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Opportunities and risks faced by independent non-executive directors in Hong Kong

May 2017  |  SPECIAL REPORT: OPERATING AN EFFECTIVE BOARD

Financier Worldwide Magazine

May 2017 Issue

May 2017 Issue


It is increasingly recognised across jurisdictions as a matter of good corporate governance and effective boards that independent non-executive directors play essential roles in the boardroom.

Since 2012, recognising that a strong representation from independent directors is an important element of modern corporate governance, the rules governing listing of securities in Hong Kong (the Listing Rules) require independent directors to constitute one-third of the board. As at the end of 2016, there were close to 2000 companies listed in Hong Kong with more than 6000 independent directors serving on their boards. While corporate governance reforms have led to increase in the demand and expectation for independent directors, independent directors, in assuming a more central role in corporate governance, are adapting themselves to this new role with increasing opportunities, workload and risks.

Independent directors must be seen to be independent

Independence matters. Modern corporate governance is developed on the principle that the non-executives will not be able to fulfill their duties effectively unless they are independent from management. This is particularly important in Hong Kong where a high percentage of Hong Kong-listed companies are family-owned and family-run. Independent directors are expected to provide an independent objective view and balance the interests of minority shareholders.

On the meaning of independence, the relevant tests relating to personal and professional relationships and business interest can be found in the Listing Rules. For example, independence will be questioned if a director holds more than 1 percent of shares in the company, or is related to entities which currently provide or have recently provided services. Shareholder activists argue that independent directors serving Hong Kong-listed companies cannot genuinely be described as independent because controlling shareholders are allowed to vote on their election. Further, management (or the controlling shareholder) may occupy a position to influence the nomination of directors.

Different proposals have been put forward to provide better assurance of independence, including the UK’s dual-voting process, under which an independent director will have to be approved by an ordinary resolution of the shareholders and a separate ordinary resolution of the independent shareholders. Another proposal, known as ‘negative voting’, prevents a candidate from being elected if he receives more than a certain percentage of opposing votes from independent shareholders. However, reform in this area is not imminent. In light of such perceived insufficiency in the appointment process, to gain trust in his opinion, an independent director must demonstrate his objectivity and integrity. After all, having a title prefixed by ‘independent’ may not mean much. The best approach is to act independently and be seen to be doing so.

Independent directors must appreciate the difference between management and governance

An independent director, being non-executive, does not participate in management, but plays the important role of supervising management, participating in setting strategic directions and protecting the interest of all shareholders. To properly understand his role, an independent director must appreciate the difference between management and governance. In summary, management makes operational decisions and keeps the board informed, while the board focuses on higher level strategic decisions and performs its oversight function. At a practical level, the more strategic a decision is, the more likely the board ought to be the decisionmaker. It is certainly not the case that the non-executives do not make decisions; on the contrary, they make important decisions.

Independent directors who misidentify themselves as part-time executives, or claim that they could not realistically be expected to know much about the business, must realise that such positions are no longer defensible. They may not have detailed knowledge of the business, but having sufficient knowledge about the company’s strategy, policy and performance, and governance processes, is crucial.

Independent directors must understand the heightened duties imposed on them

In respect of Hong Kong-listed companies, independent directors perform many important duties, including serving on the audit, nomination and remuneration committees, taking a lead where potential conflicts of interest arise, and scrutinising the company’s performance and reporting. Where an independent board committee is required to advise shareholders on connected transactions or conduct internal investigations (when things go wrong), independent directors usually play a significant role.

In law, the duties of an independent director are no different from those of an executive director, given the essential unitary nature of the board. It does not mean that all directors have identical duties and the expected standard varies depending on a number of factors, including the functions to be performed by the director concerned and his professional skills and knowledge. What is clear is that the legal duties have or will become more stringent and independent directors are exposed to more legal risks accordingly.

Generally, the law in Hong Kong has developed to expect more from directors. First, the classic subjective standard of care that a director needs not exhibit in the performance of his duties a greater degree of skill than may reasonably be expected from a person of his knowledge and experience is now seen to be too low. Since the codification of the common duty of care of directors in Hong Kong in 2014, a director is required to exercise the care expected of a person carrying out these functions (an objective test), as well as bearing in mind his particular knowledge and skill (a subjective test). This new test is often known as the ‘mixed objective/subjective test’. The objective limb of the new test based on reasonableness prevents lowering of the standard to an unacceptable level. Second, the notion that it was permissible for a director not to give continuous attention to the affairs of the company may no longer be acceptable. Every director, executive or independent, is expected to ensure that he can give sufficient time and attention to the company’s affairs.

It is notable that five independent directors were subject to disciplinary sanctions by the Stock Exchange of Hong Kong in 2016. In one case, where financial assistance was provided by a listed company to a third party without the requisite due diligence and shareholders’ approvals required under the Listing Rules, an independent director was censured because, among other things, he failed to make enquiries with other directors when he became aware of the relevant transaction. In another case, three independent directors were censured for, among other things, a failure to raise questions with the executive directors about a questionable refund arrangement, give due consideration to the auditors’ concerns and procure the company to seek professional advice.

Oversight by independent directors is seen as the solution to many corporate governance issues. It is not fanciful to suggest that an independent director may face serious consequences if he failed to fulfill this role adequately. Although it is not anticipated that there will be a sudden or dramatic increase of litigation, disqualification or disciplinary proceedings against independent directors, the potential legal risks should encourage independent directors to diligently discharge their responsibilities.

Independent directors must assess a company’s commitment to board effectiveness

Full effectiveness can only be achieved by an independent director when all the factors are right. The attitude of the chairman of the board, the composition of the board, and ultimately the company’s commitment to good corporate governance are crucial to the success of an independent director.

According to the ‘2016 Hong Kong Institute of Directors’ survey’, the corporate governance level of Hong Kong-listed companies is steadily improving. Hang Seng Index constituent companies, or other large conglomerates, generally understand the essential roles played by independent directors. Other companies, including some family-controlled ones, may still operate at a low level of governance. It is prudent for a prospective independent director to conduct due diligence into whether his personal qualities match the company’s needs and management style. If the matching is wrong, he is unlikely to add value to the company, or fulfil his personal goals.

Searching for competent independent directors

The ability to recruit competent independent directors is a meaningful indicator of good corporate governance, but finding a suitable match is difficult, especially for companies with high monitoring needs. Some say that there are few qualified individuals in Hong Kong; some say that the rewards are unattractive. Whatever the true reasons, it appears the familiar faces are found sitting on boards in many Hong Kong-listed companies. It is envisioned that the increased workload and risks will cause the ‘busy’ independent directors to decrease the number of directorships and encourage companies to seek out new candidates to fill board seats.

In the past, a directorship in Hong Kong was not an onerous position. At the time, companies tended to select candidates for independent directors based on their real-world business experience, rather than board governance knowledge. More is expected of independent directors. Increasingly, companies are responding to the call for director professionalism and are more open to using structured board appointment services to conduct customised searches for directors who have acquired the relevant expertise.

On the path of building an effective board and a culture of good corporate governance, much emphasis is placed on the value of independent directors. Current and prospective independent directors must understand this new role with increasing opportunities, workload and risks. Companies would be advised to expand their searches for qualified and competent independent directors from a diverse range of candidates in order to find the right match.

 

Eddy So is a partner at Reed Smith Richards Butler. He can be contacted on +852 2507 9815 or by email: eddy.so@reedsmith.com.

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