In Part 2 of our review of the proposed Listing Rule changes, we look at the fundamental question of independent directors and committees. Here again, the SEHK wins a perfect 6.0 in the "form over substance" category. They are skating on thin ice by allowing controlling shareholders to elect " independent" directors, a system which has failed to prevent numerous horror stories on Independent directors should be elected by independent shareholders.

Listing Rules Review Part 2: Board Games
21 February 2002

Long-time readers of will recall the many corporate horror stories we have covered. In almost every case, the listed company in question complied with the technical requirement in the Listing Rules of having two "independent non-executive directors" (INEDs). And yet disaster still struck. How many times have you wondered "why don't the independent directors do something about this?"

What are INEDs for?

The main purpose of INEDs, if you are a public shareholder, is to provide a "watchdog", a set of independent eyes and ears in the boardroom, ideally attached to an independent brain, which will represent and monitor your financial interest in the company, and try to prevent the rest of the board from favouring the directors or controlling shareholder above all the other shareholders, including you. Directors are often privy to information that cannot for commercial or other reasons be published, so INEDs provide a buffer to tell the board what independent shareholders might think if they knew - and protect their interests accordingly.

Under the Listing Rules, INEDs are often called upon to form a committee to advise public shareholders on whether a "connected transaction" between a company and its controlling shareholder is fair and reasonable. For example, asset injections of dot-com companies or PRC property projects which may be priced artificially high in order to extract cash from a company, or under-priced sales in the opposite direction. Other cases involve transfer pricing of raw materials or finished goods from or to connected parties, joint ventures with connected parties and so on. All of these are an opportunity for theft if there are no checks and balances.

In privatisation offers under the takeover code, INEDs have to advise shareholders on whether to accept the offer. Other duties of INEDs, common in other markets but not yet in HK, are to form remuneration committees (to review executive directors' pay packages) and nomination committees (to review new appointments to the board).

Of course, other non-executive directors can also be appointed to provide expertise from their current or former profession, and may provide valuable advice or guidance to the executive board in their strategic decision making. But that role is very much one of a consultant, and does not remove the need for watchdogs.

Why INEDs are ineffective in Hong Kong

The reason that INEDs are so ineffective is quite simple, and its the same in any market where controlling shareholders predominate. The INEDs are not usually independent. They are chosen by the executive board, which in turn is appointed by the controlling shareholder. Depending on the country of incorporation and the Articles of Association (or rules), at the first Annual General Meeting (AGM) after his or her appointment, a director has to stand for election by shareholders, and then typically every 3 years after that. However, the controlling shareholder also gets to vote on that election or re-election, and thereby determines the outcome. In addition, most companies have Articles which allow the board to remove a director by a 50% or 75% majority vote of the other directors.

So the monitors are appointed and removable by the people they are supposed to monitor, and the system is fundamentally flawed. Of course, some companies have honest and diligent management who seek out truly independent souls and appoint them to their board. These are the companies who we have least to worry about, whose INEDs then have less to worry about too!

On the other hand, if a controlling shareholder has something to hide, or wants a particularly favourable deal, then any INED who starts opposing and behaving independently will be voted out at the next AGM, and knowing this, will normally accept his final pay cheque and resign upon request. Indeed, the simplest way to get rid of an INED is probably to stop paying them.

Over 90% of Hong Kong-listed companies have a single shareholder (family or government) or concert party who hold sufficient votes to control the board. Amongst the Hang Seng Index, which covered 82.9% of the market value at 31-Dec-01, only one of the 33 stocks has no controlling shareholder - and that is HSBC Holdings plc, a UK-domiciled, UK-listed and UK-headquartered company, so they are good, but they don't count.

Mandate and Accountability

We first wrote about this problem back in Apr-99. The solution is simple, and would involve just a few paragraphs in the Listing Rules. 

INEDs should be elected by independent shareholders. Any shareholder or concert party holding 20% of more of the votes, should be prohibited from voting on such elections unless they can show to the satisfaction of the regulator that they have no existing board representation.

The rule in companies' articles which allows INEDs to be removed by the other directors should be scrapped. Any proposal to remove an INED should be put to independent shareholders in general meeting.

Given these simple steps, we would then have INEDs who are accountable to independent shareholders, and who have a mandate to act on their behalf. Without fear of ejection, they can then ask whatever questions and for whatever material or expert advice they think is necessary to carry out their duties to ensure that all shareholders are  treated fairly and equally.

The nominations committee of each company would then make recommendations which are acceptable to minority shareholders, who would also be at liberty (with a nomination requirement of say 5% of the publicly held shares) to nominate their own candidates instead.

INEDs should receive a decent pay for carrying out their duties, and the Listing Rules should set a minimum fee, so that companies cannot avoid their responsibilities by offering so little to INEDs that only the unqualified will apply. The actual pay package for each INED should be fixed and approved by shareholders in the same vote as the election, so that there is no possibility of executive directors bribing the INEDs to approve dodgy deals in return for bonuses, share options or anything else at their discretion.

The SEHK Position

The SEHK knows where we stand. They say in their consultation paper:

"We also note comments that INEDs should be appointed or removed by minority shareholders so as to ensure that INEDs are not influenced by controlling shareholders"

but then here comes that old "Asian values" argument:

"A harmonised board is an essential element for an effective board"

We are not talking about barbershop quartets here. It may be the way the National People's Congress is run, but in successful developed economies, a difference of opinions, debate, and fair representation of all parties is essential to good governance. There are unfortunately strong echoes of Hong Kong's non-democratic system of executive government in the way the SEHK thinks boards should be appointed, with the majority shareholder choosing all the directors. That's no way to run a company, let alone a society.

Look no further than the board of HKEx (owner of SEHK) for proof of this. Even though it is one of the few listed companies in Hong Kong with no controlling shareholder, a majority of its directors are appointed by the Government to ensure that it is controllable as a for-profit monopoly and regulator. That power was just recently used to maintain the anti-competitive minimum brokerage rate. The Government also has majority ownership of the listed MTR Corporation Ltd and as far as we know, the Government votes on all the directors' elections. 

Incidentally, the Government also obtained a blanket waiver at the time of its IPO to prevent minority shareholders from voting on land transactions between the Government and the MTR. So much for leadership in corporate governance.

The SEHK concludes:

"We do not consider that it is necessary to require appointment or reappointment of INEDs to be subject to independent shareholders' approval."

If a company wishes to receive the benefit of public capital, then it must be willing to allow public representation in its boardroom.


We could almost stop there, but just in case the SEHK sees the error of their ways and agree that minority shareholders deserve (minority) representation in the board room in return for their money, we will review the SEHK proposals on committees next.

The SEHK gives a lot of space in its consultation paper to the notion of recommending (but not requiring) companies to have remuneration committees and nomination committees, and making audit committees mandatory. While these committees are good things in principle, they are almost pointless so long as the INEDs which form these committees are not elected by independent shareholders. This is the "form over substance".

The SEHK first proposes to amend the rules to require that "not less than one-third" of the board shall be INEDs, and in any event not less than 2. That last part almost goes without saying, because the first part means you need 1 INED for every pair of executive directors (EDs) and one more if there is an odd number of EDs. So if you have 3 or more executive directors (as nearly all companies do) then one INED will not be enough.

It brings up the interesting scenario that HK-listed companies will strive to have an even number of Executive Directors, to avoid the INEDs being more than one third of the board. So boards of  3, 6 or 9 directors (with 2, 4 or 6 EDs) will become popular. Again, the one-third rule is nice in principle, but the move is meaningless if they are not independently elected.

Audit committees

The SEHK proposes to make audit committees mandatory. Audit committees are currently required if you want to comply with the Code of Best Practice in Appendix 14 of the Listing Rules, which is non-binding. Making it mandatory is not a huge step, because nearly all listed companies comply with the code of best practice, since if they don't, they are required to say why not, under paragraph 34 of Appendix 16. It's like so many of Hong Kong's codes - you are practically presumed to be bad in the event of other disciplinary matters if you don't comply with the code. So boards have voluntarily complied and set up audit committees to reduce their overall exposure.

Remuneration committees

In the most tentative terms, the SEHK brings up the idea that directors might, just maybe, have a teensy weensy conflict of interest in deciding their own pay, writing:

"There may be a conflict of interest when board members are asked to decide their own remuneration packages"

"May be"? There always is, by definition. It's like asking a skater to score her own performance. However objective they are, the conflict exists. The SEHK then strengthens its view, stating:

"We take the view that this is particularly relevant in the Hong Kong context where controlling shareholders in management [who are also directors] tend to have significant influence on the board."

Our hearts leap with anticipation, and this seems to be heading the right way, until the next sentence, when they contradict this position, stating:

"We are of the view that a remuneration committee may be more appropriate for large issuers or issuers with widespread shareholding structure."

Eh? Just now you said it was important in the case of controlling shareholders, and now you say it is more important for widespread shareholding structures, where by definition there are fewer or no controlling shareholders? Which is it to be? Someone must have done some last minute editing there!

In the final sentence of its analysis, the SEHK again shows its true colours by providing an excuse for the 90% of the companies (by number) which makes up 10% of the market value:

"It may not be appropriate to impose such a requirement on issuers with smaller boards".

In fact, it is exactly the opposite - small companies with small, family-dominated boards can do proportionately far more damage to shareholder value with inflated pay packages than giving an extra million or two dollars to a director of a large company with billion-dollar profits.

The SEHK concludes that they propose to amend the Code of Best Practice to recommend, but not require, remuneration committees.

Nomination committees

Here we go again. The SEHK says:

"a nomination committee may not be appropriate for issuers with small boards".

Stop and think about this. If you are making an addition of one singer to say, a barbershop trio, turning it into a quartet, then it may have a pretty dramatic impact on the sound, even if they are "harmonious". Make one change to a 32-voice choir, and the impact is much more subtle. So the importance of who you select for that small board should be greater because of the voting weight they carry and the share of the management duties they undertake.

In the case of both remuneration and nomination committees, most of HK's 900 listed companies, which have "small boards" will now have a ready-to-wear reason, from the mouth of the SEHK, for not voluntarily setting up these committees.

At this rather odd point in the consultation paper, the SEHK also throws in for good measure:

"the enhancement of corporate governance standards should be a progressive process"

For progressive process read slow and gradual. In other words, "Lord make us holy, but not just yet". We know a euphemism when we see one.

©, 2002

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