Directors have a unique role to play in promoting a culture of compliance in the companies they work for. At the second session of the Institute’s new directors’ training series, speakers from Hong Kong Exchanges and Clearing Ltd (HKEX) highlighted the regulator’s view of what such a culture should look like.
The Institute’s new training series, Director training – a focus on INEDs, offers practitioners the chance to hear from regulators, experienced directors and governance professionals on how directors, in particular independent non-executive directors (INEDs), can enhance their contribution to good corporate governance.
At the second session of the training series, held on 17 February 2023, two HKEX speakers – Christine Kan, Managing Director, Head of Listed Issuer Regulation, Listing Division, and Joe Fan, Vice-President, Listed Issuer Regulation, Listing Division – reminded participants that the Listing Rules set clear standards relating to directors’ responsibilities. In particular:
- directors are expected to act honestly, in good faith, in the interests of the company as a whole and in a proper purpose
- directors have to safeguard the interests of the shareholders and the company as a whole, and avoid any actual or perceived conflict of interest, and
- directors have to apply a sufficient degree of skill, due care and diligence at all times.
Directors’ responsibilities in corporate transactions
Both HKEX and the Securities and Futures Commission (SFC) have been focusing their educational and enforcement work on promoting a better understanding of directors’ duties to exercise independent judgement when evaluating the fairness of corporate transactions. In particular, they need to look at whether proposed corporate transactions have commercial merit, and whether the terms are fair and reasonable to shareholders.
The HKEX speakers urged directors to be alert to ‘red flags’, such as where the company is buying a target company at a very high consideration that appears unreasonable. Other red flags include:
- where the consideration is based on a profit guarantee that is not supported by the historical track record of the target company
- where the target is newly set up, has a track record of losses, very few customers and a revenue that appears to be inflated and unsustainable, and
- where there are unusual terms in the transaction, such as a significant deferral in the delivery of an asset with no adequate explanation.
INEDs, with their outside perspective, can play a beneficial role ensuring that corporate transactions are in the interest of the company and the shareholders as a whole. They are expected to look at whether there is a clear commercial rationale for the transaction and whether it is consistent with the issuer’s business strategy.
The HKEX speakers emphasised that INEDs also need to review due diligence performed on any counterparties involved in proposed corporate transactions. They should also take reasonable steps to verify the accuracy and reasonableness of the information presented to them by management that would likely affect the valuation of any assets to be acquired. This includes looking at any financial forecasts and assumptions presented to them and getting a reliable valuation.
‘You should not rely on forecasts provided by the counterparties without performing any due diligence,’ Ms Kan said. ‘If you feel that the information given is not sufficient, by all means ask management for more information and consider engaging a professional valuer or an advisor if you need expert advice.’
Engaging a valuer does not discharge directors from their duties, however, and they are still expected to exercise independent judgement. They are also expected to engage a valuer that is appropriately qualified, independent from the company and the counterparties, and has the expertise and resources to perform the valuation.
The role of INEDs on the audit committee
The training session also addressed the important role that INEDs on the audit committee should play in the financial reporting process, in particular overseeing the effectiveness of audit processes.
‘I cannot overemphasise the importance of planning and maintaining oversight of the audit process,’ Ms Kan said. ‘This should involve, for example, maintaining a dialogue with auditors to discuss the nature and scope of the audit, and, during the audit itself, to fully understand its progress and if necessary facilitate timely resolution of any issues.’
1. Financial reporting
Financial reports are the key documents that communicate to shareholders the position of the company and the audit process gives investors confidence in the financial information they receive. Ms Kan pointed to a number of common failings relating to the financial reporting and audit processes of listed companies in Hong Kong. In fact, last year 80% of trading suspensions of listed companies were the result of financial reporting issues, including delays in the publication of results, accounting irregularities identified by auditors, or disclaimers of audit opinions on the financial statements.
Ms Kan highlighted some of the common failings identified by HKEX in its latest review of listed issuers’ audited financial results. These include problems with the valuation of assets and assessing asset impairment, and maintaining proper books and records.
2. Auditor selection and remuneration
INEDs on the audit committee also have a crucial role in making recommendations on the appointment, reappointment, removal and remuneration of auditors.
The Accounting and Financial Reporting Council (AFRC) has noted that in announcements relating to a change of auditor in Hong Kong, the reasons given for auditor resignations tend be quite generic, with about 70% of companies giving ‘audit fees’ as the reason for a change of auditor. ‘The audit committee should discuss with the outgoing auditors the reasons for the resignations and any unresolved audit issues. This should be discussed in the announcements,’ Ms Kan said.
The AFRC also found that a majority of listed companies paid lower or the same audit fees after a change in auditors. While companies may argue that auditor fee arrangements are a commercial decision, Ms Kan pointed out that the fee level may reflect the quality of the audit. ‘Audit committees should ensure that the audit fees are commensurate with the extent of audit work required,’ she pointed out.
This issue resurfaced in the Q&A. Panellist Melissa Fung, Risk Advisory Southern Region Lead Partner, Deloitte China, pointed out that, while the fee quotation will naturally be an important part of deciding which is the successful bid in a tendering process, listed issuers should not blindly adopt the lowest fee quote approach.
This approach has led to audit firms facing severe fee competition in the market and may lead to audits being underresourced. She also pointed out that there are other more important criteria for the audit committee to consider in the tendering process, such as the qualifications and reputation of the audit firm and its industry experience. ‘As an INED, I hope that you can ensure that the audit firm has a robust quality assurance process because this will protect your company’s interests,’ she said.
She added that a high-quality audit is not only a matter of meeting regulatory requirements – it can be highly useful in decision support. ‘As auditors, we always try to provide more value than just auditing the financials. Through the audit process, we can also provide some recommendations to management and the board to improve their decision- making,’ she said.
3. Separating non-audit work from the financial audit
Another important issue for the audit committee to consider is the need to preserve the independence of the financial audit. The independence of the auditors undertaking this work is an essential part of making the work trustworthy. The practice of getting the same professional firm to provide your internal and ‘external’ audit services is therefore not acceptable.
This will definitely affect the independence of the firm doing your audit work, Ms Fung pointed out, and effectively turns the financial audit into a self-review. She also noted that some professional service providers package this type of arrangement as a ‘staff loan’ service where they ‘loan’ staff to the listed company to perform the internal audit. ‘This is independence in appearance only,’ she said.
The impact of technology
1. The regtech factor
The impact of technology was another major theme of the training session. Mr Fan and Ms Kan spoke about the ways that regtech has increased the efficiency and also the effectiveness of investigation and enforcement work carried out by regulators in Hong Kong. HKEX, for example, are using tech tools to enhance their monitoring of corporate transactions.
This is particularly relevant to INEDs since they are responsible for taking the lead in situations of potential conflicts of interest. Tech tools have been invaluable in helping HKEX to enhance their monitoring of the network of relationships linking counterparties to listed issuers.
‘HKEX has been using technology to do desktop investigations based on public documents and you would be quite surprised by the amount of information in the public domain,’ Ms Kan said. For example, HKEX’s relationship mapping tool searches announcements relating to earlier transactions and maps the relationships between the counterparties to corporate transactions. The tool connects seemingly separate transactions and identifies patterns in transactions inside relationship networks.
Tech tools have also helped HKEX to review public filings to identify technical non-compliances. For example, they screen DI reports close to inside information publication dates to identify potential breaches such as insider dealing. Meanwhile, the HKEX internal case management system helps build a repository of regulatory data that has helped the regulator in applying a risk-based approach to regulating issuers, for example, by building issuer risk profiles.
‘Technology can help us improve regulatory efficiency, reduce compliance costs for issuers and promote compliance by making the information available to the public,’ Ms Kan said.
2. How far can you automate governance?
Tech tools have also vastly extended the potential sampling coverage of financial audits, increasing the chance of spotting anomalies, but will such tools eventually remove the need for humans to be involved at all?
‘Technology cannot fully replace human efforts in the audit,’ Ms Fung said. ‘Some of the documents are still paper-based and we therefore need to look at the actual documents to validate their authenticity. We also still need human judgement, particularly for valuation estimates.’
This point was supported by Ms Kan. She cited the way the artificial intelligence (AI) tools used by HKEX help identify where companies have failed to disclose required information, but they cannot, as yet, identify problems in the quality of disclosure.
Asked by the Panel Chair David Simmonds FCG HKFCG, Institute Vice-President and Chief Strategy, Sustainability & Governance Officer, CLP Holdings Ltd, whether AI will eventually replace the role of directors in companies, speakers and panellists agreed that there will always be a need for human beings on boards.
‘The numbers in your system can be wrong,’ Ms Fung said, ‘and AI will not always detect those errors. In the end, we still need to rely on human experience and judgement to identify abnormalities.’