precisely for that reason. There has been and continues to be the hope that institutional influence will increase over time as it has done in Japan, Korea and jurisdictions in Europe where activism plays a part. I think there is still a good case for the largely principles-based approach we have, but I do expect it progressively to move more towards a prescriptive approach,’ he says.

Regulators to the rescue?

Mr Tong’s colleague, Hannah Cassidy, Partner, Herbert Smith Freehills, points out that Hong Kong does not have to rely on investor pressure alone to hold companies to account for their compliance with the Code. Regulatory enforcement is another way to reinforce the expectations of the Code and the Stock Exchange of Hong Kong (the Exchange) has been more active from an enforcement perspective – in particular holding senior management to account for breaches of regulatory expectations. Revised policy statements published by the Exchange earlier this year, for example, were intended as a clear warning to the market that the Exchange intends to hold individuals to account. 

Moreover, while the Exchange may not have the same array of sanctioning powers as the Securities and Futures Commission (SFC), it has recently expanded the range of reputational sanctions available to it in cases of malpractice. ‘Having a public notice out there criticising your behaviour as a director of a listed company is still potentially very damaging and, depending on the underlying issue or breach, there is always the possibility that the securities regulator might also be able to take parallel action,’
Ms Cassidy says.

She also puts these issues in the context of global developments in securities regulation since the 2008 global financial crisis. Immediately after the crisis there was an expectation that there would be a large-scale shift towards more prescriptive rules. Many argued that the crisis demonstrated the limitations of the principles-based approach. Nevertheless, many jurisdictions, Hong Kong among them, concluded that the main lesson to learn was the need to hold individuals to account. Hence the regulatory shift towards ensuring senior management accountability described above.

Could legal reforms help?

There has been a long-running debate in Hong Kong about whether legal reforms – in particular adopting a class action legal regime and contingency fees – would improve shareholder rights. Given the discussion above, could this also improve the effectiveness of the principles-based regulatory framework in Hong Kong? 

‘This could be a very powerful tool,’ Mr Tong says, but he warns that Hong Kong needs to be careful of the potential unintended consequences. Class action and contingency fees could, for example, open the system to abuse by those without a legitimate grievance. This could lead to higher legal costs for compliant companies, increased market volatility and a greater burden on the legal system. 

Ms Cassidy agrees that Hong Kong isn’t ready for that type of legal regime and she points out that regulators in Hong Kong can and do seek shareholder compensation in cases of malpractice. The SFC, for example, has investor compensation powers and it has shown itself very ready to exercise them. ‘So, to the extent that a listed company has caused financial detriment, there is the ability to seek compensation for investors,’ she says. 

She also questions the inference that principles-based regulation reduces the ability of shareholders to get compensation. This is perhaps based on the notion that it is more difficult to prove a breach of a principle than a breach of a rule. She points out that, even where regulators can’t point to a specific rule breach, they can hold individuals to account for failing to exercise the expected skill, care and diligence.

The role of governance professionals 

The appropriate role of principles-based regulation in Hong Kong has a special relevance for governance professionals. This approach to regulation requires companies, and the governance professionals advising them, to raise their compliance and governance game. In short, it is easier to ensure that a company is doing what it is told than to build the organisational culture necessary to achieve desired governance and ethical outcomes. 

Mr Tong points out that this is where having a good company secretary pays dividends. Boards comprise individuals with different skills and areas of expertise, and, while directors generally see the value of compliance and good governance practices, this may not be their primary focus. He welcomes company secretaries’ transition from being often perceived as having a back office, administrative role to being key gatekeepers of good corporate governance. 

‘This promotes the profession and increases the value of working in the profession, but from the companies’ perspective it also ensures a genuine source of information and advice on good corporate governance for directors,’ he says. 

Ms Cassidy adds that the board advisory roles of company secretaries has extra relevance and importance in the current operating environment. ‘Companies need to ensure that their boards are up to speed on a whole range of different issues,’ Ms Cassidy says. ‘For example, boards are under increasing pressure to understand what their cybersecurity and their ESG risks are.’

Does that mean all companies now need to have cybersecurity or ESG experts on their board? Regulators certainly expect companies to be constantly looking at their board’s composition and thinking about whether they have the right skills to be a public company in an environment where the biggest threats include issues like cybersecurity and climate risk. However, it also means that ‘directors have to be constantly evolving – and having access to relevant training, whether from outside counsel or the advice of a governance professional, is therefore becoming increasingly important,’ Ms Cassidy says. 

Where are we heading? 

Given the discussion above, will the principles-based approach continue to be a part of Hong Kong’s regulatory philosophy in the years ahead? Both Mr Tong and Ms Cassidy believe that it will. Apart from anything else, they point out that Hong Kong’s regulatory regime has been an important part of maintaining Hong Kong’s global competitiveness as an international financial centre.

‘Regulators here have borrowed and leveraged a lot of what has been implemented at the global level, and, as long as Hong Kong remains part of the international regulatory community, I don’t see an imminent move to the rules-based approach,’ Ms Cassidy says.

She adds that Hong Kong is very visibly part of the international regulatory community. The SFC is a member of the International Organisation of Securities Commissions (IOSCO) and the SFC’s CEO chairs the IOSCO board. Moreover, the international profile of regulators like the SFC and Hong Kong Monetary Authority enhances investor confidence by ensuring that Hong Kong’s capital markets operate in a fair, efficient and transparent manner, in line with international standards. 

Mr Tong adds that continuing with the principles-based approach is an essential part of this. ‘Continuing with this approach has the benefit of allowing the Hong Kong framework to develop in a consistent manner to keep up with international standards and maintain investor familiarity,’ he says.  

Nevertheless, the principles-based approach was never meant to eliminate the need for rules and Hong Kong needs to find the right balance between the rules-based and principles-based approaches. There are areas of regulation where the principles-based approach simply isn’t relevant. Some rules require regulators to set specific quantitative thresholds, for example, and taking a more prescriptive approach may also be desirable where the principles have failed to achieve desired outcomes.

Mr Tong cites board gender diversity as a good example of this. Despite many years of regulatory nudges and encouragements, the proportion of female directors on Hong Kong boards remains stubbornly low (women make up around 14% of listed company directors). Is it time, then, for a more prescriptive approach? The Institute certainly thinks so. In February last year, it published a report – Missing Opportunities? A Review of Gender Diversity on Hong Kong Boards – calling for an amendment to Hong Kong’s Code to set a target of a minimum 30% female representation on listed company boards within a six-year transition period. 

This target would be prescriptive in the sense that it sets a quantitative threshold, but, being part of the Code, it would be subject to the ‘comply or explain’ disclosure regime. It was therefore intended to achieve the right balance between the top-down imposition of a mandatory quota and the more principles-based approach of the Code. Mr Tong points out that such an amendment, if adopted, would prompt issuers to step up efforts to achieve genuine board diversity since if companies don’t meet the minimum they could face significant adverse investor scrutiny. He adds that an effective quota for gender diversity now exists in the Listing Rules. With effect from 1 January this year, Rule 13.92 provides that ‘the Exchange will not consider diversity to be achieved for a single gender board’ and that listed companies with a single gender board will have to appoint at least one director of a different gender on the board no later than 31 December 2024.  

This, he adds, is the right approach to take since, where the principles aren’t working, more prescriptive requirements need to come into play. ‘Sometimes the principles give too much room to senior management to argue their way out of accountability. When the regulators lose too many of these cases, they try to plug the gaps and that’s where you see more specific rules put in place,’ he says.