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THE HONG KONG INSTITUTE OF CHARTERED SECRETARIESTHE INSTITUTE OF CHARTERED SECRETARIES AND

ADMINISTRATORS

International Qualifying Scheme Examination

CORPORATE GOVERNANCEDECEMBER 2015

Suggested Answer

The suggested answers are published for the purpose of assisting students in theirunderstanding of the possible principles, analysis or arguments that may be identifiedin each question

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SECTION A

1.

Silver Heart Jewellery Company Ltd (Silver Heart) is an established jewellerymanufacturer, wholesaler and retailer and is listed on the main board of the HongKong Stock Exchange. The company sells high quality gem-set jewellery, goldproducts, platinum/white gold products, and watches. Gem-set jewelleryrepresents products made with diamonds and gemstones.

Ringo Hui, a businessman, acquired a majority stake in the company during June2013. Following the change of control, Ringo became the new chairman and herecruited his nephew, Simon Hui, to be the new chief executive officer (CEO).

The board of directors currently comprises four executive directors and twoindependent non-executive directors (INEDs). The executive directors are Simon(CEO); William Kwok, the chief financial officer (CFO) and company secretary;Rick Chan, the product and quality control director, who is responsible fordiamond and gold procurement and production management; and Eric Fung,marketing director, who is in charge of the marketing function.

Simon holds a master’s degree in business administration has extensiveexperience in jewellery trading business. However, due to the close relationshipbetween him and Ringo, Ringo still dominates the board’s decision-makingprocesses and always acts as the company’s spokesperson.

One of the INEDs is Iris Wu, a lawyer, who has been a good friend of Ringo formore than 10 years. Iris has been an INED of Silver Heart since June 2013. Theother INED is Victor Foo, who is a Certified Public Accountant with 20 years’industry experience including as a finance director. He has been an INED of SilverHeart since 2000. The board has set up an audit committee, nominationcommittee and remuneration committee. The board committees currentlycomprise the chairman and two INEDs, and Iris Wu chairs all three committees.

From 2010 to 2013, the company’s financial results were good due to the increasein numbers of inbound Mainland tourists. Silver Heart is considering acquiringstakes in diamond mines to secure a long-term supply of the gems as demand forthese is growing from the tourists. In December 2013, a due diligence report wascommissioned on a target diamond mine located in Botswana, an African country.In a board meeting held in the first quarter of 2014, Ringo presented the due

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diligence report to the board members. Victor, one of the INEDs, questionedwhether the existing senior management had the expertise to operate thediamond mine as this would represent a totally different business line from SilverHeart’s core business. Ringo simply said that it was not difficult to operate adiamond mine and he would take care of that. The board then approved theproposal without further questions.

In June 2014, Silver Heart entered into a memorandum of understanding (MOU)with the Botswanan government under which Silver Heart intends to acquire a100% interest in the diamond mine.

During the period from July to December 2014, the company entered into a total of15 connected transactions with Ringo in relation to the leasing of certainproperties owned by Ringo as new retail branches. The aggregate amount of therental of these connected transactions was around $5m and the transaction pricesare considered to be 20% higher than the market rate.

Like other manufacturers, Silver Heart takes advantage of cheap skilled labour inMainland China on its jewellery production. In December 2014, the poor treatmentof Silver Heart’s workers in its Chinese factories was exposed by an undercoverCable TV News Digest investigation. The report said that its undercover reporterswere overwhelmed by the workload. Work shifts had ‘built-in’ overtime, in strongcontrast with the company's policy that stipulates that all overtime must be strictlyvoluntary. Workers worked for more than 60 hours a week. Simon has instructedEric to conduct an investigation into Cable TV’s allegations because of Eric’s goodrelationship with the media.

The company needs to finance the diamond mine acquisition, but it is already at ahigh gearing level. In the second half of 2014, Simon conspired with William, theCFO, to adopt an off-balance sheet financing scheme to hide the company’s debtsthrough vehicle companies which are not intended to be consolidated into thefinancial statements. Some creative accounting treatment was also used tocapitalise certain operating expenses so as to improve the company’s profitability.As a result of these moves, Simon and William can look forward to being awardedsubstantial bonuses based on the improved financial results.

The external auditor has noted the creative accounting measures, but is hesitant

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to report these to the audit committee as the audit firm is afraid of losing this client.The internal auditor has only recently joined the company.

REQUIRED:

1. (a) Identify and analyse the corporate governance issues regarding thecompany, the board and its committees.

(10 marks)

Ans (a) Board composition

William Kwok is the CFO and company secretary. However, his backgroundand qualifications are not provided. The company needs to clarify whether heis qualified to be a company secretary under the Listing Rules requirements.

Board diversity: No board members have experience of acquiring andoperating a diamond mine.

Iris is a good friend of Ringo. Her independence may be compromised due toher close relationship with Ringo.

It seems that Victor has no other relationship with Ringo. However, accordingto CG Code A.4, serving as an INED for more than nine years could berelevant in determining a director’s independence. (CG Code A.4.3)

Iris is a lawyer and has no industry experience or financial managementexpertise.

Simon’s appointment as CEO was determined by the chairman without goingthrough any formal approval nomination committee procedures.

The board should have at least three INEDs [Listing rules 3.10(1)]

Board committees

Iris chairs all board committees (in spite of her close relationship with Ringo).

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Lack of checks and balances at board

Ringo has been a powerful chairman and there are weak INEDs on the board(there are only two INEDs, one of which is his old friend). Ringo dominatesthe decision-making process.

Dominant influence of chairman on CEO: Simon is Ringo’s nephew, and wasrecruited by him in 2013. It is likely that the chairman exercises a dominantinfluence on the CEO and as a result there may not be a balance of powerand authority on the board.

Weak INEDs

The INEDs have failed to constructively challenge the proposal presented bymanagement. Victor tried to question the acquisition of the mines but Ringoquashed his concerns.

The chairman has failed to encourage the INEDs to give their views at boardmeetings.

Conflict of interests arising from connected transactions

The connected transactions are at a 20% mark up over the market rate. Thepurpose of the transactions appears to be to enable Ringo to receive ahigher-than-market rental income stream.

CEO/CFO pays issues

Bonuses are largely based on short-term achievements, such as share pricegrowth or profitability, and insufficient attention is given to longer-termconsiderations.

Short-term performance measures are themselves unreliable and often opento manipulation by management.

Overall issues: the structure of the executive pay packages encourages theCEO or executives to undertake a higher risk business strategy, or to focuson short-term profit or manipulate the financial figures, using aggressive

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accounting to make the company performance seem better than it is.

Inadequate risk management and internal control

High risk arising from aggressive business strategy – acquisition of diamondmines will lead to cash flow problems

Weakness in internal control system – Eric to lead the investigation on CableTV allegations

No internal audit to check operations and report to the audit committee

External auditor hesitate to report the management fraud

1. (b) Suggest what procedures or processes the board or its committees shouldestablish or strengthen to address the issues mentioned in your answer topart (a).

(15 marks)

Ans (b) Chairman and CEO

In view of the close personal relationship between the chairman and the CEOand the dominant influence of the chairman on the CEO, Simon should not actas the company’s CEO. Instead, Sliver Heart should recruit an externalprofessional with adequate industry and management experience to assumethe role of CEO in order to counteract the influence of the chairman and toensure a balance of power and authority. It would be acceptable for Simon tostay on the board because of his industry experience.

OR

Simon can still act as the company’s CEO (in view of that he has the relevantindustry experience). However there should be a clear division between theCEO’s and the chairman’s responsibilities to ensure a balance of power andauthority, so that power is not concentrated in any one individual.

Board composition

The board should comprise members with skills, experience and diversity ofperspectives appropriate to the requirements of the company’s business.(CGCode A.3)

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To ensure adequate board diversity, the company should appoint one or twomore executive directors with adequate experience of acquiring and operatingdiamond mines.

The board should ensure that William meets the Listing Rules’ requirement tobe appointed as Sliver Heart’s company secretary.

If more executive directors are appointed, more INEDs should also beappointed. This would enable the company to comply with 3.10A of ListingRules which states that one-third of board members should be INEDs. Theboard should strengthen the monitoring role of the INEDs to counteract thedominant influence of the family CEO and chairman (i.e. Ringo and Simon).

Since Victor has served as an INED for more than nine years, his futureappointment should be subject to a separate resolution to be approved by theshareholders.

Recruit one more INED

Board committees

Victor or a newly-appointed INED should chair all board committees instead ofIris.

To put checks and balances in place on the board

The monitoring role of INEDs should be strengthened to counteract thedominant influence of the chairman.

INEDs must exercise independent judgment and ensure accountability andconsideration of shareholders’ interests.

INEDs who are members of the audit committee and remuneration committeemust perform their oversight roles over risk management and internal controland executive pay issues.

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To strengthen boardroom practices

The chairman should brief directors and encourage INEDs to give their views.A.2.2 of CG Code: The chairman should ensure that all directors are properlybriefed on issues arising at board meetings.

A.2.6 of CG Code: The chairman should encourage all directors to make a fulland active contribution to the board’s affairs and take the lead to ensure thatthe board acts in the best interests of the issuer. The chairman shouldencourage directors with different views to voice their concerns, allowsufficient time for the discussion of issues and ensure that board decisionsfairly reflect board consensus.

The INEDs need to actively participate in board discussions and bring anindependent judgment to these discussions before arriving at decisions. A.6.8of CG Code: Non-executive directors should make a positive contribution tothe development of the issuer’s strategy and policies through independentconstructive and informed comments.

To strengthen the oversight role over executive pay

The remuneration committee needs to review the structure of remunerationpackage of the CEO and CFO, taking into account the relevant principles: CGCode B.1 Principle: Remuneration levels should be sufficient to attract andretain the directors needed to run the company successfully, but companiesshould avoid paying more than is necessary for this purpose.

CG Code B.1.7: A significant proportion of the executive director'sremuneration should be structured so as to link rewards to corporate andindividual performance.

Base pay should be competitive and reflect the contribution of the executivesconcerned, taking into account salaries paid by comparable companies.

To strengthen the risk management and internal control system

The internal auditor understand the company’s business, system, etc

To establish or strengthen whistle-blowing procedures for reporting fraud and

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malpractices

1. (c) Identify the operational and financial risks faced by Silver Heart andcritically evaluate the roles that the internal auditor and external auditor canplay to manage these risks.

(15 marks)

(Total: 40 marks)

[Where appropriate, candidates may refer to the Corporate Governance Code, theCorporate Governance Report and to cite the Listing Rules]

Ans (c) Risks identified

Operational risk

The acquisition and operation of a diamond mine represents a challenge to theexisting board.

The board members have no working experience of Botswana – they do notknow about the political or business environment there.

Cable TV’s allegations – these might affect Sliver Heart’s reputation and makeit more difficult to recruit skilled labour in the future.

Financial risk

Off-balance sheet financing scheme – this hides the extent of the company’sleverage

Acquisition of the diamond mines will put pressure on cash flow. If serious, thiscould affect the company’s ongoing operations.

Role of the internal auditor

Reviews the adequacy of the risk management system and internal controlsystem

Reports to the audit committee and management on issues relating to riskmanagement and internal controls

Provides assurance on compliance with corporate policies, legislation andregulations

Alerts management and the audit committee to possible instances of fraud orother internal control failures or weakness that might occur

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To manage the above risks, the internal auditor should investigate theoff-balance sheet financing scheme and report on this to the audit committee.

The internal auditor should be the person to investigate Cable TV’s allegationsinstead of Eric, and should report his/her findings to management and theaudit committee.

Role of the external auditor

To perform an audit on the financial statements and give an independentopinion on whether they provide a true and fair view of the company’s financialposition and whether they comply with accounting standards and relevant laws

To provide assurance that the financial statements are objective and can berelied upon by shareholders or investors

In this case, the external auditor should review and assess the assumptionsand calculation of the cash flow projection within the due diligent report toassess the financial impact of the acquisition of the diamond mine. He/ sheshould report to the audit committee on the results of this assessment.

The external auditor should assess the impact of the off-balance sheetfinancing scheme since this will disguise the company’s true financial positionand will affect the reliability of the financial statements.

He/ she should report to the audit committee on any accounting malpracticewhich might involve fraud and breach of accounting standards.

He/ she should uphold his independence and integrity without fear of losing theclient.

Examine internal controls and risk management system of the company.

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SECTION B

2. The corporate ownership structure is considered to be one of the main factors of acountry’s corporate governance system. For example, in the UK, institutionalinvestors hold the majority of shares in listed companies.

One means of categorising these corporate governance systems is theinsider/outsider-dominated model.

REQUIRED:

2. (a) Explain the meaning of the insider-dominated system and theoutsider-dominated system and discuss the advantages and disadvantagesof each.

(12 marks)

Ans (a) Insider-dominated systems

Companies listed on the local stock exchange owned and controlled by a smallnumber of major shareholders. The shareholders may be members of thecompanies’ founding families, banks, other companies or the government.

The corporate governance environment dominated by insiders due toconcentrated ownership, family control, limited institutional investor activism,and lack of main bank monitoring. As a result, boards of directors aredominated by insiders and/or represent the interests of the controllingshareholders.

Advantages of insider-dominated systems

Close ties

It is easier to establish close personal ties between owners and managers andreduce the agency problem if the owners are the same people who areinvolved in management.

Shareholder influence and dialogue with management

It is also easier for the major controlling shareholders to influence managementdecisions through their majority shareholding rights and through dialogues withsenior management who do not wish the major shareholders to vote against

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their decisions. It may be easier for management to convince the controllingshareholders in an insider-dominated system that they are taking a long-termview and that maximisation of immediate shareholder profits can be deferred.

The close ties between management and shareholders can therefore avoid theproblem of short-termism where management needs to be aware of theshareholders’ expectations of dividends by ways of a return on their investment.

Disadvantages of insider-dominated systems

Discrimination and expropriation of the wealth of minority

Insider-dominated systems may allow for discrimination against minorityshareholders as regards availability of information and expropriation of thewealth of the minority.

Company only develops formal mechanisms in a crisis

Insider-dominated systems do not encourage shareholders to develop a formalgovernance structure until they are forced to do so in a crisis. A typical HongKong crisis generally arises from the death or incapacity of a senior familymember or a family disagreement on how to deal with succession issues.

Reluctance to hire outsiders

A family management/shareholder group may be reluctant to employ outsidersas outsiders are perceived as possibly being disruptive to the closerelationship in the company.

Potential misuse of funds

The tendency to misuse the company’s funds for personal gain to structureopaque financial arrangement to disguise what is in effect a loan to a directoror shareholder, not taking into account the interests of the company as awhole.

Distortion of the market place

The dominance of one or two controlling shareholders may have a distortingeffect on the price of the shares so that instead of true competition in themarket place, the dominant shareholders can artificially uphold the share price.

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Outsider-dominated system

Outsider-dominated systems are those where the shareholding is more widelydispersed and there is separation between owners and managers.

Advantages of outsider-dominated systems

More robust legal and corporate governance systems

The separation of ownership and control (i.e. management) has provided animpetus for the development of more robust legal and governance regimes toprotect shareholders.

Effective voting rights by shareholders

Without any one person controlling the listed company, all shareholders canexercise their votes effectively and achieve a meaningful shareholderdemocracy.

Frequent hostile takeovers

Hostile takeovers are far more frequent and threat of a hostile takeover can actas threat to management. The threat is seen as a motivator for self-disciplinefor the directors who wish to keep their position in the company.

Disadvantages of outsider-dominated systems

Agency problem magnified

The company is more likely to have an agency problem and to suffer the costthat result from the agency problem.

Short-term interest of larger shareholders

Larger shareholders in these regimes may have short-term priorities and mayprefer to sell their shares for immediate gain rather than put pressure on thedirectors to improve their performance and change the company’s businessstrategy.

2. (b) Discuss how an institutional investor can help improve the corporategovernance standards of a company in which it invests.

(8 marks)

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(Total: 20 marks)

Ans (b) Institutional investors may help to improve corporate governance through thefollowing interventions with investee companies:

Dialogue with invested companies

To be more active in making their views known to the companies they invest inby engaging in an active dialogue with the board of directors in the hope ofinfluencing its decisions.

To have a policy in place for meeting an investee company’s board and seniormanagement to exchange views and information.

Considered use of votes

To attend general meetings where appropriate and practicable and take stepsto ensure their voting intentions are translated into practice.

To vote on all their shares held directly or on behalf of clients at generalmeetings wherever practicable to do so.

To make positive use of their voting rights, to bring about changes whennecessary to improve the standards of corporate governance.

Proactively monitoring investee companies

To review annual reports and accounts, and circulars issued by companiesand general meeting resolutions.

To raise questions about investee companies’ affairs at their general meetings.

To take a positive interest in the composition of board of directors and exercisevoting rights to elect directors, with particular reference to the checks andbalances and the appointment of non-executive directors of necessary calibre,experience and independence.

Evaluation of governance disclosures

To evaluate disclosure of corporate governance practices by investee

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companies to ensure compliance with the corporate governance code, whichmay be laid down by the regulators or institutional investors themselves.

To take a reasoned and flexible approach when judging the compliance ofcompanies with corporate governance requirements.

When evaluating company disclosures on corporate governance, particularlythose relating to board structure and composition, institutional shareholdersshould give due weight to all relevant factors drawn to their attention.

Institutional shareholders should carefully consider the explanations given bycompanies for any departure from the provisions of the corporate governancecode and make a reasoned judgment in each case.

If they do not accept the company's positions, they should explain their viewsin writing to the company, and be prepared to enter into a dialogue on thismatter if necessary.

They should avoid a box-ticking approach to checking compliance with thecorporate governance code and to assessing a company's corporategovernance.

Setting strategies on intervention

To exercise their votes and, where necessary, intervene objectively and in aninformed way.

To nominate board representation to the investee companies, wherenecessary.

To set out the circumstances (e.g. poor company performance, internal controlfailure, inadequate succession planning) when they will actively intervene andwhat the nature of that intervention might be.

If boards do not respond constructively when institutional shareholdersintervene, then they will consider on a case-by-case basis whether to escalatetheir action, for example, by making a public statement in advance of the AGM

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or an EGM or requisitioning an EGM, possibly to change the board, to disposeof their shareholding or to launch litigation.

To monitor and evaluate the effects of their activism.

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3. The Hong Kong Stock Exchange has added an Environmental, Social andGovernance Reporting Guide (ESG Guide) to Appendix 27 to the Main BoardListing Rules and Appendix 20 to the GEM Listing Rules.

The ESG Guide covers four areas: workplace quality, environmental protection,operating practices and community involvement.

REQUIRED:

3. (a) What is environmental, social and governance (ESG) reporting? What arethe benefits of ESG reporting?

(12 marks)

Ans (a) What is ESG reporting?

Reporting on environmental, social and governance (ESG) issues. Also calledCSR reporting or sustainability reporting. Performance reporting on issues that arerelevant and important to company’s business, to complement company’s annualreport and accounts.

Benefits of ESG reporting

Improve reputation and trust

An ESG report will help external stakeholders understand the company and itsapproach to ESG issues. Greater transparency may also increase a company’scredibility, improving its image and reputation in the long run. An ESG reportneeds to be backed up by a positive approach to CSR, which includes assessingand anticipating operational impacts towards society and the environment,mitigating those negative risks and developing positive impacts. Having goodvalues, beliefs and actions that are well communicated consistently andcontinuously can have a positive impact on the reputation of the company.

Attract investors

An investor can learn how a company manages its ESG issues through its ESGreport. A good ESG report can display to investors how the reporting companymanages its environmental and social challenges and risks. A good ESG report

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also indicates the companies’ effort in improving corporate governance, increasingtransparency and thereby reducing financial risks.

Enhance management efficiency and employee relations

The reporting process helps a company assess its ESG performance andidentifies gaps for improvement. For example, good environmental managementmay save a company’s costs through increasing energy efficiency. Also, acompany that has set key performance indicators (KPIs) for safe and healthyworkplace issues and implemented relevant measures to cultivate good workconditions may be more likely to retain employees and increase workplaceefficiency. Disclosing these KPIs may enhance the sense of belongings ofemployees and enhance loyalty to the company

Develop competitive advantage and increase visibility

A company that outperforms others in ESG matters sets itself apart from peers.Communicating periodically what the company is doing for the environment andsociety helps raise its business profile and increases its visibility.

Enhance risk management ability

The preparation of an ESG report can sharpen a company’s ability to analyse,prepare for and manage potential risks.

3. (b) Outline and discuss the key performance indicators of different aspects ofworkplace quality.

(8 marks)

(Total: 20 marks)

Ans (b) ESG Guide: Work Quality and its KPIs

Work condition

KPI A1.1 Total workforce by employment type, age group and geographical

region.

KPI A1.2 Employee turnover rate by age group and geographical region.

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Health and safety

KPI A2.1 Number and rate of work-related fatalities.

KPI A2.2 Lost days due to work injuries.

KPI A2.3 Description of occupational health and safety measures adopted

how they are implemented and monitored.

Development and training

KPI A3.1 The percentage of employees trained by employee category (e.g.

senior management, middle management, etc.).

KPI A3.2 The average training hours completed per employee by employee

category

Labour standard

KPI A4.1 Description of measures to review employment practices to avoid

child and forced labour

KPI A4.2 Description of steps taken to eliminate such practices when

discovered

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4. An issuer (i.e. listed company) should arrange appropriate insurance cover inrespect of legal action against its directors.

[Principle A.1.8, the Corporate Governance Code and Corporate GovernanceReport of Hong Kong, Hong Kong Main Board Listing Rules (CG Report) ]

REQUIRED:

4. (a) What is directors’ and officers’ (D&O) liability insurance?

How can D&O liability insurance promote corporate governance?

(8 marks)

Ans (a) What is D&O liability insurance?

D&O liability insurance is coverage designed to address the personal liability thatcompany directors and officers can incur for acts or omission arising from theirduties as directors or officers which may or may not be covered by an indemnityfrom the corporation.

A D&O liability insurance policy normally cover directors (executives andnon-executives) for personal liability, officers (including senior managers, internalauditors, the company secretary or other named persons) for personal liability, andthe insured company for corporate liability. Usually, the insured company includesthe company itself, its parent and/or subsidiary companies.

How can D&O liability insurance promote corporate governance?

D&O insurance plays a role in promoting corporate governance because without it,directors could be exposed to the risk of legal action for any negligence, default,breach of duty or breach of trust in relation to the company or its associatedcompanies. If this risk is perceived to be excessive, individuals could refuse to takeup the offer of a post as a director (or company secretary), and it could be difficultfor companies to appoint anyone (in particular, non-executives) to their boards.

4. (b) What protection does D&O liability insurance provide and what are the majorexclusions from D&O liability insurance cover?

(12 marks)

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(Total: 20 marks)

Ans (b) Protection given by D&O insurance

Protects directors and officers from litigation and provides liability insuranceshould such litigation arise from actions taken in the conduct of their duties.

The D&O insurance contract is a three-part contract:

D&O liability insurance protects individual directors and officers of the companyin situations where the company does not indemnify them. From a legalperspective, a company may not be able to indemnify directors and officers or itmay not be financially capable of doing so.

Company reimbursement protects the company from claims made againstdirectors and officers when it indemnifies them. Such coverage is usuallysubject to a deductible amount or excess, which must be absorbed by thecompany.

Entity coverage protects the company with respect to: (1) securities claimsarising out of the sale or purchase of shares, which may be brought by ashareholder or a group of shareholders against directors or as a derivativeaction in the name of the company, if permitted by law; (2) claims arising out ofbreaches of employment practices by the company, which may include wrongdismissal, wrongful termination, discrimination or harassment claims.

The following losses will generally be covered under a D&O policy: damage,judgments or settlements and associated costs and expenses, prosecution(criminal or otherwise), defence costs, and all other reasonable costs andexpenses.

Major exclusions from D&O liability insurance cover:

Prior knowledge: The policy excludes pending or prior litigation, demands, orjudgments known to the insured before the inception of the policy. It alsoexcludes circumstances in which the director received notification under a priorinsurance policy.

Fraudulent, dishonest and willful conduct: An insurer will not cover criminal,

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dishonest, or fraudulent acts or omissions that are against public policy or areuninsurable as a matter of law.

Insured versus insured exclusion: The exclusion precludes coverage for claimsby one director or officer against another. The purpose of this exclusion is toeliminate coverage for four types of situations: (1) employment practicesclaims, (2) internal disputes/infighting, (3) claims involving collusion, and (4)claims by organisations against their directors and officers for imprudentbusiness practices.

Bodily injury or property damage exclusion: This protection is usually affordedby other general liability or property insurance policies.

Pollution claims exclusion: Coverage is provided for shareholder derivativeactions alleging environmental damage, along with limited defence costcoverage for insured persons.

Major shareholder claims: Exclusions usually prevent claims brought byshareholders holding and with interest in shareholdings of 15% or more of thecompany.

War and terrorism or nuclear risk exclusion.

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5. The company secretary plays an important role in supporting the board byensuring good information flow within the board and that board policy andprocedures are followed. The company secretary is responsible for advising theboard on governance matters through the chairman and/or the chief executive andshould also facilitate induction and professional development of directors.

[Principle F, the Corporate Governance Code and Corporate Governance Reportof Hong Kong, Hong Kong Main Board Listing Rules (CG Report) ]

REQUIRED:

5. (a) Outline and discuss how a company secretary should discharge his/herduty to actively promote good corporate governance.

(15 marks)

Ans (a) In discharging their duties to actively promote good corporate governance,company secretaries should consider the following personal and professionalresponsibilities:

Establishing an effective working relationship with the chairman and chiefexecutive officer, with accountability to the board (through the chairman) for allmatters relating to directors’ duties as an officer of the company.

Ensuring the smooth running of the board’s and board committees’ activitiesby helping the chairman to set agendas, preparing papers and presentingpapers to the board and board committees, advising on board procedures andensuring that those are followed.

Keeping under close review all legislative, regulatory and corporategovernance developments that might affect the company’s operations, andensuring that the board is fully briefed on these and that it has regard to themwhen taking decisions.

Ensuring that the concept of stakeholders (particularly employees) is in theboard’s mind when important business decisions are being taken.

Advising the board on the need to ‘comply or explain’ with the CorporateGovernance Code, including provisions relating to adopting variousgovernance policies and periodic reporting of measureable objectives forimplementing such policies, and updating progress thereon in the corporate

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governance report.

Advising the board on potentially adopting some or all of the recommendedbest practices under the Corporate Governance Code.

Keeping abreast of sustainability issues and environmental, social andgovernance (ESG) reporting developments, advising the board in relation to itssustainability and ESG policies and practices and reporting thereon.

Acting as a confidential sounding board to the chairman, non-executivedirectors and executive directors on matters that may concern them, andtaking a lead role in managing any difficult inter-personal issues on the board.

Acting as a primary point of contact and source of advice and guidance fordirectors and, in particular, non-executive directors, as regards the companyand its activities in order to support the decision-making process.

Acting as an additional enquiring voice in relation to board decisions whichparticularly affect the company, drawing on his or her experience andknowledge of the practical aspects of management including law, tax andbusiness finance: to act as the ‘conscience of the company’.

Ensuring, where applicable, that the standards and/or disclosures required byListing Rules are observed and, where required, reflected in the annual report.The company secretary usually takes the lead oversight role in the preparationof the annual report, in particular in drafting the directors’ report and corporategovernance report, and agreeing these with the board and board committees.

Compliance with the continuing obligations of the Securities and FuturesOrdinance, Listing Rules and Takeovers Code, including ensuringpublication and dissemination of the annual report and accounts and interimreports within the periods laid down in the Listing Rules; timely disseminationof announcements to the market and ensuring proper disclosure of insideinformation.

Managing relations with investors, particularly institutional investors, withregard to corporate governance issues and the board’s practices in relation tocorporate governance.

Induction of new directors into the business, explaining their roles andresponsibilities, facilitating their continuing professional development andmaintaining relevant records of each director’s training.

Ensuring that the board is fully aware of its responsibility to avoid engaging inany market misconduct practices, including not putting out or allowing therelease of misleading information, or by engaging in a course of conduct which

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could amount to market misconduct.

Ensuring compliance with all statutory filing requirements and regulatorydisclosures.

Arranging and managing any general meeting, the annual general meeting(AGM) and establishing, with the board’s agreement, the items to beconsidered at any general meeting and the AGM, including resolutions dealingwith governance matters.

5. (b) How can the independence of the company secretary be upheld?

(5 marks)

(Total: 20 marks)

Ans (b) Maintaining independence requires the person holding the position of companysecretary to have the required knowledge, relevant experience, ethicalresponsibility, integrity and understanding of ‘what is right’. This avoids him/herbeing influenced to take a course of action which will not be in the best interests ofthe company as a whole.

To protect the company secretary’s independence:

The company secretary’s remuneration should be determined by theremuneration committee on the recommendation of the chairman or CEO.

The issue of appointment and removal of the company secretary is explicitlyaddress in Corporate Governance Code (F.1.1) in order to reduce thepossibility of any individual director gaining undue influence over the companyby way of exercising the power to determine the secretary’s appointment andremoval.

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6. Directors frequently encounter actual and potential conflicts of interests inperforming their roles. Improper handling of conflicts of interests is one of themost common breaches of corporate governance, exposing the company and itsdirectors to potential civil and criminal liabilities.

REQUIRED:

Critically evaluate this statement by discussing the following issues relating todirectors:

6. (a) Conflicts of interests typically encountered by directors; and

(10 marks)

Ans (a) Conflicts typically encountered by directors

Connected transactions

The Listing Rules contain detailed procedural and disclosure requirements ontransactions between a company and its connected persons: these arebroadly defined as the directors, significant shareholders of the company andtheir respective affiliated entities. These requirements are determined byreference to specific thresholds and are designed to provide a check andbalance effect.

Placement of equity securities

The placement of equity securities under a general mandate is often made toinstitutional investors through a placing agent. Such a placement can offer thecompany additional working capital and enable an investor who is not aconnected person to increase its influence over the management of thecompany. However it might be not the right business strategy for thecompany. A director who supports a placement without the benefit of anindependent market assessment and a company specific evaluation may bein breach of his/ her duty of skill, care and diligence.

Board composition

The constitutional documents of the company often give directors power toappoint an additional or replacement director to serve on the board until thenext annual shareholders’ meeting. A director may be in breach of his/ herduty to act in good faith for the company’s benefit if the decision to change theboard’s composition is motivated by a desire to consolidate power.

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Directors’ remuneration

A conflict may arise in relation to directors’ remuneration. The conflict can bemanaged partly through different procedural requirements (e.g. appointing aremuneration committee chaired by an INED). Indemnification of directors anddirectors’ liability insurance are other issues that pose specific concerns.

Corporate opportunity

A director may encounter business opportunities that might be of interest tothe listed company. A director who elects to pursue such an opportunity(either directly or indirectly through another company in which he is ashareholder, director or officer) without disclosing the opportunity to the boardmay be in breach of the duty to act honestly for the company’s best interests.

Benefits from third parties

Gifts or other benefits given to directors by third parties as part of theirmarketing efforts may compromise the director’s ability to exercise impartialjudgment in evaluating dealings between the company and such third parties.

Confidential information

In the course of performing their duties, directors frequently have access toinsider information. If a director shares insider information with any person forpecuniary or other gain, a director may breach his duties to act honestly in thebest interests of the company. It may also result in breach of the director’sservice agreement and violation of securities law.

6. (b) How directors’ conflicts of interests can be managed by building up atransparent framework to identify conflicts of interests and to handle themso that they can be dealt with impartially and with discretion.

(10 marks)

(Total: 20 marks)

Ans (b) Building a framework

The company should have a written policy governing the management ofdirectors’ conflicts. The policy could, among other things:

Require directors to disclosure and periodically update the company inrelation to actual or potential conflicts (such as by completing a director’squestionnaire and affirming the contents annually)

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Consolidate all applicable internal and external requirements (e.g. M&A, theListing Rules, etc) into a single set of guidelines for easy reference.

Require an interested director to declare his interests on any relevanttransaction before each board meeting and refrain from voting on suchtransactions.

Translate some of the common law standards into well-defined thresholds(e.g. a company might require a director to refuse gifts from a third party witha fair market value in excess of a specified dollar amount).

In a situation where risk (likelihood of conflict) is high, the company may wantto implement supplemental guidelines or specific declarations from directorsas to their potential interests. For example, when the company is evaluatingwhether to develop a new product line but a director is associated with one ormore of the company’s suppliers, customers, competitors or distributors.

Handling conflicts

Delegate the subject matter to an independent committee comprisingdisinterested directors. The committee should be given the power to retainfinancial and legal advisors to assist them on the subject matter.

Defer the subject matter to disinterested shareholders following fulldisclosure: for example, the company’s purchase of a business from itscontrolling shareholder. Adequate information, such as an independentvaluation report, should be provided to enable shareholders to make aninformed decision.

END