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THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES

THE INSTITUTE OF CHARTERED SECRETARIES AND

ADMINISTRATORS

International Qualifying Scheme Examination

CORPORATE GOVERNANCE

DECEMBER 2013

Suggested Answer

The suggested answers are published for the purpose of assisting students in their

understanding of the possible principles, analysis or arguments that may be identified

in each question

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SECTION A

1.

Healthy Living Limited (Healthy Living), which has been listed on the Main

Board of The Stock Exchange of Hong Kong Limited (SEHK) since 2009, is

a leading retailer of organic foodstuffs and healthy dietary supplements in

Hong Kong.

Alvin, Billy, Carl and David are shareholders and executive directors of

Healthy Living. The shareholdings of each of them immediately after

Healthy Living’s listing were as follows: Alvin (32%), Billy (18%), Carl (10%)

and David (9%). In addition, the company’s board also includes three

non-executive directors (NEDs), each of whom holds 2% of the shares in

Healthy Living, and three independent non-executive directors (INEDs),

none of whom hold any shares in Healthy Living.

Alvin is the chief executive officer (CEO) of Healthy Living, and exerts great

influence on the other directors, particularly two of the three NEDs. Healthy

Living's board has few procedures for the directors to follow; this enables

Alvin to force his will over the other directors on how to run the company's

business.

In September 2011, a health food company based in Singapore started

negotiations with Alvin to purchase his entire shareholding in Healthy

Living. Billy, Carl and David, however, were against the proposed sale

fearing that the transaction, if successful, might lead to a possible takeover

of Healthy Living by the Singaporean company. Accordingly, the board, by

a majority vote passed at a board meeting, resolved to allot shares to Eric

pursuant to the general mandate given by the shareholders at the annual

general meeting. The result of the share allotment would dilute Alvin's

shareholding in the company to approximately 29%.

Alvin was furious with the board's decision to dilute his shareholding, and

decided to requisition an extraordinary general meeting (EGM) to overturn

the allotment decision. He also instructed his solicitor to initiate

proceedings in the High Court to sue the other directors of Healthy Living

should his challenge of the allotment decision at the EGM fail. His solicitor

suggested him to consider pursuing legal remedies under the statutory

derivative action under Part IVAA of the Companies Ordinance or unfair

prejudice remedy under section 168A of the Companies Ordinance.

In media interviews about his other investments, Alvin took the opportunity

to criticise the other directors of Healthy Living for undermining his interest

in the company. Billy, Carl and David, for their part, were angry with Alvin’s

media criticism of them, and possible legal action, which, in their view, was

against the company's interest and harmed its reputation. While Alvin was

on holiday in Australia, they called a board meeting at which they proposed

that Alvin should be stripped of his directorship and all his duties as

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chairman and CEO of the company. Despite objections from certain INEDs

and NEDs, the majority of the directors present decided to convene an

EGM for the purpose of passing an ordinary resolution to approve the

removal of Alvin.

At that board meeting, the directors also discussed the need to find a

suitable replacement to succeed Alvin as the next CEO of Healthy Living.

The board, however, was not keen on appointing the next CEO from within

the company's ranks as it wanted an outsider to offer a new perspective on

the business and take the company to a higher level. The directors

reasoned that if the successor came from within the company, he or she

may have been influenced by Alvin's style of management to a significant

extent and would not be able to offer a different perspective on how to run

the company's business. The appointment of a new chairman and CEO

was yet to be decided after the EGM.

REQUIRED:

1. (a) Discuss the implications of the possible takeover and the share

allotment on the rights and interests of the shareholders, including

the controlling shareholder and minority shareholders.

Ans (a) Alvin as the controlling shareholder wants to sell his entire shareholding

interests in Healthy Living to a third party. The proposed sale will trigger

a mandatory offer to be made by the Singaporean company, resulting in

a change of control of the company.

Under the Takeovers Code, a person or group of persons acquiring

30% or more voting rights of a company is required to extend offers to

all shareholders of the company.The possible takeover will affect all the

shareholders including Billy, Carl and David and other minority

shareholders.

If the takeover is successful, the Singaporean company will become the

controlling shareholder and may nominate new directors to the board

and/or make any changes in management or business strategy.

Billy, Carl and David do not want the control of the company to be

changed to a party with whom they appear to disagree or do not want

any change in the status quo. So they act together to prevent the

possible takeover by proposing the share allotment.

The share allotment will dilute Alvin’s interest to below 30%, which

might make the deal abortive as the Singaporean company probably

wants to acquire a controlling stake from Alvin.

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The share allotment will also dilute the interest of other minority

shareholders. If the allotment is not made with a proper cause, the

interests of shareholders will be prejudiced.

If the share disposal triggers a mandatory offer, the minority

shareholders have the right to sell their shares to the offeror under the

same terms as Alvin.

With the share allotment, the deal might be called off and minority

shareholders will be deprived of their rights to consider the terms of a

possible takeover, whether these terms are favourable to them or not.

In the case of a takeover, there should be timely and adequate

information to enable shareholders to make an informed decision as to

the merits of an offer and ensure that there is a fair and informed

market in the shares of the company.

The shareholders are entitled to accept or reject the offer, unless

compulsory acquisition is enforced under the Takeovers Code.

1. (b) Discuss whether or not Alvin might be successful in challenging the

company’s decision to allot shares to Eric and whether Alvin can

pursue the two legal remedies as suggested by his solicitor against

the other directors of Healthy Living.

Ans (b) Each of the directors of Healthy Living occupies a fiduciary position towards

the company of which he or she is a board member: Regal (Hastings)

Limited v Gulliver [1967] 2 AC 134. According to Mason J in Hospital

Products Limited v United States Surgical Corp (1984) 156 CLR 41, a

fiduciary undertakes to act in the interests of another person when

exercising a power or discretion which will affect the interests of that person

in a legal or practical sense.

One of the core obligations of a fiduciary is that of loyalty and good faith:

Bristol and West Building Society v Mothew [1998] Ch 1. Specifically,

directors are required, among others, to:

Act in good faith for the benefit of Healthy Living

Exercise their powers for proper purposes

Exercise power for proper purpose / act in the interests of the company

The purpose of the board’s decision to issue shares to Eric was to dilute

Alvin’s shareholding. As held by the Privy Council in the leading case of

Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 82, such an allotment

of shares is not a proper exercise of directors’ powers for which they were

conferred. Further, what the directors purported to do was for their own

benefit, i.e. to avoid the possibility of a takeover by the Singaporean

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company, and not for the company’s own interest. The allotment is

therefore a breach of directors’ duties, hence prima facie voidable: Piercy v

S Mills and Co Ltd [1920] 1 Ch 77; Hogg v Cramphorn Ltd [1967] Ch 254.

In their defence, the directors could argue that they were allowed to

exercise their powers in what they believed was in Healthy Living’s best

interests: Re Smith and Fawcett Ltd [1942] Ch 304. This argument,

however, is unlikely to succeed these days because of the need to inject an

element of objectivity into the Fawcett subjective test. Objectively speaking,

no reasonable director would consider the rationale of the allotment to be in

the interests of the company.

Nevertheless, while the directors may have prima facie breached their duty

by allotting the shares to Eric, this breach might be cured by shareholders’

ratification in an extraordinary general meeting (EGM) after full disclosure:

Hogg v Cramphone Ltd [1967] Ch 254, Bamford v Bamford [1970] Ch 212.

The ratification is relatively easy to achieve since only a simple majority of

the shareholders present at the EGM is needed to approve the ratification:

Wong Kam San v Yeung Wing Keung [2007] 2 HKLRD 267. Moreover,

unlike in the UK (see section 239(4) of the Companies Act 2006), votes

cast at the EGM by the defaulting directors/shareholders ratifying the

breach are counted in Hong Kong. (This will be changed by clause 473(3)

of the new Companies Ordinance, which was passed in July 2012, with the

new Companies Ordinance to come into operation in 2014). Under 473(3)

of new Companies Ordinance, the defaulting directors/shareholders

ratifying the breach are not counted.

Provided that there is no evidence of fraud or other illegal activities involved

in the breach, the ratification would succeed: Cook v Deeks [1916] 1 AC

554. For these reasons, it is unlikely that Alvin will be able to overturn the

allotment decision.

Also, a company is required to seek prior shareholder approval for an

allotment of shares if the new shares are not allotted to existing

shareholders on a pro rata basis. Healthy Living has already obtained a

general mandate from shareholders to allot shares from time to time during

the year up to 20% of its issued share capital and the allotment of shares to

Eric was made pursuant to such mandate. If all procedures are followed

and there is no fraud involved, it will be difficult to overturn the allotment

decision.

There are a number of legal actions that Alvin may consider taking against

the other directors, two of which could be successful in court.

1. Statutory derivative action

Under Part IVAA of the Companies Ordinance, Alvin could bring a statutory

derivative action (SDA) on behalf of Healthy Living in respect of the

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misfeasance committed against it. As per section 168BB(2), misfeasance

means:

Fraud;

negligence;

default in complying with law; or

breach of duty.

or

Under new Companies Ordinance

Under sections 731 and 732, Alvin could bring a statutory derivative action

(SDA) on behalf of Healthy Living in respect of the ‘misconduct’ committed

against it, where misconduct means:

fraud;

negligence;

default in complying with law; or

breach of duty.

Leave of the court must, however, be obtained to bring a SDA. Pursuant to

section 168BC(3), the court may grant leave if it is satisfied, inter alia, that

(i) it appears to be prima facie in the interest of the company that leave be

granted, and (ii) there is a serious question to be tried. Except where leave

is granted by the court to dispense with the service of a written notice, the

applicant must serve a notice in writing on the company stating his intention

to seek leave to bring a statutory derivative action and the reasons for his

intention.

Here, since the directors have breached the duties of:

acting in the best interests of the company; and

exercising powers for proper purposes,

the SDA has a high chance of success.

If the SDA is successful, the court has a wide discretion under section

168BG(1)(d) and (2) (or under new Companies Ordinance section

737(1)(d) and (2)) to make an order appointing an independent person to

investigate the facts or circumstances that gave rise to the proceedings or

under section 168BG(1)(c) to make an order directing the company to do or

not to do any act, e.g. for payment of compensation to Alvin.

2. Unfair prejudice remedy

Alvin can conceivably petition the court for an order under section 168A (or

under new Companies Ordinance section 724) of the Companies

Ordinance if it can be established that Healthy Living’s affairs have been

conducted in a manner unfairly prejudicial to the shareholders’ interests.

According to Fuad J in Re Taiwa Land Investment Co. Ltd. [1981] HKLR

297, ‘unfairly prejudicial’ means conduct departing from accepted

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standards of fair play which amount to unfair discrimination against the

minority. The conduct complained of must be both unfair and prejudicial at

the same time.

Alvin is likely to rely on the directors’ breach of duties as evidence of unfair

prejudice. If successful, the court has a wide discretion under section

168A(2)(a) to grant an order to Alvin, e.g. a buy-out order.

Since the breach of the directors’ duties by the other directors of Healthy

Living appears to be an isolated incident, and it would be hard to allege a

pattern of unfair prejudicial conduct on the part of those directors, the

chance of success of the unfair prejudice claim would be lower than that of

the SDA.

1. (c) Identify and discuss the problems about the existing functioning of

the board of directors and the role that the independent non-executive

directors should play in the case.

Ans (c) Problems with the existing board functioning:

The board is not functioning smoothly due to issues relating to conflicts

of interests and worsening relationships among the directors.

The roles of the chairman and CEO are combined. Alvin exerts great

influence and there is a lack of proper checks and balance in the board.

The other directors are not satisfied with Alvin’s management style,

complaining that Alvin forces his strong will on other directors in running

the business.

Certain directors have shareholdings in the company and a conflict of

interest arises when Alvin wants to sell his controlling stake to a

Singaporean company; the other directors are against such a disposal

since this would trigger a possible takeover, which they do not want.

There is an apparent lack of procedures governing the declaration of

interests in the matters transacted by the board – directors who have

conflicts of interests are voting for the share allotment proposal.

The directors have criticised each other and even made a proposal to

remove one of their board members indicating that the board is not

working in harmony.

There is insufficient independent elements in the board as the INEDs

represent less than one-third of the board and are weak to challenge

the share allotment proposal or removal of director and fail to resolve

the conflicts of interests among the executive directors.

There is a succession risk if Alvin is removed. Board functioning will

probably be disrupted as no succession plan is in place; there is a

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pressing need to identify any candidate(s) to take up the role of

chairman in leading the board and that of CEO in running the business.

Role of independent non-executive directors:

Take the lead to resolve any potential conflicts of interest in the

decision-making process, exercising independent judgment and

requiring those directors who have conflicts of interest to abstain from

voting

Exercise due care and diligence when considering the share allotment

proposal, taking into consideration the purpose of share allotment and

potential dilution of shareholdings of existing shareholders – not to

cause dilution of their interests without proper cause

Ensure equitable treatment to all shareholders and take care of the

interest of not only the major shareholders, but also the minority

shareholders who may be affected by the possible takeover and share

allotment

Assess the implication of the possible takeover and consider whether

the terms of the possible takeover are fair and reasonable to the

minority shareholders and if necessary, consult an independent

external advisor

Ensure proper procedures are in place for any removal of directors and

nomination procedures and succession planning for directors and the

CEO

1. (d) Critically discuss the importance of succession planning and its

related procedures, including design and best practices, that Healthy

Living may adopt in an effort to find the best candidate to succeed

Alvin.

[Where appropriate, candidates may refer to:

case law to support their arguments in answering parts (a) and (b); and

the Corporate Governance Code of Hong Kong in answering parts (c)

and (d)]

Ans (d) The importance of succession planning

Succession planning is an important feature of a well-developed corporate

governance system. It refers to the well-planned process of ensuring that

unexpected disruption to the company's decision-making processes or

unexpected changes in policy or direction can be avoided and that the

company has systems and a strategy in place for the development of future

leaders.

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A succession plan reflects the competency of the board of directors. The

existence of a well-conceived CEO succession plan, announced in

advance, conveys a firm message of the vision and mission of the company

and serves to reassure investors, customers and suppliers that the

company understands its strategic direction and knows how to get there.

It also sends a strong message to employees that the company is secure in

its assessment of the future and has the interests of its employees at the

centre of its decisions.

It gives shareholders a reliable expectation of business continuity in case of

the loss of key managers and helps resolve any potential conflicts within

the controlling shareholder. It sets the tone for personnel management for

the whole company, can be a model for company-wide career development

planning, and provides motivation to mid-level managers through

development activities and recognition.

Succession planning design

It typically includes:

a system for assessing the qualifications and skills needed for any post;

a programme for the professional development of personnel who can

move into key roles;

a system to facilitate the search for potential candidates from outside

the company for key positions; and

last but not least, emergency succession plans for the CEO, all senior

management and other key positions in the company.

Succession planning must involve the full board or, if planning is delegated,

the nomination committee. Under the Higgs Guidance: Summary of the

Principal Duties of the Nomination Committee, the nomination committee

should give full consideration to succession planning in the course of its

work, taking into account the challenges and opportunities facing the

company and what skills and expertise are therefore needed on the board

in the future.

The succession planning process ideally should be chaired by a

non-executive director and the non-executive directors involved should be

informed of the strategic plan.

The succession plan should be reviewed each year in conjunction with the

review of the strategic plan. The nomination and remuneration committees

should develop a draft succession policy for key positions on an ongoing

basis.

The board should review and approve the draft succession policy; it should

review candidates for the CEO position. Within the ranks of senior

management, emergency succession plans for key positions should be

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well-understood, but not publicly disclosed. Shareholders should be

provided with general information about the succession planning systems

in place.

Best practices for succession planning

Every company goes about recruiting its CEO and other members of its top

management team in its own way, but the best ways are to identify key

roles for succession planning, define the competencies required to

undertake those roles, assess people against these criteria, find the best

sources for the talent they need; and assure the quality of the initial work

experience for recruited executives.

Selecting the 'right' CEO and determining the success factors for the CEO:

Based on a strategic assessment of a company, a board should ask

itself:

What must this company do well to succeed now and in the future?

What are the dynamics of the industry?

How is the competitive environment affecting the company?

What are the company's critical imperatives for success?

Matching the CEO to the corporate strategy is the foundation of

succession planning. The CEO, as well as the talent pool of potential

replacements, must be a solid match with the company's current

business landscape, the company's emerging needs and future

business challenges.

The board must ask itself what the next person in the CEO seat must

do extremely well to achieve the company's strategic imperatives. The

board should define the job and its success factors. The board should

ask itself what kind of person would fit the needs of the company.

The key question about a CEO candidate is whether this person will be

able to succeed in their new job in the new environment. Does the

candidate fit into the existing corporate culture? The board may carry

out an appraisal of the candidate's track record and abilities against

defined selection criteria and develop the candidates to be ready for

advancement into the key roles.

The Corporate Governance Code (Hong Kong Code) states that there

should be plans in place for an orderly succession for appointments to the

board. The nomination committee should discharge its duties to make

recommendations to the board on relevant matters relating to the

appointment or re-appointment of directors and succession planning for

directors in particular the chairman and the CEO: Hong Kong Code, A.4,

A.5.2(d).

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Another consideration for the board of Healthy Living is that the successor

candidate should ideally join the board 6 to 12 months prior to the

retirement of the chairman and CEO. This allows the successor candidate

and the board to have increased exposure to each other and the issues of

the board to facilitate a smooth transition.

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SECTION B

2.

A major corporate governance difference between countries is the board

structure, which may be unitary (one-tier) system or dual (two-tier) system.

REQUIRED:

2. (a) Describe and distinguish the unitary board structure and dual board

structure.

Ans (a) Unitary board structure:

Characterised by one single board of directors

Comprising both executive and non-executive directors

The unitary board is responsible for all aspects of the company's

activities and makes all decisions

Shareholders elect the directors to the board at the company's annual

general meeting

Commonly found in countries like the US and UK

Dual board structure:

Comprising a supervisory board and an executive board of

management

Management board consists exclusively of executives while the

supervisory board consists of all non-executive members and often

includes a significant number of employee representatives.

Management board makes decisions about operational matters of

major importance while supervisory board has oversight of

management board

Shareholders appoint the members of the supervisory board (other than

the employee members), while the supervisory board appoints the

members of the management board

Commonly found in continental European countries like Germany and

state-owned enterprises in China

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2. (b) Critically discuss the case for each of the unitary board structure and

the dual board structure. In your opinion, which system serves

shareholders’ interest the best?

Ans (b) Case for unitary board

One-tier system is probably more efficient in cases where the company

has a major or prevailing shareholder where the goals and objectives of

such company are largely determined by the major shareholder, thus

bringing about more efficient and faster decision-making.

The combination of supervisory and management function suggests the

advantage of no real conflict between the shareholders and the board.

The unitary board may result in a closer relationship between the

supervisory and managerial bodies.

The unitary board may result in better information flow between the

supervisory and managerial bodies.

In the unitary board structures, all directors (executive or non-executive

directors) have equal legal status and equal responsibility in law. By

holding all directors equally accountable, board accountability is

enhanced.

The presence of non-executive directors with wider perspectives and

expertise can lead to questioning and scrutiny of the actions and

decisions made by executive members.

Single-board system avoids disruptive management decision-making,

particularly relating to sensitive discussions on labour negotiations and

salary compensation for the board, since the presence of

non-management employees in the boardroom may cause problems.

Traditional rights of the owners, especially family companies, are

protected and directors are shielded from being voted down by worker

representatives. A single-board system may avoid the growth of worker

unions which may hinder shareholder interests.

Case for dual board structure

It helps promote a stakeholder approach to corporate governance,

taking into account the needs of the other stakeholders.

Other stakeholders are allowed to sit on the supervisory board, along

with other director and shareholder representatives, in order to oversee

the management board. They have equal rights and authority to

support or withdraw members from the management board.

In a dual system, there is a clear separation between the functions of

supervision (monitoring) and that of management since there is no

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overlapping of members among the two boards.

It prevents the case in a single board in which some individuals bear the

responsibility for both supervising and overseeing processes; they can

become muddled and the supervisory function may become weakened.

Executive management is accountable to the supervisory board which

can ensure the management to establish company’s goals and identify

common interests of shareholders.

The German two-tier system of employees’ participation in supervisory

board allows the represent employees to work with management so as

to undermine the power of trade unions.

Which system serves shareholders’ interest the best

Each board structure offers unique benefits. Different models of

governance have been formed in different economic and social

systems. There is no universal answer to the question of which system

serves shareholders’ interest in the best.

Effectiveness of board structures might depend on an excellent working

relationship between the supervisory body and management body.

Regardless of the types of board structures, there should be a healthy

interaction between the supervisory function and the management

function.

It is impractical to propose that the unitary board structure is superior to

the two-tier board structure or vice versa. Relevant decisions in

choosing the types of board structure depend on the corporate

ownership, companies’ culture, company law, etc., of a particular

country.

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3.

John, who has been the chairman and chief executive officer (CEO) of

Pesa Engineering Limited (Pesa) for more than 20 years, is thinking of

retiring after the company lists on the Hong Kong Stock Exchange in 15

months’ time.

John wants to appoint his son, Rick, the current chief financial officer, to be

Pesa’s new CEO after the company is listed. He also wants to become

Pesa’s non-executive chairman and appoint more non-executive directors

(NEDs) to meet the listing requirements of the Hong Kong Stock Exchange,

but is aware of some of the comments against NEDs. John asks for your

advice.

REQUIRED:

Discuss the situation with John, focusing on the following issues:

3. (a) The suitability of appointing Rick as Pesa’s CEO from a good

corporate governance perspective.

Ans (a) If the same person is in charge of the management of the board (role of

chairman) and day-to-day management of the company's operations and

business (role of CEO), there is a risk that one single person can dominate

the company with too much power concentrated in him: Hong Kong

Corporate Governance Code (Hong Kong Code), A.2.

The Hong Kong Code does not require the chairman and CEO to be

independent from each other, therefore there is no formal reason why Rick

cannot be appointed as the next CEO.

However, under the Listing Rules, the Corporate Governance Report of a

listed company must disclose the nature of relationship among board

members, the identity of the chairman and CEO and whether these two

roles are segregated: para I(h) and J of Appendix 14 to the Main Board

Listing Rules.

It is doubtful that, given their close relationship, John will not exert his

influence over Rick.

John’s attention should be drawn to a comparison between the Hong Kong

Code and the UK Corporate Governance Code (UK Code). The UK Code

states that the chairman of a listed company should be non-executive and

independent and that a CEO should not go on to become the chairman of

the same company. It would be hard to convince local and foreign

institutional investors that there are checks and balances within the

company when members of John’s family are chairman and CEO of Pesa.

If the board of directors insists on appointing Rick as the next CEO, one

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way to enhance the checks and balances within the board of directors

would be, as John has said, to appoint more independent non-executive

directors than the minimum requirement at the time of listing.

3. (b) The usual duties of a non-executive chairman other than chairing

board meetings and general meetings.

Ans (b) Regarding the basic duties of a non-executive chairman other than those

relating to chairing board meetings and general meetings, a chairman

should, for example:

lead the board in setting the values and standards of the company;

maintain a relationship of trust with and between the executive and

non-executive directors;

facilitate the effective contribution by the non-executive directors;

ensure effective communication with the shareholders, and ensure that

the board members develop an understanding of the views of the

majority shareholders (e.g. institutional investors) and other

stakeholders (e.g. employees, customers, etc.);

ensure effective communication between the board of directors and

management;

work with the CEO to ensure that important information is appropriately

represented to the board of directors in a timely manner;

work with the CEO on the making of corporate strategy. In the words of

Sir Adrian Cadbury: "Both the chairman and the chief executive have a

responsibility to ensure that the company is working to a strategy which

is understood inside the company and externally";

provide advice to the CEO and management on major issues, e.g. crisis

management;

take a major role in representing the company to the shareholders and

the outside world (e.g. financial institutions, the media, etc.) to ensure

that "the outside world is as well informed as possible about the

company and that it sees its activities in a positive light";

take the lead in providing suitable induction for new directors and

identifying and meeting the development needs of individual directors;

ensure that the performance of the board as a whole and of individual

directors is evaluated on a regular basis; and

ensure that good corporate governance practices and procedures are

established.

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3. (c) The usual criticisms of NEDs.

Ans (c) Some individuals hold executive positions in other companies or too

many non-executive directorship positions in listed companies, more

than they could possibly serve effectively since they cannot give

sufficient time to any individual company.

The law makes no distinction between executive and non-executive

directors. The threat to equal criminal or civil liability with executive

directors makes non-executive directors more likely to support their

executive colleagues.

Non-executive directorships have frequently been given to the

executive directors of other listed companies, giving rise to the

concerns about a "you scratch my back and I'll scratch yours" mentality.

This can make non-executive directors reluctant to criticise a fellow

executive director.

The relationship between a non-executive director and the company

can become too cosy over time, as the non-executive director becomes

more familiar with the executive directors.

Non-executives should help to make the board more accountable to the

shareholders. However, shareholders have only limited opportunities to

discuss the company's affairs with the non-executives in a formal

setting.

The presence of non-executive directors does not necessarily prevent

the company from making disastrous strategic decisions.

When a company makes bad strategic decisions or fails to achieve its

strategic targets, the non-executive directors do not necessarily hold

the CEO to account for his/her failure.

Non-executive directors lack the insider knowledge which executive

managers have over business operations; they need to rely on the

integrity of the information supplied to them by management and

executive directors. This restricts the scope for non-executive directors

to make a meaningful contribution to board decisions.

Non-executive directors fail to stand up for shareholders' rights and to

prevent domination of the company against over-powerful executives

for self-perpetuating reasons.

A founding family or a close-knit shareholding group has the controlling

shares of the company so that the family or group can dominate the

company, and has the right to appoint and remove any directors. The

non-executive directors have insufficient power to counteract the

widespread influence of these family corporations.

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Non-executive directors are badly paid, and their pay is not proportional

to the responsibility or risk they take.

The opinion of the executive directors is likely to carry greater weight as

they know the company better. Non-executive directors may be put

under pressure to accept the views of their executive director

colleagues.

Non-executive directors may delay decision-making within a company.

The time required to convene and hold a meeting, giving the

non-executive directors sufficient time to reach a well-informed opinion

about the matter under discussion, may delay the implementation of the

proposal.

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4. “Corporate governance involves creating business value while managing

risk.” (Bob Tricker, Corporate Governance – Principles, Policies and

Practices (2009), page 328).

REQUIRED:

Critically evaluate this statement by discussing the following issues:

4. (a) The role of risk management in corporate governance.

Ans (a) Risk management is the process by which executive management, under

supervision by the board of directors, identifies the risks (e.g. operational

risks, financial risks, legal risks) arising from the business and puts control

activities in place to manage those risks.

It is the responsibility of the board of directors to look after the assets of the

company and to protect the value of the shareholders' investment. This

includes a duty to take risk management measures to prevent losses

through error, omission, fraud and dishonesty.

Risk management help reduce the probability of the company being

jeopardized by unforeseen events in achieving its corporate goals.

The board should be satisfied that, in their decision making, managers take

risk into account as well as expected returns. Similarly, when the board

takes major investment decisions itself or decides on corporate strategy,

risks as well as expected returns should be properly assessed.

Principle C.2 of the Corporate Governance Code requires that the board

should ensure that the company maintains sound and effective internal

controls to safeguard the shareholders' investment and the company's

assets.

Code Provision C.2.1 requires that the directors conduct a review of the

effectiveness of the system of internal controls of the company and its

subsidiaries at least annually and report to shareholders that they have

done so in the Corporate Governance Report.

The board should set appropriate policies on internal controls and seek

regular assurance to satisfy itself that the system is operating effectively.

The board should also ensure the system of internal controls is effective in

managing risks in the way it has approved.

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4. (b) The principles of establishing an effective internal control system to

reduce a company’s risk exposure.

Ans (b) The board should set appropriate policies. In deciding its policies for internal

controls and assessing what constitutes an effective internal control system,

the board should consider the following factors:

The nature and extent of the risks facing the company.

The extent and categories of risks that it regards as acceptable for the

company to bear.

The likelihood that the risks will materialise.

The company's ability to reduce the incidence and impact on the

business of risks that do materialise.

The costs of operating particular controls relative to the benefits to be

obtained from managing the risks they control.

An effective internal control system should include control activities,

communication processes and processes for monitoring the continued

effectiveness of the system.

It should be embedded in the operations of the company and form part of its

culture, and be capable of responding quickly to risks to the business as

they emerge and develop.

It also needs to include procedures for reporting immediately to the

management responsible any control failings that have been identified and

any corrective action that has been undertaken.

4. (c) The benefits and limitations of implementing a risk management

process in a company.

Ans (c) Benefits of implementing risk management process

The risk management process is implemented by the company's board,

management and other personnel and is applied in a strategic setting and

across the whole organisation. It is a process that provides a robust and

holistic top-down view of key risks facing an organisation.

Implementing systematic risk management can:

Help the company identify and manage the potential events or actions

that may adversely affect the company to provide reasonable assurance

regarding achieving its objectives and implementing its strategies

Ultimately increase the company's chances of success and reduce the

possibility of failure

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Enable the company to have a more cost-effective way of dealing with

risk

mitigates some of the current economic impacts

Ensure the company is better prepared in the future to face severe

sudden shocks

Help the company gain greater investor confidence

Limitations of implementing a risk management process

Implementing a risk management process requires input from the

company's resources and management effort. Lack of senior management

support for risk management is a key barrier to full implementation of a risk

management programme.

In some cases, the cost of implementing a sophisticated risk management

programme may outweigh the benefits received.

In addition, a risk management programme cannot ensure that a company

eliminates or mitigates all the risks since some of the risks, such as natural

disasters and political instability, cannot be controlled and managed by the

company.

Ineffective risk identification and assessment channels, lack of a clearly

documented and communicated risk appetite that defines the amount of risk

the company is willing to accept in pursuit of its objectives, and lack of

ongoing risk monitoring are also some of the barriers.

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5. Financial scandals, such as the collapse of Enron in the US and the HIH

Insurance and One.Tel failures in Australia, have heightened the debate on

the roles of the auditor and of the audit committee.

REQUIRED:

In the context of good corporate governance, critically discuss the following

issues:

5. (a) The auditors’ role.

Ans (a) The role of auditor

The external auditors' responsibility is to express an opinion on the financial

statements of the company based on their audit, and to report to the

members of the company.

They conduct their audit in accordance with acceptable standards on

auditing which require that they comply with ethical requirements and plan

and perform the audit to obtain reasonable assurance as to whether the

financial statements are free from material misstatement.

The duties of the auditor have now been strengthened and include

accountability to shareholders and a duty to the company to exercise due

professional care in the conduct of the audit.

An auditor is expected to be independent of the company and to report on

the company objectively. Greater attention is paid to ensuring auditor

independence, including steps to manage and minimise potential conflicts

of interests.

The engagement of an external auditor can help resolve agency problems.

The external auditor facilitates a situation where managers are encouraged

or compelled to be held more accountable.

Through an appropriate application of accounting policies, the external

auditor can help facilitate a position where creative accounting practices

and inflation of figures are discouraged.

There are popular misconceptions on the nature and extent of the role of

auditors. Auditors are not responsible for preparing the financial

statements, or for providing absolute assurance that the figures in the

financial statements are correct, or for detecting fraud or error in the

financial statements, or providing a guarantee that the company will

continue in existence. In fact, the company's management is responsible

for preventing and detecting fraud and error by implementing an adequate

system of accounting and internal controls. While auditors are not

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responsible for detecting fraud or error, auditors assess the risk and

probability of fraud or error which might cause the financial statements to

be materially misleading.

External auditors play a vital role in corporate governance through their

involvement and their examination of financial statements and accounting

policies. Relevant provisions in the Hong Kong Code include code

provisions C.1.2, C.1.3, C.3.3(d) to (j) and principle C.2.

5. (b) The perceived threats to auditor independence.

Ans (b) Threats to auditor independence

The auditor should be independent from the client company to prevent any

interventions when making judgments so as to avoid any influence from a

relationship between the auditors and the company. It might be argued that

unless suitable corporate governance measures are in place, a firm of

auditors might reach opinions and judgments that are heavily influenced by

their wish to maintain good relations with the management of a client

company.

The following issues affecting auditor independence need to be addressed:

An audit firm should not have to rely on a single company for a large

proportion of its total fee income, because undue dependence on a

single audit client could impair objectivity.

A risk to objectivity and independence arises when the audit firm or

anyone closely associated with it (such as an audit partner) has a

mutual business interest with the company or any of its officers.

Similarly, objectivity could be threatened when there is a close personal

relationship between a member of the audit firm and an employee of

the company.

An audit firm should not have as a client a company in which a partner

holds a significant number of shares.

Auditor independence is significantly impaired when the auditor relies

on the company's management to secure his appointment and

re-appointment as auditor.

To maintain good relationships with client companies, some auditors

might give a subjective opinion which is favourable to the company.

However, qualified accountants are expected to carry out their

professional duties with integrity and honesty. A code of ethics may act

as a measure of this behaviour.

The audit firm might become over-familiar with the client company, and

the auditors begin to accept what they are told without question.

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Objectivity is impaired when an auditor performs any management

functions in a client company or takes any management decisions.

An audit firm taking non-audit work like advisory work could put its

independence at risk. The main problem with auditors doing non-audit

work is that when the firm audits transactions recommended by its

consultancy or taxation arms, it is unlikely to take an independent view.

The risk to auditor objectivity and independence from carrying out

non-audit work became apparent in the wake of the Enron collapse.

Non-audit work should be restricted by setting a limit on the amount of

fees which an audit firm can earn from these additional assignments.

5. (c) Whether having an effective audit committee can raise the standards

of corporate governance in a company.

Ans (c) Audit committee’s core functions to enhance corporate governance

The main role and responsibilities of the audit committee should include:

to monitor the integrity of the financial statements of the company and

any formal announcements relating to the company's financial

performance, reviewing significant financial reporting judgments

contained in them;

to review the clarity and completeness of disclosures in the financial

statements and consider whether the disclosures made are set properly

in context;

to consider significant accounting policies, any significant estimates

and judgments;

to review the company's internal financial controls and, unless

expressly addressed by a separate board risk committee composed of

independent directors or by the board itself, the company's internal

control and risk management systems;

to monitor and review the effectiveness of the company's internal audit

function;

to make recommendations to the board for it to put to the shareholders

for their approval in general meeting in relation to the appointment of

external auditor, and to approve the remuneration and terms of its

engagement;

to review and monitor the external auditor's independence and

objectivity and the effectiveness of the audit process, taking into

consideration relevant professional and regulatory requirements;

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to develop and implement policy on the engagement of the external

auditor to supply non-audit services, taking into account relevant ethical

guidance regarding the provision of non-audit services by the external

audit firm; and to report to the board, identifying any matters in respect

of which it considers that action or improvement is needed and making

recommendations as to the steps to be taken;

to review arrangements by which staff of the company may, in

confidence, raise concerns about possible improprieties in the matter of

financial reporting or other matters and to ensure that arrangements are

in place for the proportionate and independent investigation of such

matters and for appropriate follow-up action.

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6.

You are the company secretary of a leading blue chip company listed in

Hong Kong, and you act as the head judge in a competition selecting the

company with the best corporate governance performance in the past year.

REQUIRED:

Prepare a memorandum for the chairman of the competition’s organising

committee critically discussing the key criteria and key analytical issues relating

to the following corporate governance issues:

6. (a) The quality of the board and board effectiveness.

Ans (a) Key criteria:

A board should be structured in such a way as to effectively promote

and protect the long-term interests of all the shareholders and to ensure

their interests be represented fairly and objectively. Key functional

areas, including audit, nomination and compensation, are addressed

either through a formal committee structure or other structural

mechanisms.

The board should include an appropriate combination of executive and

non-executive directors (and, in particular, independent non-executive

directors) such that no individual or small group of individuals can

dominate the board’s decision making. A sufficient degree of board

independence helps ensure fair protection of all shareholders' interests.

The board should be of sufficient size and the board composition

should represent an adequate skill mix and professional experience.

The compensation plan for executive directors should not encourage a

short-term focus.

The board should have overall accountability for the performance of the

company.

The board should play a meaningful role in overseeing strategic

planning and the implementation of the company's strategy, in

reviewing the performance of the CEO and other senior management,

in avoiding conflicts of interest, and in ensuring that management

succession, appropriate financial, operational and internal controls and

risk management systems are in place. Effective boards are active and

demonstrate true independence of mind vis-à-vis company

management.

There should be a formal, rigorous and transparent procedure for the

appointment of new directors to the board.

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All directors should be able to allocate sufficient time to the company to

discharge their responsibilities effectively.

All directors should receive induction on joining the board and should

regularly update and refresh their skills and knowledge.

The board should be supplied in a timely manner with information in a

form and of a quality appropriate to enable it to discharge its duties.

The board should undertake a formal and rigorous annual evaluation of

its own performance and that of its committees and individual directors.

Key analytical issues include:

board size and composition, skill mix, CEO/chair split and tenure

board independence

board compensation

director selection and nomination process

other external directorships

role of the board

board access to information

review of committee charter and processes, meeting agendas and

papers

code of ethics

oversight of internal control, risk management

succession policies

processes for board and director evaluation

director training

frequency of directors' meetings, attendance rates

6. (b) Board and executive compensation.

Ans (b) Key criteria:

Executives should be fairly remunerated and motivated to ensure the

success of the company. Levels of remuneration should be sufficient to

attract, retain and motivate directors.

There should be clearly articulated performance evaluation and

succession policies/plans for directors of the company.

The company should link executive pay to performance.

There should be a formal and transparent procedure for developing

policy on executive remuneration and for fixing the remuneration

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packages of individual directors. No director should be involved in

deciding his own pay.

There should be clear disclosure of the remuneration policy for

directors and senior management.

Key analytical issues:

form of compensation, performance-based pay;

compensation setting process; and

performance evaluation criteria.

6. (c) Shareholder rights.

Ans (c) Key criteria:

The processes and procedures used for advising shareholders of

general meetings should provide for equal access for all shareholders

and should ensure that shareholders are furnished with sufficient and

timely information.

Shareholders representing a certain level of voting rights (at least 10%)

should be able to call a special shareholders' meeting and

shareholders should have the opportunity to ask questions of the board

during the meeting and to place items on the agenda beforehand.

There should be secure methods of ownership of shares and full

transferability of shares.

The company's share structure should be clear and control rights

attached to shares of the same class should be uniform and easily

understood.

All shareholders should receive equal financial treatment including the

receipt of an equitable share of profits.

Voting control rights should be in proportion to the shareholder's

shareholding in the corporation.

Shareholders should be able to appoint directors to represent them and

disallow the appointment of directors they do not wish to represent

them.

Key analytical issues:

provisions of memorandum and articles and by-laws regarding

shareholder rights and board authority;

share structure - class and rights of shares; and

dividend policy.

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6. (d) Transparency.

Ans (d) Key criteria:

There should be adequate public information on the company's

ownership structure including, where relevant, information on beneficial

ownership behind corporate nominee holdings.

Reporting and disclosure should be clearly articulated and completed

to a high standard. Financial reporting and non-financial reporting are

both important for full disclosure.

All publicly disclosable information should be promptly available and

freely accessible to the investment community and shareholders.

The company should maintain a website and make company reports,

summary reports and/or other investor relevant information available in

both the local language and English.

The company should be proactive in its investor relations and

management should be available for communication with the

investment community.

Key analytical issues:

identification of substantial/majority holders, including indirect

ownership and voting control;

accounting standards;

financial statements disclosed to shareholders and the investment

community;

operating and governance-related disclosure;

procedures for the disclosure of corporate actions and market-sensitive

information, frequency of reporting, continuous and fair disclosure;

timing and scope of event-driven disclosure;

channels of disseminating information which should provide for equal,

timely and cost-efficient access to relevant information by users;

responsiveness to requests for additional information; and

reports to shareholders, website and web-based reporting.

END