Sharan Gill, writer, lawyer and CSj contributor, looks at the unique relationship between independent non-executive directors (INEDs) and company secretaries in their key roles as governance gatekeepers.

One wonders whether the three INEDs on the board of Mayer Holdings Ltd realised what was in store for them when they took up their positions. In 2017, the Market Misconduct Tribunal (MMT) ordered a 12-month disqualification of all three INEDs, along with a number of the company’s executive directors, for not taking measures to ensure that proper safeguards existed to prevent a breach of Hong Kong’s disclosure requirements. 

The directors, including the three INEDs, were fined HK$900,000 and were ordered to pay the substantial costs and expenses incurred by the government and the Securities and Futures Commission (SFC). That they may not have been as culpable as other involved parties was rejected as a consideration in apportioning costs. 

The Mayer case is not an isolated one. With prosecutions by the SFC and civil actions mounting, it is clear that independent directors are facing increased legal liabilities. Institute Chief Executive Ellie Pang points out that the Enforcement Bulletin – published by the Listing Enforcement Department of Hong Kong Exchanges and Clearing Ltd (HKEX) – provides ample proof of this trend. She recommends the Bulletin to both INEDs and governance professionals as a way to stay up to date with the lessons to be learned from HKEX regulatory enforcement cases (see ‘Recommended reading’). 

The question arises whether breaches similar to those in the Mayer case could be averted by implementing processes to better advise INEDs on their duties and potential liabilities. This article explores the views of leading governance and stewardship professionals on this question, and looks at how company secretaries can help to enhance the effectiveness of INEDs as governance gatekeepers. 

Regulatory expectations

In January this year, the Institute published its Guidance Note Relating to Independent Non-Executive Directors: Selective Roles, Responsibilities and Liabilities (Guidance Note) – looking at these issues from the perspectives of both INEDs and company secretaries (see ‘Recommended reading’). ‘The guidance is wide in its coverage and its war stories clearly demonstrate where companies can go horribly wrong,’ says Mohan Datwani FCG(CS, CGP) FCS(CS, CGP)(PE), Institute Deputy Chief Executive.

While INEDs have the same responsibility in law as other directors, their role effectively imposes rather different expectations on them. To protect their independence, the Guidance Note points out that INEDs should not: 

• place unquestioning reliance on others in the exercise of their duties
• completely abrogate their responsibilities, or 
• permit one individual to dominate and control them.

Regulatory enforcement actions in Hong Kong have emphasised the importance of getting this right, as the INEDs in Long Success International (Holdings) Ltd (Long Success) found to their detriment. In proceedings brought under Section 214 of the Securities and Futures Ordinance (SFO), they were disqualified for varying periods of up to 30 months for, among other things, ‘not putting into place an effective system of controls, thus allowing the chairman to exercise his domination and control the board’. 

To fulfill their regulatory duties and responsibilities, INEDs should be able to exercise independent judgement freely and fearlessly without the threat of repercussions. That is the theory, but in practice there can be many obstacles to genuine independence of thought among INEDs. In particular, there may be questions as to how genuinely independent INEDs are from controlling shareholders. Nicholas Allen, Chairman of Link Asset Management Ltd, makes a distinction between a major shareholder that actually controls the board and one that is able to, but does not. 

Ms Flora Wang, Director of Sustainable Investing for Fidelity International, echoes this point. ‘Ultimately INEDs are just one component of the board and we wouldn’t necessarily judge INEDs as not independent just because there is a controlling shareholder. We really evaluate the board’s effectiveness and evaluate the INEDs’ trustworthiness by looking at the company’s track record and how the board performs as a whole,’ she says.

Mr Allen adds that periodic board reviews can also help by bringing in a third-party perspective on board effectiveness. ‘The periodic board effectiveness review is a really good start as it creates opportunities not only for discussion of board effectiveness, but also acts as a platform for INEDs to speak out. The controlling shareholders’ influence could still be felt, but the fact that you have a process where a third party comes in and asks for directors’ views is a healthy achievement and this is getting some traction,’ he says.

The nominations process

Boosting the effectiveness of INEDs will usually start with the nominations process. The Guidance Note emphasises that the majority of the nomination committee’s members should be INEDs to ensure strong independent representation. 

Mr Allen, who is also an INED on the board of CLP Holdings Ltd, emphasises that as a ‘barometer of independence’ the make-up of the nomination committee is an important factor. The nomination committee has the capacity to shape the diversity and effectiveness of the board, and the composition of the nomination committee is a key factor in the process to generate genuinely independent directors.

Ms Wang makes the point that, in family owned companies, controlling shareholders may play a role in the nominations process – for example vetting INED candidates. She emphasises, however, that some of the best run companies are family owned and ultimately the track record of a company speaks for itself, family owned or not. Mr Datwani also points out that the environment companies work in has changed significantly in recent years and it would be difficult for family run companies to bulldoze appointments under the increasing scrutiny of their large institutional investors. 

Is enough use being made of independent search firms?

Another recommendation for governance professionals is to promote the use of independent consulting search firms to find suitable INED candidates. Mr Allen points out that it often takes at least six months to find a director who is a really good fit for a board. ‘Directors are often busy and may not be available at the point in time that you need them. Search firms are very good at having a longer view and add a different dimension to the search,’ he says. 

A reluctance to use search firms may not only affect the quality of INED candidates, it can also hinder the process of putting together a diverse board. Ms Pang, in a former role with HKEX, drafted the first HKEX consultation paper on gender diversity. She points out that HKEX has been promoting board diversity since 2012 and, in 2019, it upgraded the requirement for listed companies in Hong Kong to have a diversity policy, including relating to gender diversity, to the status of a Listing Rule. 

Unfortunately, these efforts have not moved the dial very much in Hong Kong on board diversity, but the Institute is hoping to build momentum around its recent proposal to impose a 30% target for women on boards in Hong Kong to be implemented over a six-year period. The target would be subject to a ‘comply or explain’ regime. This proposal is set out in the Institute’s Missing Opportunities? A Review of Gender Diversity on Hong Kong Boards (see ‘Recommended reading’). 

The question of tenure 

If it is difficult to get genuinely independent directors onto boards, it is equally difficult to get directors who are no longer independent off them. Code Provision A.4.3 of Hong Kong’s Corporate Governance Code provides that if an INED has served for more than nine years, his or her further appointment should be subject to a separate resolution to be approved by shareholders. The board should explain to shareholders why it believes the particular INED is still independent and why he or she should be re-elected. 

Mr Allen points out that it helps to have fixed director terms – not only for board refreshment but also to make the nominations process more predictable. He adds that directors have a dual role, they are expected to be both challenging and supportive of management. It takes a while for INEDs to get to understand the business sufficiently to have a point of view and they do not suddenly lose their independence, but there is likely to be an imperceptible shift from taking a more challenging stance to slipping into a more supportive role. Nine years would be a critical point at which it would be necessary to reassess whether the board has become too comfortable a network where everyone gets on with each other a little too well, he suggests.

Director induction and board support

Probably the best-known area where company secretaries contribute to the effectiveness of the independent component of the board is in their director induction and board support roles. ‘Company secretaries are the interface between the company and the INEDs,’ says Mr Datwani. Since INEDs are not involved in the day-to-day business of running the company, the company secretary has a crucial role in ensuring that INEDs have the information they need to be effective in their oversight of company transactions and strategy. 

‘The INEDs’ first port of call should be the company secretary. Directors themselves should take the initiative to approach the company secretary whenever they need to,’ Ms Pang says. She recommends directors and governance professionals read HKEX’s Guidance for Boards and Directors for a useful summary of the governance roles of both INEDs and company secretaries (see ‘Recommended reading’). 

She adds that the company secretary should be ready, in some circumstances, to arrange for legal or other expert advice for the board. Nevertheless, the burden in the Listing Rules is very much on the directors themselves, she points out, so once company secretaries have discharged their obligations, it is up to the directors themselves to fulfill their fiduciary duties.

Advising INEDs on the full extent of their personal liability

Professor CK Low FCG FCS, Institute Council member, Assessment Advisory Panel Vice-Chairman, Education Committee member, Technical Consultation Panel (TCP) member, Academic Advisory Panel member, TCP-Securities Law and Regulation Interest Group member, and Associate Professor in Corporate Law at The Chinese University of Hong Kong Business School, emphasises that too often when individuals are asked whether they would take on the role of an INED, the issue of personal liability rarely crosses their minds. While in the not-too-recent past INEDs were rarely subject to prosecution, the litigious landscape in Hong Kong is fast changing. Recent SFC enforcement cases have seen the long arm of the law reach INEDs even after they have left their board positions. 

INEDs can therefore no longer be complacent about the extent of their exposure. They need to be advised of the spectrum of penalties that could be laid at their door, not least of which is significant financial retribution. Thus, in the ongoing case of Perfect Optronics Ltd, the INEDs involved are now facing an action for a compensation order under Section 214 of the SFO for breach of their fiduciary duty. If convicted, they could be compelled to personally compensate the company for losses caused by their misconduct. 

Mr Datwani points out that when he talks, in general, to aspiring INEDs, he finds that many of them simply say that they do not mind being an INED of any company as long as they are not exposed to liabilities. That, however, seems to defeat the purpose. Prospective INEDs should possess certain skill sets and want to be an INED to contribute these to the company. Also, their best protection against liabilities is their understanding of their roles and responsibilities and how to discharge them. 

Majority independent boards 

There are compromises for controlling shareholders in having genuinely independent views on the board, but this is the essence of having real checks and balances on the exercise of executive power. This article has reviewed some best practice ideas – such as tightening the rules around the nominations process and setting limits on director tenure – to boost the effectiveness of INEDs, but is it time to consider moving to majority independent boards? 

The Listing Rules (Rules 3.10 and 3.10A) require that every listed company’s board must include at least three INEDs, and the INEDs appointed must represent at least one-third of the board. Ms Wang points out that it has been close to 10 years since these requirements were implemented and in the meantime the market has changed. Perceptions of the board as an old boy’s network are increasingly seen as archaic and any notion that a board appointment is a comfortable retirement position has been dispelled by the more rigorous regulatory scrutiny. 

‘It is about time companies in Hong Kong had majority independent boards,’ says Ms Wang. ‘Having a majority of independent directors would certainly change how some of the key decisions are made at the board level – I believe the market is ready for this,’ she says. 

Sharan Gill

Sharan Gill is a lawyer and writer based in Hong Kong. 

 

SIDEBAR: Recommended reading

• Guidance Note Relating to Independent Non-Executive Directors: Selective Roles, Responsibilities and Liabilities – published January 2021 by The Hong Kong Institute of Chartered Secretaries (the Institute). 
• Missing Opportunities? A Review of Gender Diversity on Hong Kong Boards – published 9 February 2021 by the Institute.
• Guidance for Boards and Directors – published in July 2018 by Hong Kong Exchanges and Clearing Ltd (HKEX).
• Enforcement Bulletin – first published November 2020 by HKEX (the Enforcement Bulletin replaces the previous Enforcement Newsletter). 

The above publications are available from the relevant websites (www.hkics.org.hk and www.hkex.com.hk).