This second and final part of the winning paper of the Institute's Corporate Governance Paper Competition 2016 completes the authors’ elaboration of their five-stage inclusive stakeholder model of corporate governance.

In this article, we advocate an inclusive stakeholder model for the implementation of better corporate governance. The first part of this article, published in last month's CSj, sketched out our definition of corporate governance, the existing problems of corporate governance in Hong Kong and covered the first standard setting stage of our five-stage inclusive stakeholder model of corporate governance. This second and final part of our article will look at the remaining four stages of the model.

2. The compliance stage

The role of the company secretary has experienced a fundamental shift in recent years – from minute-taking to advising the board and helping to determine the company's future strategies. Every listed company in Hong Kong must have a company secretary, who serves the critical purpose of ensuring the board complies with the listing rules and fulfils its statutory responsibilities. Company secretaries also play a vital role in ensuring compliance with laws and regulations, and the company's own internal guidance. The company secretary is also expected to spot any governance problems in the company and provide the board with workable solutions. The importance of the company secretary in corporate governance is observed in their advisory position to the board. Given the company secretary's role connecting the internal stakeholders, we suggest that the company secretary should:

• mobilise employees in the company to raise awareness of corporate governance, and
• coordinate the information flow between the board and employees.

Corporate compliance activities are not governed by widely accepted standards. Therefore, externally, professional associations from each industry could set out new standards of compliance for their members to follow. The drawback of setting out a general compliance standard is that it is not specific to each industry and the company could therefore use this as an excuse not to follow the standard. Creating industry-specific compliance standards allows no room for ignorance of the requirements. The relevant associations can also host sharing sessions to talk about success stories with their members. As a result, the compliance side of corporate governance can be advanced externally and internally.

3. The monitoring stage

Regular monitoring can aid the discovery of loopholes and the early discovery of faults can mitigate losses.

Audit monitoring

External auditors look at information disclosure during the course of their audit. They have to check to make sure the information disclosed fulfils the minimum legal requirements. Their responsibilities go beyond merely fulfilling their contractual relationship with the client. Indeed, their public responsibilities are much more important. Therefore, they should not just blindly follow the requirements of their client. Instead, they should regulate their clients by requesting any missing information and checking its accuracy. Sometimes, their clients do not like this. However, this is also the reason why auditors serve as one of the important external monitoring forces for better corporate governance.

Public inspections

Due to the importance of the external auditors, they should be monitored as well. Auditors have to stay independent and be aware of any conflicts and associated relationships with their clients. Public inspections on audit companies are hence required to achieve comprehensive and effective corporate governance.

Market monitoring

Market monitoring is also important. Market intermediaries must report any market misconduct they find. This may reduce the monitoring costs of regulatory bodies. This mechanism can keep an eye on corporate ethics from a bottom-up perspective, which is different from the top-down perspective of the regulatory bodies.

Internal controls

In addition to the help from external forces discussed above, internal controls within the company are also useful in striving for better corporate governance and to minimise business risks. As mentioned in the standard-setting section of last month's article, we recommend that companies establish their own corporate standards, which could be above the legal requirements. However, setting standards alone is meaningless. Standards should come with an internal error correction mechanism. The company should constantly review its corporate governance, thus responding to institutional pressure. Once it realises there has been a serious deviation from the standards set, it should review the causes and make corresponding adjustments. As a result, this mechanism can maximise the effectiveness of the internally set standard.

4. The enforcement stage

Two suggestions are proposed in this stage. Firstly, in order to bring about effective reform of corporate behaviour, the duty to lead corporate governance reform falls squarely on the government. Secondly, while due regard has to be given to the unique cultural and historical background, Hong Kong has to move from transitional measures of half compliance to ultimate full compliance.

The government should lead corporate governance reform

The government should take the lead in initiating reform. Therefore, the government should be subject to the same, if not more stringent, duty to answer inquiries and the duty to account for the watering down or even rejection of the proposals for reform submitted by Standing Committee on Company Law Reform (SCCLR) and other parties, for example David Webb's HAMS proposal. The strictest duty to be accountable is required from the government for a number of reasons. First, if the government gives ambiguous and unconvincing justifications for rejecting proposals for reform, it is certain to undermine the corporate duty to be accountable when questioned by watchdog groups. The corporate sector may easily deflect external monitoring by blaming the government for having double standards for itself and the private sector. One example is the government's failure to give statutory backing to the rules on financial disclosure and connected transactions suggested in the SCCLR's 2005 proposal. Second, the government's duty to account for the rejection of proposals for reform is highly determinative in achieving good corporate governance. As mentioned, the five stages of corporate governance are interrelated and mutually-reinforcing. If the proposals for reform are not given serious consideration at the enforcement stage, this will render the efforts of the other four stages futile. Given the dysfunctional political system and legislature, the voice of activist groups serves as a better indicator to rebalance the interest of stakeholders.

Legal and regulatory reforms with teeth

As for the second suggestion, Hong Kong should move from halfway compliance to full compliance. The government must strengthen the regulatory framework and improve the overall regulatory efficiency. This involves giving greater statutory backing to the Corporate Governance Code and the listing rules, and improving co-ordination between the government, the SFC, HKEx and other regulatory bodies. Hong Kong currently adopts a comply-or-explain regime as set out in the Corporate Governance Code. The rationale for this is that 'one size does not fit all’ and companies may choose to either comply or to explain the reasons for any non-compliance with respect to their own circumstances. However, scholars have suggested that a similar model in UK depends greatly on the initiative and stewardship of shareholders and the efficiency and discipline of the market, both of which are lacking in Hong Kong. Moreover, implementation of the comply-or-explain regime is effective only to the extent of companies’ compliance but not in demanding specific explanations, as shown by the frequent use of standard explanations. Furthermore, many provisions of the Code are not specific enough and therefore unenforceable. We therefore argue that the government should require mandatory compliance for more provisions and gradually phase out the 'comply-or-explain’ model. Similarly, the broken net of the Companies Ordinance (Cap 622) should be fixed by strengthening the listing rules. The Companies Ordinance does not apply to the many Hong Kong-listed companies with an overseas domicile, so should be supplemented by equivalent requirements in the listing rules so as to create a level playing field for all companies. Alternatively, the government should expand its regulatory reach by signing more MOUs and stepping up international enforcement cooperation. A related matter is overall regulatory efficiency. It is worth noting that mere improvement of regulatory efficiency is futile if the regulator is not equipped with well-drafted legal weapons. It has been suggested by some that to sharpen the regulatory machinery, Hong Kong should have the SFC as the single regulator. This warrants caution. Only two countries in the world, Australia and Pakistan, have adopted this practice of having a single regulator. Rather, we propose that a relocation of the regulatory function from HKEx to the SFC would suffice avoiding conflicts of interest between the securities market operator and the market regulator. The functions of market operation and enforcement shall remain separate to prevent regulatory arbitrage. In the short term, given the foreseeable opposition in reforming the comply-or-explain model and the huge costs of monitoring the quality of companies’ explanations, the government should strengthen the monitoring function in the public arena to relieve the regulatory burden.

5. The engagement stage

Despite empowering stakeholders with rights and giving them responsibilities, stakeholders may not have strong incentives to participate in the corporate governance process owing to the cultural and historical background in Hong Kong. As a result, proposals for reform can only succeed if they can influence stakeholders to think beyond their self-interest and take up more social responsibility. To do so, any proposal should take into account cultural influences.

Shareholder engagement

There has been a lack of shareholder activism in Hong Kong owing to the Asian culture of reluctance to resort to confrontation and resolution of conflicts by law. Other obstacles discourage investors from actively monitoring the company they have invested in. For example, their willingness to exercise monitoring powers is limited by the size of their shareholding, particularly where there are non-institutional controlling shareholders. Their willingness is further hampered by the lack of access to information and their preference to shy away from the spotlight. Exiting by selling their shares is simpler and generally a more favoured route for investors. Is shareholder engagement desirable or is it just chaotic activism? Institutional investors have a crucial role in monitoring nominations to the board, the performance of corporate strategy and influencing the decision-making process due to their expertise and power. What distinguishes institutional investors from retail investors is that the former have a more long-term investment objective. The inclusive stakeholder model applies to shareholder engagement. Both institutional and retail shareholders should be included. We suggest that the idea of institutional investor activism should be encouraged in Hong Kong to encourage collective activism with other minority shareholders. On one hand, there should be disincentives for the delegation of ownership obligations. But, more importantly, stronger incentives for active supervision have to be created. As mentioned above, institutional investors have a stronger willingness to monitor if they have a larger shareholding. Similarly, the composition of the voter pool is an important consideration. The targets of institutional activism are usually those firms with high institutional shareholdings and low insider shareholdings. A possible but highly disputed suggestion is to increase the free-float of shares to make room for a larger shareholding among minority shareholders. Given the political constraints in increasing the free-float of shares, the role of the retail investors in collective activism cannot be overlooked. Some institutional investors are beginning to recognise the importance of collective activism with other minority shareholders. We think that more will follow suit when the success rate grows. Therefore, we propose a voluntary approach to investor activism as opposed to current SFC guidelines on responsible ownership. This is not only because the principles are not effective, but because encouraging willingness to participate without creating incentives is not effective enough (for example Principle 5 of the responsible ownership guidelines). A UK-style stewardship code is unnecessary and inapplicable to Hong Kong.

Build up corporate culture

Corporate culture also plays a vital role in determining whether the desired corporate governance could be engaged and properly enforced within the company. Corporate culture generally refers to a set of values, rituals and standards that unifies how the employees behave in relation to the customers, fostering a unique culture for the company. Since these values are widely shared by the members of the company, in this sense, corporate governance acts to consolidate the corporate culture to a large extent. On the other hand, some have suggested that employees and the CEO, which are parts of the corporate culture, can heavily influence corporate governance. As the corporate culture defines how the company works externally and internally in terms of business transactions, the board, which ultimately determines corporate governance, is affected by the corporate culture. Corporate governance and the corporate culture can therefore be said to be interrelated. Indeed, at Lehman Brothers over-complacency badly influenced corporate governance, and this culminated in a crisis across the globe. After all these failures, whistleblowing programmes have emerged to help advance corporate governance. These form an important part of the culture of a company. Even though few studies reveal that having a whistleblowing policy can be an effective means of fighting corruption and poor corporate governance, there are many managerial issues in implementing such policies. A study by the Economist Intelligence Unit, in which more than 100 executives from various countries and industries were surveyed on their opinions on corporate governance, revealed that the largest obstacle to implementing corporate governance is cultural and managerial hostility towards whistleblowing. So we can see how the corporate culture can affect the effectiveness of a whistleblowing policy and ultimately corporate governance. The prominent relationship between corporate governance and corporate culture can be observed by contrasting the corporate culture in SMEs in Hong Kong with that of multinational corporations in foreign countries. Managers in Hong Kong SMEs are prone to ignore any misconduct or violation because of the traditional convention rooted in their mentality – turning a blind eye to any misconduct as long as the business is not harmed. On the other hand, a system of checks and balances is common within foreign companies. This separation of powers helps maintains good corporate governance. Therefore, in order to improve corporate governance in Hong Kong, the corporate culture in its SMEs needs a serious review and evaluation.

Other non-shareholding stakeholders

External parties – other non-shareholding stakeholders – cannot be neglected as they play an important part in instilling the concept of corporate governance in every market participant. Indeed, ethical market players form one of the forces structuring a company's corporate governance. For a market to be effective and efficient all the stakeholders and market participants must act with integrity. This is what we desire in the Hong Kong market. Even though they might not be the subject of regulation at this moment, there needs to be a greater awareness of corporate governance in a bid to achieve corporate governance through ethical guidelines or good communication channels. A clear example is that the capital market should not reward companies with bad corporate governance with easy access to equity capital and favourable interest rates. Most importantly, every stakeholder should take up a more active role and should not wait until the next market breakdown to catalyse any regulatory reform that could have prevented market failure. Chan Sze Wai, Chiu Wai Hung and Wong Ho Wai The University of Hong Kong