The three wise monkeys of HK boards
15 February 2011
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The Stock Exchange of Hong Kong Ltd (SEHK) has recently put out a consultation paper to review the Code on Corporate Governance Practices and associated Listing Rules. SEHK is itself owned by a listed company, Hong Kong Exchanges and Clearing Limited (HKEx, 0388), so whatever changes SEHK makes (with the approval of the SFC) will affect its parent.
The paper deals with two different areas - Part I on directors and Part II on shareholders. This article will focus on Part I.
The paper proposes a Listing Rule that one-third of the directors be labelled as "independent non-executive". That's in addition to the present requirement of 3 INEDs, which in turn was increased from 2 INEDs effective 30-Sep-2004 and from zero on 1-Aug-1993 (note: under a long transition for existing listed companies, they needed 1 INED by 1-Jul-1994 and 2 by 31-Dec-1994). So it has only taken 18 years to get this far, and what this proposal means in practice is no change if your board currently has fewer than 10 directors, because you already have at least 3/9 tagged as INEDs.
The Webb-site database shows that most listed companies have the bare minimum of INEDs. Currently, of 1416 primary-listed companies, 1100, or 77.7%, have 3 or fewer INEDs. The average number of INEDs is just 3.29, only 0.29 above the minimum. As for the ratio of INEDs, the database shows that there are only 279 companies with less than 1/3 tagged INED, or 19.7%, so 80.3% already comply with the proposed rule. That's mainly because most boards are smaller than 10 seats - our database shows that only 437 companies (30.9%) have more than 9 directors.
But what is an INED? The word "independent" is an adjective - so independent of what? The answer, of course, is that an INED should be independent of management and controlling shareholders. An INED is often required by the Listing Rules to opine on whether a connected transaction between the listed company and its controlling shareholder is fair and reasonable, or under the Takeover Code to opine on whether a privatisation proposal from the controlling shareholder is fair and reasonable, or whether a "whitewash waiver" should be granted, avoiding a takeover offer. An INED also often sits on a Remuneration Committee which determines, or advises the board, on the remuneration of executive directors, who are often also substantial shareholders of the company. An INED also often sits on an Audit Committee which reviews the accounts produced by management, and which reviews the internal controls intended to prevent management and staff from misappropriating (or stealing) the company's assets.
But all of these checks and balances on the behaviour of management and controlling shareholders are undermined when they get to decide who the INEDs are, because the controlling shareholders and other directors are allowed to vote in shareholders' meetings on the election of INEDs. About 90% of HK-listed companies have a controlling (30%) or majority (50%) shareholder or group of shareholders who determine who should be "independent" of them in the board room. It is rather like having a parliamentary democracy in which the ruling party picks the members of the minority party.
The result is that many HK-listed companies fulfil the requirement to have 3 independent directors by picking 3 wise monkeys - see no evil, hear no evil, speak no evil. They serve at the pleasure of the King, and if they ask too many questions, or object to what the King wants to do, then they will be shown the door.
There is not a shred of evidence that the 2004 reforms, in which the number of INEDs was increased from 2 to 3 and audit committees were made mandatory, has made any difference to the quality of corporate governance in HK-listed companies. Nor has the fact that 80.3% of companies already have one-third of directors labelled "INED" made any difference. We still get regular fraud-induced failures like EganaGoldpfeil, Ocean Grand and Moulin. We still have INEDs who support connected transactions which are voted down or heavily opposed by independent shareholders, showing a complete lack of recognition by INEDs of what is in the best interests of the company. This is as much true for Government-controlled companies as it is for family-controlled companies. We still have INEDs who hold far too many other jobs and positions to devote enough time to do the job properly. We also have INEDs who have no relevant experience, either in the company's area of business or in financial, legal or accounting matters. Examples include school friends, golfing buddies, family doctors, or former mainland officials who are owed a favour. For many, a fee of HK$10-20k per month for turning up 4 times a year and facing almost no risk of litigation for neglecting the duties of the job is easy money.
We also have INEDs who sit as "independent" at multiple listed levels in the same corporate pyramid - so when a listed company does a deal with a listed subsidiary, or tries to privatise it, the INED is conflicted from giving an opinion on both sides. And we have INEDs who have spent all their working lives at a firm, then retire for a year before coming back as an INED, which the rules allow.
Much hand-wringing has taken place about the need for the right "mindset" and a better "quality" of INEDs. This misses the point. A few good companies, which want expertise and independent opinions in the boardroom, will pick good people, but many will just pick 3 wise monkeys, or noddies - they nod at everything. For these companies, incompetence, senility and ignorance are considered desirable attributes in INEDs.
Boards should of course be allowed to nominate candidates whom they think they can work with, and who they think will add value, but they must be candidates who are acceptable to independent shareholders. Unless and until we exclude connected persons (directors and substantial (>10%) shareholders) from the shareholder vote, the INEDs will only be as independent and as capable as these conflicted parties want them to be. After all, why should shareholders who cannot vote on connected transactions be allowed to elect the people who advise on those transactions?
Without that simple step, most of the SEHK proposals on boards and committees are just re-arranging deck chairs on the Titanic. We won't even bother to comment on them in detail. But with that simple step, more icebergs could be avoided, because INEDs would:
- be accountable to independent shareholders at the ballot box
- have a mandate to ask difficult questions without fear of removal
- only get elected or re-elected if a majority of independent shareholders (by votes cast) think they are suitable for the job
Many of the same people who currently hold INED positions would continue to serve, but if controllers proposed candidates with no relevant experience, or people who are too close to management, or people who are former employees, or people who are just too busy, then independent shareholders would likely vote them down. Similarly, if the INED has a history of presiding over companies which have breached the Listing Rules or collapsed in accounting frauds, then he is unlikely to be elected by independent shareholders.
To be clear, we are not calling for all directors to be elected this way. Controlling shareholders and management should still be able to call the shots and make strategic decisions about the business, electing executive directors and non-independent non-executive directors. All that we are asking for is that directors should not be called "independent" unless they have been elected by independent shareholders. At the first AGM after a listing and at each AGM thereafter, all INEDs should be required to stand for re-election, so that the current body of independent shareholders can either endorse them or replace them. Investors should not have to wait 3 years after listing to do this, nor should we have to wait 3 years to remove an under-performing INED.
Unlike the key-man importance of executive directors, the business of a company should not be dependent on particular INEDs, so there is no continuity risk in subjecting INEDs to annual re-election. Most of the time, they would receive support, and the annual election would keep them on their toes. If candidates are appointed by boards to fill vacancies, then they should not be called independent until independent shareholders have elected them, and a meeting should be convened for that purpose unless the AGM is pending.
This call for independently-elected directors is not a new call - we have made the same point in articles in 1999 and 2002.
We also submit that INEDs should have their own section in the annual report in which they each either confirm that they had no material disagreements with the rest of the board during the year, or state what those disagreements were. They should confirm in that report whether they have received all the information they consider necessary to perform their duties. We should not have to wait until they resign before hearing whether they have concerns which investors should be made aware of. All too often, dissent is masked by statements that "the board" believes something, or even "the board, including the independent directors" believes something. That only means that a majority of all directors believes something, not unanimity. Whenever an INED disagrees with a statement made on behalf of the board, we should be told. The minority opinion in any judgement is almost always informative.
Or stop pretending
The alternative to requiring independently-elected directors is to stop pretending that companies have independent directors. Drop all the rules, and be honest about the fact that controlling shareholders elect the entire board. Leave it up to companies to persuade the free market on whether they have a good board or not, but prohibit them from calling anyone "independent" unless the controlling shareholders and directors have abstained from voting on the election of that person. We don't favour this route, but it would be more honest than the current false comfort of tagging people as independent when they are usually not.
A limit on seats?
The paper asks whether a limit on the number of INED seats held by a person should be set by Listing Rules or Code Provisions. We say no. The number of seats a person can responsibly handle depends on what other responsibilities he has - for example, if he is supposed to be a full-time CEO, or a legislator, or a member of the Executive Council (HK's cabinet), or sit on multiple Government committees or charities, then he may not be able to spare enough time to do handle more than 1 or 2 INED seats properly. On the other hand, if he is a retired former partner of a law or accounting firm, with no other responsibilities, then he might well be able to handle 5 or more positions and still have time to play golf. It also depends on the complexity of the business - a multinational bank or retailer, for example, or a simple small-cap consulting firm, might require different time commitments. A company struggling with financial or business restructuring would entail a larger time commitment.
The best way to resolve issues like this one is to allow the market to decide. Again, that means subjecting all INED candidates to a vote of independent shareholders. The market, in the form of institutional investor bodies and proxy advisory firms, would then evolve standards and make voting decisions to back up those standards, making exceptions where appropriate.
The Webb-site Database continuously tracks the number of directorships and the number of INED positions each person holds on companies with a primary listing in HK. At present, the database shows that the average person holds 1.354 INED positions, but 46 people (including 2 women) hold more than 5. Including other directorships (NED and ED), the database shows that there are 77 people who hold more than 5 seats (including 3 women), but the average number of HK-listed seats is just 1.249. That excludes seats on overseas-listed companies, private companies, charities, government boards and other positions.
HKEx itself shows up badly in this respect. There are 6 Government-appointed non-executive directors (we don't regard them as INEDs, because they are not subject to election by shareholders, let alone independent shareholders). Of these 6, the Chairman, Ronald Arculli, is a partner in a law firm, a member of HK's cabinet, sits on the board of 9 HK-listed companies (including HKEx), and is a member of 4 Government committees and a director of at least 2 charities. That's at least 17 positions. Another Government-appointed NED, Moses Cheng Mo Chi, is senior partner of a law firm, sits on the board of 11 HK-listed companies, chairs 4 Government committees and sits on one other, and also sits on 2 school councils. That's at least 19 positions including his day-job. He has the 5th-largest number of HK-listed directorships - here's a list of the busiest ones. Another Government-appointed director, Stephen Hui Chiu Chung, sits on 6 HK-listed boards and is also Managing Director of a brokerage in his day job.
It is notable that the Government-appointed directors of HKEx hold on average far more positions than those who are elected by shareholders. Unlike most listed companies, HKEx has no controlling shareholder (the Government is the largest, at 5.9%), so the 6 elected directors, although comprising a minority of the 13-member board, really are accountable to the outside shareholders and have to justify their position at each election (every 3 years by rotation). If Messrs Arculli, Cheng and Hui were subject to shareholder election then we doubt that they would be re-elected with their current workloads. Your editor David Webb was an elected INED of HKEx from 2003 to 2008, so he knows first-hand what this accountability means. In 2003, shareholders voted out 3 incumbent directors, and he was elected to fill one of the vacancies, running on his own ticket, and was re-elected in 2006 in a contested election, along with Christine Loh Kung-wai, whom he nominated.
So we don't think that SEHK will find a lot of support from its parent HKEx for limiting the number of seats a person can hold. Let the market do that.
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