Independent Directors and their role in corporate governance

Published:

Corporate governance refers to the rules and incentives by which the management of a company is directed and controlled to maximize the profitability and long-term value of the firm for shareholders while taking into account the interest of other legitimate stakeholders (Stone, Hurley, and Khemani 1998).

Hong Kong Exchange and Clearing Limited (HKEX) is the primary regulatory organization responsible for the supervision and regulation of listed companies. In order to make sure that listed companies run properly and the rights of minority shareholders are protected. HKEX issue some listing rules for strengthening the principles and practice of corporate governance in listed companies (with the support of governments and international organizations). These rules require companies to fulfill their fiduciary duties and follow the standards set by the laws of Hong Kong. For example, they require at least two non-executive directors to sit on the board of an organization to ensure independent and won't enlarge the power of majority shareholders. They also require disclosure of director's emoluments and other information and statement of director's interest. However, all these Listing Rules are not legally bounded, the punishment of it being public censure and a period of cold shouldering. The Securities Disclosure of Interest Ordinance (SDIO) also provides some framework and disclosure requirement for related transactions. Related transactions mean a transaction between a listed issue or its subsidiary and a connected person. HKEX requires related transactions to be to be approved by shareholders in a general meeting and restrains the related person from voting on it. The Securities (Insider Dealing) Ordinance supervises the use of price-sensitive information in securities trading. Like signing of an important contract, build up a joint venture, takeover and mergers, fund raising activities…etc to ensure an orderly market.

Importance of corporate governance

Lady using a tablet
Lady using a tablet

Professional

Essay Writers

Lady Using Tablet

Get your grade
or your money back

using our Essay Writing Service!

Essay Writing Service

Corporate governance has wider implications and is critical to economic and social well being, firstly in providing the incentives and performance measures to achieve business success, and secondly in providing the accountability and transparency to ensure the equitable distribution of the resulting wealth. The significance of corporate governance was designed for the stability and equity of society between economic and social goals, and between individual and communal goals. The governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources.

A listed company is not expected to state whether it has complied with a recommendation or to publish its reasons for not following the recommended practices. After two full years of operation we understand our Exchange is now reviewing whether there is a need to revise the Code. The Code provides the basic corporate governance expectation for companies listed in Hong Kong. But that is just the beginning. For each individual listed company, the pressing issue is to ask itself what is the right corporate governance for its company. Just like it is for each jurisdiction to decide what is right for its own market taking into consideration the local circumstances, the decision on what is right for each listed company is for the company itself to determine in light of its circumstances. Each board of directors must determine how its company should be governed.

Corporate governance and international convergence codes

Hong Kong ranks as the highest on the Corporate Governance in Asia, followed by Singapore, India, Taiwan and Japan. In certain extent, this reflected the buoyant economic and market environment of Hong Kong with less pressure on corporate governance. The successes of Hong Kong are determined by several factors. Its rule of law that provides a framework of robust regulatory framework that promotes orderly and efficient markets, efficient financial infrastructure, and talent pool of professionals, enterprising business community, and the presence of market participants from around the world. With these, companies can differentiate and position themselves to be more attractive to investors that would become more careful and discriminating with their funds in an uncertain economic environment. Investors would look to companies that show potential to ride through the tough economic times and increase the value of the company and share price. Investors are attracted to markets that provide the investment opportunities they are looking for. Investors will commit their money to companies that provide good corporate governance so they will commit their investments to markets that provide significant numbers of investment opportunities with good corporate governance.

Lady using a tablet
Lady using a tablet

Comprehensive

Writing Services

Lady Using Tablet

Plagiarism-free
Always on Time

Marked to Standard

Order Now

The experience of the market turmoil in recent years also offers some useful insights on how governance went wrong. Basically, "corporate" is something that belongs to a corporate and "governance" is the act or manner of governing. So, corporate governance is simply the manner of governing a corporation. For a more formal definition, we can refer to the Principles of Corporate Governance established by the Organization for Economic Cooperation and Development (OECD) which was established in 1961, the OECD is an international organization composed of the industrialized market economy countries, as well as some developing countries, and provides a forum in which to establish and co-ordinate policies. This principle were updated and republished in 2004, it represent the first initiative by an intergovernmental organization to develop the core elements of a good corporate regime. The OECD Principles are intended to assist OECD and non-OECD governments in their efforts to evaluate and improve the legal, institutional and regulatory framework for corporate governance in their countries and to provide guidance and suggestions for stock exchanges, investors, corporations, and other parties that have a role in the process of developing good corporate governance. The principle was focus on publicly-traded companies, both financial and non-financial. However, to the extent that they are deemed applicable, they might also be a useful tool for improving corporate governance in non-traded companies, e.g. privately-held and state-owned enterprises.

Board of directors

Disclosure and transparency

Corporate must provide adequate, accurate and timely information to shareholders and the public regarding financial performance, liabilities, ownership and corporate governance issue. This is critical if investors are to be able to make informed judgments on the risk and rewards of any investment (OECD 1998)

Directors pay

The board of directors always generally determines their own remuneration without effective monitor. They can decide to pay their own compensation in excess of their performance. So disclosure of their remuneration is important in effective corporate governance. So that minority shareholder can use this information to choose decide their investment on the company and this information is also an important for institution investors. HKEX requires listed companies to disclosure director's remuneration on annual report which must disclosure information on compensation of the top executives. In addition, it would be more grateful for senior management to form an independent remuneration committee with non executive board members to make remuneration decisions.

Non-executive independent director

Independent director is playing an increasingly substantial role in the procedure of corporate governance. But how independent are independent direction? Mark Mobius President of Templeton Emerging Markets Fund and one of the speakers at the roundtable said that non-executive directors are often not as independent as they should be. Many people believe that the concept of independent non-executive director for improving a company's corporate governance system is only a myth. The advantages of having non-executive directors in a company are overridden due to the following reasons:-

According to Higgs' definition a non-executive director is considered independent when the board determines that the director is independent in character and judgment and there are no relationships or circumstances which could affect, or appear to affect, the director's judgment. To state simply the expression independent directors has been defined to mean directors who apart from receiving director's remuneration, do not have any other material pecuniary relation or transactions with the company, its promoters, its management or its subsidiaries, which in the judgment of the board may affect independence of judgment of directors.

Functions of impendent directors

In theory, independent directors should fit into the overall structure of corporate governance, and are necessary to ensure effective, balanced boards. The board is the most significant instrument of corporate governance. The non-executive directors should contribute to and constructively challenge development of company strategy. They should also scrutinize management performance, satisfy them that financial information is accurate and ensure that robust risk management is in place, meet at least once a year without the chairman or executive directors. Also, there should be a statement in the annual report saying whether such meetings have taken place. They should also prepare to attend AGMs and discuss issues relating to their roles, as especially chairmen of committees. At the same time they should have a greater exposure to major shareholders, particularly the senior independent director. To ensure the effectiveness of the board as the oversight body, they directors should oversee what the management does, in response to any recent scandals of disclosures and audits, size and scope of present day enterprise and complexity of operations.

Lack of independence

Lady using a tablet
Lady using a tablet

This Essay is

a Student's Work

Lady Using Tablet

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

Examples of our work

The independent non-executive director can improve the company's corporate governance system is basically relied on his nature of "independence". But in practice, the independent non-executive director may not actually independence. Although there have requirement that the independent non-executive director of the company must not be or have been connected to a director, the chief executive or substantial shareholders, the directors would like to select whose would co-operate with them as the independent non-executive director.

Even though they cannot select the connected person, e.g. their relatives or business partners as the independent not-executive directors, they can find their friends or someone who has the same view (e.g. marketing strategy) with them as the independent non-executive director, instead of finding some who are really independent and helpful in making the right decision. It would be easy to say that they are not connected with each other. It is especially easy to occur in case the directors are also the substantial shareholders, because the substantial shareholders (as the same time the directors of the company) have the voting right in appointing the non-executive directors, just like the family - based companies in Hong Kong.

If the independent non executive director being appointed is not 'independent' enough, they may not be able to protect the interests of all shareholders. They may only agree with the directors and the substantial shareholders and may not be able to provide independent and objective judgment and advice to the board of director. For example, the independent non-executive director are usually the members of the audit committee, if they are not independent enough, they may not be able to provide objective opinion or review on the financial reporting process, internal controls and the audit function. Moreover, they may also take part in determining the directors' remuneration, if they are connected with the directors, they may consent to the unreasonable high directors' remuneration without any inquiry.

Audit committee

Stricter rules for the audit committee and the independence of the board will help prevent financial scandals and ensure a better monitoring, but we are tempted to ask whether the independence of the board as a whole entity is sufficient to solve all the problems. When the directors sitting on the board are generalists, even if they are totally independent and lack the technical financial knowledge needed to understand the complicated reports and operations presented to them, they could unconsciously vote for resolutions that do not necessarily increase shareholders' wealth.

The financial knowledge requirement applies only to the audit committee members, which will certainly lead to improved monitoring of the firm's accounting statements but not necessarily to a board that takes optimal decisions from a shareholder perspective. We think that financial knowledge should not be exclusive to the directors sitting on the audit committee. Listed company manual requires all members of the audit committee to be financially knowledgeable or to become it in a reasonable period of time; and the definition of financially knowledgeable is left to the discretion of the board of directors. Even if a financially knowledgeable audit committee is sufficient to guarantee an effective monitoring from the board. Audit committee must have accounting or related financial management expertise, as the company's board interprets such qualification in its business judgment". Unfortunately, the time consuming aspect of data collection oblige us to limit our discussion only to the requirements concerning the audit committee. They are considering problems other than accounting scandals which are supposed to be prevented by the regulation on the audit committee.

One area of concern is whether the accounting firm acts as both the independent auditor and management consultant to the firm they are auditing. This may result in a conflict of interest which places the integrity of financial reports in doubt due to client pressure to appease management. The power of the corporate client to initiate and terminate management consulting services and, more fundamentally, to select and dismiss accounting firms contradicts the concept of an independent auditor. Changes enacted in the United States in the form of the Sarbanes-Oxley Act prohibit accounting firms from providing both auditing and management consulting services.

The Enron collapse is an example of misleading financial reporting. Enron concealed huge losses by creating illusions that a third party was contractually obliged to pay the amount of any losses. However, the third party was an entity in which Enron had a substantial economic stake. In discussions of accounting practices with Arthur Anderson, the partner in charge of auditing, views inevitably led to the client prevailing.

Family members

Management shareholdings Hong Kong has many family-controlled businesses

That is actively managed by the first or second generation of the family. By family control, that means the directors and their families have substantial shareholdings and voting power. The traditional familial culture that runs in Chinese blood means that family businesses are guarded closely. A benign tax regime - there is no capital gains tax and relatively low personal, estate and corporate taxes in Hong Kong - makes it easier for family fortunes to be kept intact. The family-ownership characteristic extends to listed companies and many are majority owned by an individual or a family, and that individual or family manages the firm. The percentage share ownership by entrepreneurs, directors and their families is much higher than for firms in industrialized countries where previous CEO pay research has been carried out. High share ownership by directors brings about different types of agency problems than those present when ownership is widely dispersed. When managerial ownership is low, investors are concerned about managers shirking their duties. This problem is alleviated when management share ownership is high. However, a different agency problem emerges when top managers own substantial share stakes. Here, the majority owners may expropriate assets away from the minority owners. One way to expropriate assets is to pay extremely high and unwarranted compensation to the manager-owners. In spite of the expropriation of assets argument, we contend that directors who have substantial shareholdings will be associated with lower direct compensation; we use three arguments to back our contention.

First, the need for higher direct compensation is reduced when the directors have high shareholdings because they receive substantial cash dividends from the shares owned. Unlike US, majority of firms in Hong Kong pay cash dividends. Moreover, Hong Kong's popular media is very obtrusive and wealthy business people are often the target for adverse commentary. The disclosure of top management pay can attract a great deal of undesirable publicity, so directors with large share holdings naturally want to avoid criticism.

Second, taking relatively modest compensation gives directors a lever to reduce the wage demands of lower level managers. Although counter arguments exist, namely that directors with substantial share ownership may use their voting power to give themselves large and unwarranted compensation, this is unlikely to be the case in Hong Kong where there exist more subtle ways to expropriate minority shareholders' wealth between the listed firm in question and the directors' private firms.

Third, the board of directors is the major internal governance mechanism that oversees management actions including the setting of top management pay. As boards of directors typically include executive directors and the CEO, firms have to institute procedures to guard against self-serving behavior. One such procedure is to appoint independent non-executive directors to the board to look after the interests of outside shareholders. Non-executive directors are expected to deter over-generous top management pay and, further, to promote the use of performance related pay. Independent non-executive directors are motivated to take their responsibilities seriously, as they want to maintain and even enhance their reputations. Additionally, of course, the directors have fiduciary duties to the shareholders. Research studies have used the proportion of non-executive directors as a measure of the strength of board monitoring of top management pay. Effective monitoring by non-executive directors in Hong Kong is very important as the executive directors often have substantial voting power. As a reflection of this concern, the Stock Exchange of Hong Kong is taking proactive steps to enhance the standing and importance of non-executive directors in listed firms. Although non-executive directors are supposed to look after the interests of shareholders, there are reasons to question their effectiveness. The principal concern, here, is the independence of the executive directors.