The third and final session of the Institute’s director training series, held in collaboration with Hong Kong Exchanges and Clearing Ltd (HKEX), urged all directors, but independent non-executive directors (INEDs) in particular, to avoid the danger of complacency about their roles in upholding good governance.
The third and final session of the Institute’s director training series (Director training – a focus on INEDs) was held on 17 March 2023 at the HKEX Connect Hall.
In their speaker presentations, Jon Witts, Senior Vice-President, Head of Enforcement, and Candy Au, Assistant Vice-President, Enforcement, both of the Listing Division, HKEX, clarified the standards expected of directors, in particular INEDs, in their roles as champions of governance. They pointed out that many directors who find themselves involved in HKEX enforcement investigations and disciplinary actions are well-intentioned and surprised to find themselves in the spotlight. It is often complacency and a lack of awareness regarding the roles they are supposed to be fulfilling, rather than a desire to commit fraud, that has put them there. In this context, the speakers focused on three key factors that HKEX looks at when assessing whether directors have adequately fulfilled their duties.
1. Providing independent judgement
The first factor relates to the exercise of independent judgement. ‘Contributing their independent judgement on the business of the company is at the absolute core of everything INEDs do,’ Mr Witts said. ‘They need to have and speak their own mind.’
This includes avoiding groupthink, and INEDs must not become a puppet for the controlling shareholder who may have had a hand in their appointment. It also involves being proactive in getting the information they need to be able to provide independent judgement.
Mr Witts used the example of a director being asked to assess a complex corporate transaction that is out of his or her area of expertise. He emphasised that directors are not expected to be an expert on everything, but they are expected to act when they realise that they don’t have enough information to provide independent judgement. ‘This is where they need to ask questions to ensure that they are aware of what’s going on in the company,’ Mr Witts said.
Ms Au further clarified this issue in her presentation. She said that INEDs involved in disciplinary cases often use the defence that they, unlike the executive directors, are not responsible for the day-to-day business affairs of the company.
‘We’re not saying that you share the same role as executive directors,’ she said. ‘In fact, you may delegate and rely on others, whether they are other board members, professional advisers or other staff members, but we do expect you to play at least a continuing supervisory role. We want to see that you have an inquiring mind, and that you use your wisdom and experience to make independent decisions,’ she said.
This topic came up in the panel discussion at the end of the webinar. The chair of the session, Mohan Datwani FCG HKFCG(PE), Deputy Chief Executive, The Hong Kong Chartered Governance Institute, invited the panellists to share their own insights on the topics under discussion. Panellist Ernest Lee FCG HKFCG(PE), Institute President, and Technical Partner, Deloitte China, emphasised that providing independent judgement was particularly critical where INEDs are reviewing corporate transactions.
‘It is really important for INEDs to exercise independent thinking as to whether the transaction makes sense for the company and whether the transaction terms are fair and reasonable,’ he said.
He added that Listing Rule 3.08 makes it clear that directors, as a group collectively and individually, are responsible for the affairs of the company. This he linked to the point made above by Ms Au about INEDs frequently relying on the defence that they cannot be expected to share the same level of culpability as the executive directors. He emphasised that all directors are expected to exercise their duties of care, skill and diligence.
‘INEDs need to recognise that they are dining with the other directors – eating the same food from the same kitchen,’ Mr Lee said.
2. Providing effective oversight of internal controls
Under Hong Kong’s Corporate Governance Code, boards are required to oversee the company’s risk management and internal control systems on an ongoing basis. In particular, internal controls should be subject to a review at least annually. INEDs, as members of the audit committee, have a particular responsibility here. The audit committee’s terms of reference are required to include an obligation to review listed companies’ risk management and internal control systems and INEDs have to make up a majority of the audit committee members.
Ms Au addressed this aspect of the INED role. She said that another common defence INEDs raise in disciplinary cases is that they relied on the external auditors’ oversight of the internal controls. She pointed out that the role of the external auditor is to audit the company’s financial statements – they will not normally conduct an internal control review as part of their regular auditing work. Certainly, auditors may flag up any control deficiencies that they find during the course of their work, but that is not the same as performing a dedicated and focused internal control review.
‘So you cannot rely on audit work to satisfy your compliance with the Corporate Governance Code as an INED,’ she said.
She also reminded listeners that INEDs should not take a ‘passive approach’ to internal control reviews. This refers to the practice of assuming that, if no concerns have been raised since the last review, the controls must still be sound. Sometimes the absence of any red flags regarding the controls may be due to the absence of a proper channel for staff to voice their concerns and bring them to the board’s attention. Ms Au reiterated the need for ongoing reviews for the company’s internal controls to ensure they are still fit for purpose.
This issue was further discussed in the panel discussion. Julia Charlton, Principal Partner, Charltons, sought to raise awareness among directors that a failure to ensure adequate internal controls can, in and of itself, be a breach of the Listing Rules. Moreover, in its enforcement work HKEX not only looks at what went wrong when companies breach the Listing Rules, it also looks at the control environment to assess why this failed to prevent things from going wrong.
Typically, inadequate internal controls will be an indicator of a breach of directors’ duty to exercise the skill, care and diligence. It may also be deemed to be a breach of their directors’ undertaking under the Listing Rules, Ms Charlton said. She added that, since listed company boards are also responsible for ensuring that adequate internal controls are in place in the company’s subsidiaries, this is therefore something to consider when a company acquires a new subsidiary.
She also made the point that, since setting up an internal control system at the listing stage is a critical part of achieving a successful listing, it often gets the due diligence it deserves. Once the company is listed, however, directors may ‘take their eyes off the ball’. ‘They are not always focused enough on reviewing and evolving their internal control systems so that they remain fit for purpose both in terms of new requirements coming into place and evolving business situations and the new risks which come up,’ Ms Charlton said.
She also pointed out that the fact that the audit committee takes the lead role in reviewing the company’s internal controls doesn’t absolve the company’s other directors from any responsibility in this area. They are still expected to understand and oversee the audit committee’s internal control review and to take an active interest in any potential deficiencies identified and assist in implementing the necessary improvements.
3. Ensuring good record keeping practices and cooperating with HKEX
Last October, HKEX published a new guidance note on cooperation. Mr Witts urged participants, if they have not already done so, to read the guidance as it clarifies HKEX’s expectations regarding the cooperation they expect from listed companies involved in enforcement actions.
He emphasised that HKEX expects timely and substantive responses to its queries and good record keeping practices will be key to being able to show HKEX the evidence of a good control environment. In other words, while good record keeping practices should be followed as a basic component of good corporate governance, they will also be beneficial if companies find themselves involved in enforcement actions.
However, the new HKEX guidance note on cooperation makes it clear that a failure to cooperate when there is a duty to do so is itself considered a serious breach of the Listing Rules, warranting the imposition of some of the most severe sanctions available, and HKEX has successfully taken enforcement action on several occasions against directors who have refused to cooperate.
The Institute would like to extend its gratitude to everyone who contributed to the director training series reviewed in this article. It attracted a cumulative audience of over 1,200 directors, governance professionals and other stakeholders over the course of the three sessions. The first two sessions were reviewed in the March and April editions of this journal. More resources relating to the issues discussed are available on the HKEX website: www.hkex.com.hk.
SIDEBAR: The purpose of enforcement
When it comes to holding individuals accountable for wrongdoing, most of the focus tends to be on the adequacy of the rules. But markets with impressive-sounding regulatory regimes are not always the most honest or cleanest markets in which to do business. Effective deterrence relies on more than a good rule book – just as important is the presence of an effective enforcement regime that ensures that breaches of the rules do not go unnoticed and carry consequences for the individuals involved.
The first speaker of the training session reviewed in this article, Jon Witts, Senior Vice-President, Head of Enforcement, Listing Division, HKEX, started his presentation with a reminder of the purpose of enforcement. He pointed out that enforcement is not really about punishment in the sense of imposing retaliation or getting revenge. A better sense of the purpose of enforcement, he suggested, can be found in the words of the Duke of Wellington at the Battle of Waterloo. After winning the battle, he famously said that ‘nothing except a battle lost could be half so melancholy as a battle won’.
Wellington went on to talk about the expense that had been occurred in the battle, which he described as a heavy misfortune ‘but for the result to the public’, and that, Mr Witts said, gets us much closer to the purpose of enforcement. Regulators are in the business of trying to ensure better market quality and higher standards of corporate governance and investor protection. This can only be achieved, however, through an effective mechanism for holding individuals accountable for their actions and decisions.
HKEX has imposed public sanctions on about 400 directors, many of whom are INEDs, since the start of 2020, and the list is growing at a rate of about three a week. Public sanctions will of course have negative consequences for the people involved, ‘but it’s worth it for the results to the public,’ Mr Witts said.
He added that, in the wake of scandals such as the collapse of the crypto exchange FTX, there is a better awareness generally of why markets need regulators. Successful markets need effective gatekeepers and regulators are only one of the many gatekeepers that play a role in achieving good compliance and governance. Indeed, the roles of governance professionals and INEDs, he pointed out, are just as critical in imposing the internal discipline needed to achieve those goals.
SIDEBAR: A taxonomy of director dysfunction
The final session of the Institute’s director training series was fortunate to have Dr Kelvin Wong SBS JP, Chairman, Accounting and Financial Reporting Council, to give his insights on director effectiveness. Based on his experience serving on Hong Kong boards, together with his role as the past Chair of the Hong Kong Institute of Directors in Hong Kong, Dr Wong gave a very apposite description of different types of dysfunctional directors.
1. The overboarded director
The first type he described as the overboarded or busy director. According to the Listing Rules directors serving on six or more boards are deemed to be overboarded. Dr Wong pointed out that the danger here is quite obvious – such a director is unlikely to have the capacity to give every board appointment the time and attention needed.
Under the current definition, there is a total of 58 individuals who are classified as overboarded and they are serving an aggregate of 409 board seats. Dr Wong added, however, that the issue of whether the directors who are not serving six or more boards can devote sufficient time and attention to their board appointments is just as important. Depending on their levels of energy and diligence, for some directors, four board appointments might be too many. This led him to the second type of director.
2. The lazy director
In Dr Wong’s view, a lazy director is even less useful than an overboarded one. And, once again, he suggested that the statistics will not always give an accurate picture.
‘When you calculate their attendance, they always attended full score 100% of board meetings. Largely thanks to the Covid pandemic, they are even able to attend more than one directors’ meeting at the same time. This is because they can afford to have two iPads, three iPhones and four computers in front of them. But while lazy directors attend every meeting, they don’t say anything. They agree, even before the resolution has been finished, with the proposals under discussion. This is not uncommon among listed companies in Hong Kong,’ Dr Wong said.
3. The tired director
This type of director, Dr Wong pointed out, are often the victims of the situations they find themselves in. This is particularly true of INEDs since 75% of all listed companies in Hong Kong have only three INEDs serving on their boards. Dr Wong pointed out that, in addition to attending regular board meetings, these INEDs need to serve on the critical board committees where a majority of INEDs is required by the Listing Rules, namely the audit, remuneration, nomination and now ESG committees. In other words, while they may not be overboarded, they are likely to be overburdened.
‘I encourage HKEX to consider raising the bar,’ Dr Wong said. ‘With the increasing burden and also higher public expectations of the role of INEDs, I believe it is high time to have a holistic review as to what should be the optimal number, or the optimal proportion, of INEDs on the boards of listed companies in Hong Kong.’
4. The vanishing director
Dr Wong saved the most dysfunctional type of director to the last. Vanishing directors are those who disappear as soon as they find themselves under investigation by regulators. Since more than 55% of listed companies by number, and in terms of market capitalisation more than three quarters, are either state-owned enterprises or privately owned enterprises from the Mainland, many of the directors of these companies are currently able to escape the jurisdiction of Hong Kong regulators simply by returning to the Mainland. Dr Wong recommended regulators in Hong Kong look at what can be done to ensure that their enforcement actions can reach beyond Hong Kong, in particular to the Mainland.