The Relevance of Independent Directors and Audit Committee Stephen Y. L. Cheung Professor (Chair) of Finance City University of Hong Kong

The Relevance of Independent Directors and Audit Committee

Stephen Y. L. Cheung

Professor (Chair) of Finance

City University of Hong Kong

2

Contents

1. The characteristics of Asian companies

2. The role of independent directors

3. Are they functioning properly?

4. What need to be done?

3

Role of Corporate Governance

• External mechanisms

– Institutional Investors

– Outside block holdings

– Takeover activities

• Internal mechanisms

– Insider shareholders

– Board membership and characteristics

4

Transparency and

accountability

Inefficient corporate

governance

Reliance on family and

state finance

Underdeveloped and illiquid investment

market

Limited market for corporate

control

Inadequate minority

protection

Limited disclosure

Incentives aligned with

core shareholders

“Insider boards”

Concentrated ownership

Independence and performance

Capital market liquidity

CORPORATE CONTEXT

Shareholder environment

INSTITUTIONAL CONTEXT

Source: McKinsey, 2001

What are the Characteristics of Asian Companies? (I)

5

What are the Characteristics of Asian Companies? (II)

Some commonly repeated cliches within the region (even in Hong Kong)

• “I do not need to raise any capital anytime soon. Why should I worry about corporate governance?”

• “I would rather have a higher cost of capital than higher taxes that I would be forced to pay under greater disclosure”

• “Why should I appoint independent non-executive directors? My company is well run.”

• “Why should I own a bank if I cannot lend to myself?”

6

Box 1: Hong Kong’s Experience

• According to a survey done by the Hong Kong Society of Accountants

Table 1: -- Shareholding Control

Shareholding (by single Companiesor family shareholder) Number %

i. 0 - <10% 20 4ii. 10 - <25% 46 8iii. 25 - <35% 60 11iv. 35 - <50% 134 24v. > =50% 293 53

553 100

35-<50%(24%)

25-<35%(11%)

10-<25%(8%)

0-<10%(4%)

>=50%(53%)

7

Familyshareholding

35-<50% (23%)

Familyshareholding

25-<35% (2%)

Familyshareholding

10-<25% (2%)Family

shareholding0-<10% (0%)

Familyshareholding>=50% (73%)

Figure 1: Boards having 50% or more of the directors related as family members


8

Table 2 -- Executive Directors

Shareholding (by single or family

Family presence of board of directors

shareholder) 50% or more Less than 50% Number % Number %

i. 0 - <10% 7 4 13 3 ii. 10 - <25% 9 6 37 9 iii. 25 - <35% 10 6 50 13 iv. 35 - <50% 35 21 99 26 v. > =50% 104 63 189 49

165 100 388 100


9


• Listing Rules

• SEHK’s Code of Best Practice

• Companies Ordinance

• The Securities ( Disclosure of Interests) Ordinance

• The Securities ( Insider Dealing) Ordinance

• The Code of Takeovers and Mergers

• and others

10


• In 1993, two or more independent non-executive directors were required on the Board of listed companies.

• Disclosure of more information including directors’ emoluments, statement of their directors’ interests in the five largest suppliers or customers

• A statement of compliance with the Code of Best Practice

11


• Remuneration committee

• Nomination committee

• Audit committee. In 1995, 2% of HK listed companies have audit committee.

12

Box 2: Connected Parties Transactions in Hong Kong

Companies with concentrated ownership:

• extract case by selling assets, goods, or services

• obtain loans on preferential terms

• assets transfer

• dilute the minority shareholders’ interests

13


• A connected transaction is defined as any transaction between a company (or any of its subsidiaries) and a connected person.

• Connected persons are the listed firm’s (or the subsidiary’s) substantial shareholders, the directors (current directors or anyone who held this position at any time during the preceding 12 months), the chief executive and their associates, including any company where the above hold a substantial shareholding.

• The definition also applies to any person co-habiting with the above and relatives (such as spouses, parents, step-parents, brothers/sisters, step-brothers/sisters, and in-laws).

14


• For all transactions more than HK$10 million, in addition to a public announcement, the listed company must also notify the exchange by making a filing.

• The minutes of the board meeting where the transaction was approved, noting also the views of the company’s independent non-executive directors, must be submitted to the exchange.

• Within three weeks of such notification, the listed company must send a circular to shareholders providing full details of the transaction, including an opinion by an independent expert.

• This is to be followed by approval of the transaction by shareholders in a general meeting, where any connected person interested in the transaction should abstain from voting.

15


1. There were 328 connected transactions worth at least HK$116 billion during 1998-2000. The value of the median transaction was HK$ 106 million, representing 17.5% of firm’s market capitalization.

16


1) Asset acquisition2) Asset sales3) Equity sales4) Trading relationships5) Cash payments6) Cash receipts7) Subsidiary relationships8) Takeover & joint-ventures9) J V stake acquisition10) J V stake sales

17


2. 2 times more assets acquisition than asset sales; cash from listed companies to its controlling owners

3. 3) 3.5 times more in providing cash assistance to third parties as opposed to receiving assistance

4. 4) Terms are unfavorable (acquiring at a premium or selling at a discount) for most deals when information are available

18


5. 15% did not disclose the value of transaction in filing.

6. 2.7% did not attach a report by independent financial advisors

7. 3.4% violated a previously granted waiver8. 7% had taken place in the past but had not

disclosed to the exchange9. 4.9% constitute an outright breach of listing

rules

19


-16%-14%-12%-10%-8%-6%-4%-2%0%2%

CA

Rs

-12 -9 -6 -3 0 3 6 9 12Month

All connected

Blue: Size & MB adjusted CARsRed: Size adjusted CARs

20


Returns are• Negatively related to percentage ownerships by t

he main shareholders

• Negatively related to proxies for information disclosure

– Value of transaction

– Independent financial advisor

– Big 5 as auditing firm

21


• Likelihood of undertaking connected transactions is higher

– Ultimate owners can be traced to mainland China

• Likelihood of not disclosing the value of the deal and likelihood of violating the listing rules are higher for

– Mainland China ownership

– Concentrated ownership

22


• Variable of Corporate governance do not have any impact

– Audit committee

– Number of independent non-executive directors

– CEO duality

23

Do Hong Kong Investors Care about Corporate Governance?

• Based on Revised OECD Principles (OECD, 2004) and Code of Best Practices (HKEx, 1999)

• Including five categories and 86 criteria

• Overall CG index ranges from 0~100

• Transparency index and non-transparency index are constructed

• 168 largest companies are covered

24


OECD principle

Number of questions & sub-questions

A. Rights of shareholders

16

B. Equitable treatment of shareholders

10

C. Role of stakeholders

4

D. Disclosure and transparency

30

E. Board responsibilities

26

Total 86

• OECD is internationally recognized

• HKEx guidelines comprehensively covered

• 168 public companies surveyed

25


• CG overall Index ranges from 32.86 to 76.34, average is 48.33.

• Perform well in Section B and D, poor in Section A relatively

• Finance and utilities sectors are on the top, property sector is on the bottom

26


30 35 40 45 50 55 60 65 70 75 800

1

2

3

4

5

6

7

8

9

10

Scores

To

bin

's Q

MT

BV

27


• Market-to-book ratio (MTBV) was used as proxy for company’s market value

• Positive and significant relationship between MTBV and CG Index was found

• Number of executive directors has negative impact

• The top 5 shareholders’ holding has negative impact

• The inclusion in the MSCI has positive impact

28

Conclusion

• Quantity and quality are both important

• Quality is more important than quantity

• The composition of audit committee

29

Conclusion

• Qualification?– Knowledge of Accounting and Finance

• Professional Expertise• How many board meeting (and AGM)

he/she should attend?• How many appointment (INED) should

take?– In Hong Kong, someone takes up the INED

for 19 companies.

30

Conclusion

• According to our survey, none of the 168 companies declare the definition of ‘independence’.

• Nomination Committee (less than 10%)

• Shareholding percentage

• Relationship with senior management– Relatives– Good friends.

Documents

The Relevance of Independent Directors and Audit Committee Stephen Y. L. Cheung Professor (Chair) of Finance City University of Hong Kong