How Hong Kong's controlling shareholders appoint the Independent Directors who are supposed to prevent them from abusing the company, and what to do about it.

Hong Kong's not so Independent Directors
20 April 1999

Have you ever held shares in a collapsed company, whose controlling shareholders have not been entirely honest with you? Do you think they had difficulty distinguishing their private interests from those of the company? Do you wonder why the Independent Directors, who have long since resigned and headed for the bunkers, were unable to prevent the company imploding?

A few years ago, after a wave of particularly bad behaviour by controlling shareholders, the Stock Exchange decided to require all companies to have at least two directors who are "independent" non-executive directors, or INEDs. The rules now say that INEDs must not be part of the management, each should hold less than 1% of the shares of the company, and should have no financial or other interest in the business of the group.

Who Appoints INEDs?

Unless elected at an annual shareholders' meeting, the INEDs are appointed by the board of directors, who in turn are normally appointed by the controlling shareholders. If you are a controlling shareholder, it is only natural that you should use that control to run the company through your choice of Executive Directors.

In Hong Kong there are very few companies that do not have a controlling shareholder - the only sizeable exception is HSBC Holdings plc, which is a UK-domiciled company whose ownership is wide-spread.

Once appointed by the board, the INEDs are re-elected by shareholders at the next annual general meeting, and thereafter by rotation (typically standing every three years, if they survive that long). Unfortunately, the controlling shareholders are allowed to vote in these elections, so they nearly always determine the outcome. Yes, the sheepdog is appointed by the flock, not by the shepherd. It is a clear absurdity that the controlling shareholders effectively appoint the people who are supposed to prevent them from abusing the company. This is shareholder democracy Hong Kong-style.

In fact, INEDs are often so closely allied to the executive directors that, if the company is taken over, the INEDs resign at the same time as the executive directors, and the new controlling shareholders will appoint new "independent" directors of their choice.

What are INEDs supposed to do?

In an ideal world, they would represent you, the minority shareholders. They would make sure of fair play, and whenever the controlling directors have a conflict of interest, the INEDs would take decisions on your behalf (or call a shareholders' meeting). For example, in a "connected transaction" between a company and its controlling shareholder, the INEDs must give an opinion (based on whatever advice they need) on whether or not the terms are fair to the Company. Have you ever seen a circular which says that the terms of a connected transaction are not fair? Nor have I.

The problem is that if you cannot appoint your own sheepdogs, then they have no incentive to represent you. Worse, if a sheepdog asks too many questions, the sheep will fire him and choose another one. With a lack of data, the sheepdog finds the proverbial wool pulled over his eyes. Too many INEDs are little more than rubber stamps who resign at the first sign of trouble, heading for greener pastures just when you need them most.

Audit Committees

Following good practice in other countries, the Exchange has introduced a requirement that, from the start of this year, each company must have an audit committee of non-executive directors, a majority of whom should be independent. The written terms of reference are to include "the review and supervision of the financial reporting process and internal controls". A key goal here is to cut down the amount of fraud and improve the level of disclosure in financial reporting. Unfortunately, so long as the INEDs are appointed by controlling shareholders, they will also have limited powers of investigation, since they can be removed at any time. This well-intended move by the Exchange is likely to be least effective where it is most needed - the best-qualified INEDs will be unwilling to serve on the boards of opaque companies and risk liability for what might go wrong. They simply lack the necessary authority to do their job.

Let Minority Shareholders Elect Independent Directors

What we need is a system where minority shareholders appoint the INEDs annually by way of a shareholders' vote on nominees of their choice, and the controlling shareholders (and all directors) are prohibited from voting. If an INED resigns mid-term, then he must say why, and a shareholders' meeting must be convened to consider nominations for a replacement.

INEDs would then have responsibility with accountability. They would be appointed by the very people whose interests they are supposed to protect, namely the minority shareholders. They would demand board meetings and information as often as needed, without fear of being removed by the controlling shareholders. They would make it their business to monitor your investment.

Wouldn't it be great if you could appoint someone who had to report back to you on whether they were satisfied with the conduct of the Executive directors in running the company? The report of the INEDs should be contained in each Annual Report and should go into some detail. If you are not satisfied with the INEDs' performance, you can replace them with others. This gives them every incentive to perform. They must also be able to call on the Stock Exchange and the SFC if they encounter difficulties in doing their job, and of course, they must be paid a fair wage for the time this involves, not some trivial fee for rubber-stamping decisions.

Under this scenario, if an INED is removed from office by minority shareholders then he or she has usually done a bad job, and should be barred for a period of time from taking up new INED positions, or standing for re-election, with other listed companies.

For their part, the Exchange and SFC need greater disciplinary powers. Public censure or reprimand is an inadequate deterrent. They need the ability to impose substantial fines on directors, which requires statutory backing.  Most of the time they don't even go as far as a censure - the Exchange now includes standard wording in any announcement which deals with a breach of the listing rules. It reads "the Exchange reserves its rights to take appropriate action in relation to the matter". In the words of Geoffrey Howe, that is rather like being savaged by a dead sheep.

We need INEDs without conflicts

Sometimes, you will see the same INEDs on the boards of several listed companies under common control. The Stock Exchange should ban this practice, because it means that if two related companies do a connected transaction, then the INEDs will be on both sides of the deal and will be unable to advise minority shareholders on how to vote. Perhaps controlling shareholders are aware of the potential conflict when making these appointments - it makes the INEDs even less of an obstruction to abuse of the companies.

We need Qualified INEDs

INEDs are often unqualified to do their job. They can be school-friends of the Chairman, or medical doctors, or cadres in mainland towns in which the company does business. It should be a requirement that at least two INEDs know what they are doing. That is, they should be Hong Kong-based lawyers, accountants or investment advisers. The INEDs are supposed to be our eyes and ears, but if they do not fully understand their role then they have no hope of carrying it out. With a pair of suitably qualified INEDs to take the lead, the company can then have other INEDs who are from industry-relevant backgrounds, such as an electrical engineer on the board of a power company.

Those who are professionally qualified should not also work for the auditor, lawyer or sponsor of the company. This can often mean that the company is an important customer, and therefor the INED is bound to keep his client happy and not "rock the boat". Currently the Exchange has an exemption which allows the company's advisers to act as INEDs, and this should be removed.

Accountable, responsible, qualified independent directors, directly elected by minority shareholders, would reduce abuses and improve the financial returns, as well as the reputation of Hong Kong.

© Webb-site.com, 1999


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