Member Article

1. Overview of recent corporate governance reforms a. Recent initiatives There have been numerous recent changes in Hong Kong in relation to corporate governance matters, extending well beyond legislation and nonbinding codes. The roles of relevant regulators have also been examined and proposed changes made. As far as legislation is concerned, the most significant change is the introduction of the Securities and Futures Ordinance, which came into force on April 1 2003. The ordinance consolidated and modernised various rules and requirements, as well as: • introducing a new licensing regime which makes insider dealing a criminal offence; • introducing detailed provisions on securities misconduct; and • imposing new disclosure requirements which are probably more extensive than those in various international markets. There have also been various changes and proposed changes to the Companies Ordinance concerning issues such as the regulation of foreign companies, prospectus liability and enhancement of shareholders’ remedies. Legislation aside, significant changes have also been made to the Hong Kong Listing Rules, most of which came into force on March 31 2004. These changes: • modernise and rationalise the entry requirements for listing applicants; • modernise and rationalise the continuing requirements of listed companies, particularly with respect to connected transactions and notifiable transactions; • require qualitative and quantitative disclosure in relation to accounting and other matters; • provide increased guidance and requirements on directors and their independence; and • extensively amend the Model Code, which governs when directors may deal in the securities of a listed company. Behind all these changes, the regulatory approach and structure are also being examined. The Stock Exchange of Hong Kong Limited (SEHK) is gradually moving away from pre-vetting to a disclosure-based regime, coupled with enforcement by the Securities and Futures Commission (SFC) in case of non-compliance. The Securities and Futures Ordinance introduced the concept of dual filing, and requires listing documents and various types of corporate communications to be filed with both the SEHK and the SFC. Dual filing enables the SFC to enforce deliberate or reckless misstatements by investigation and prosecution, where appropriate. b. Special circumstances affecting corporate governance As in other Asian markets, many Hong Kong issuers are family controlled. It is common to have a controlling shareholder or a group of controlling shareholders in a listed company. For this reason, the regulation of connected transactions is of utmost importance in Hong Kong. Indeed, this was one of the focal areas in the recent changes to the Listing Rules. Another feature is the predominance of the use of foreign incorporated companies. Companies incorporated in Bermuda or the Cayman Islands are often used as listing vehicles, and the SEHK also permits enterprises incorporated in the People’s Republic of China (PRC) to be listed. One focus of corporate governance reform in Hong Kong is to apply standards across the board on a uniform basis, irrespective (to the extent possible) of the place of incorporation of such companies. Since the handover of Hong Kong to the PRC in 1997, the Basic Law of Hong Kong has enabled Hong Kong to preserve its pre-1997 laws in most respects, and common law continues to apply to Hong Kong. Hong Kong also has its own Final Court of Appeal and, except in relation to limited matters such as defence and foreign affairs, disputes are subject to final adjudication by the Hong Kong courts. 2. Shareholders’ rights a. Right to call meetings and propose resolutions Members of a Hong Kong company holding not less than 5% of its issued share capital may request that meetings be convened. In relation to foreign companies, the position is governed by domestic law. The Listing Rules do not give further rights to shareholders or impose obligations on listed companies in this regard. b. Voting requirements Most matters presented to shareholders only require a simple majority vote. However, certain matters must be approved by independent shareholders. Examples include: • connected transactions, meaning transactions or arrangements between a listed group or any of its directors, chief executive officers (CEOs) or substantial shareholders and their respective associates. ‘Associates’ is widely defined to include all sorts of family interests, related trust interests and controlled company interests (meaning that the board of such companies or more than 30% of the voting rights of such companies are controlled by such persons, their family interests or trust interests); • any transactions in which a shareholder has a material interest. This may include situations where the interests of that shareholder are different from those of the other shareholders; and • certain specific types of transactions which may have a significant impact on the company or its shareholders. Examples include reverse takeovers, very substantial acquisitions or disposals, very significant rights issues or open offers, or a delisting or privatisation where the company has no alternative listing. c. Nomination and election of directors Directors of listed companies must rotate every three years. Shareholders may put forward any person as a proposed director of the company by giving notice to the company. The company is then required to circulate details including the background of that person. d. Enforcement powers The constitution of a Hong Kong company is a statutory contract between the members and the company. The Companies Ordinance has been recently amended to allow a shareholder directly to enforce provisions contained in the constitution. Although the Listing Rules are contractually binding on the company, they cannot be directly enforced by shareholders against the company. Directors owe their duties to the company. Shareholders must prove themselves within certain exceptional situations recognised under common law before they can commence a derivative action against the directors. Derivative actions in Hong Kong are rare. A bill has been issued which, if passed, will significantly enhance shareholders’ rights in the following ways: • Shareholders will be allowed to pursue directly the enforcement of any breach of duties by directors, without obtaining prior court approval; • They will be granted enlarged statutory inspection rights and a right to obtain an injunction against any contravention of the Companies Ordinance or any breach of fiduciary duties; and • The court will be given a more general power to award costs for shareholder actions in respect of corporate injury or unfair prejudice actions. These proposals also apply to foreign companies. There was an additional proposal that the SFC be authorised to commence representative actions on behalf of shareholders, but this was not accepted. e. Disclosure of interests Hong Kong has one of the world’s most complicated disclosure regimes, requiring disclosure of interests in shares and short positions as follows: • Subject to specific exceptions, all interests in issued or unissued shares must be disclosed. • ‘Interests in shares’ means interests in 5% or more of the voting shares of a listed company. Certain interests – such as family interests, certain trusts interests, controlled company interests and interests of ‘concert parties’ – are aggregated. • A person who has disclosable interests in shares (ie, long positions) must also disclose short positions of 1% or more. • Interests in derivatives must also be disclosed, including any cash-settled derivatives (even though such derivatives do not involve any creation or transfer of voting rights or interests in shares). • Notifiable interests must be disclosed within three business days to the listed company and the SEHK. f. Exercise of shareholders’ rights Listed shares deposited with the clearing house in Hong Kong are registered in the name of a nominee company of the clearing house. The nominee company, as the registered shareholder, is entitled to exercise voting rights. Shareholders have occasionally experienced problems in exercising those voting rights effectively through the nominee company. Reform proposals are being discussed. 3. Institutional investors as shareholders a. Assertion of rights There are extensive institutional interests in Hong Kong stock. Institutional investors have significant holdings in some listed companies. Hong Kong has seen many institutional investors, predominantly funds, taking the lead on behalf of minority shareholders to oppose privatisations by controlling shareholders. Certain privatisations have recently failed as a result. In other cases those privatising have increased the offer price. b. Creation of industry standards Institutional shareholders have not established or published any particular standards for Hong Kong. However, they are often consulted in their own right, as well as through their membership in various industry bodies, on matters affecting the Hong Kong market. c. Regulation Institutional investors are regulated in the same way as any other shareholders, but certain types of exemptions are available or relevant only to institutional investors. For example: • offers made to professional investors will not be considered as an offer to the public; • regarding disclosures, there are specific exceptions in relation to custodians and nominees; and • there is a Chinese wall defence for insider dealing. Analysts’ research reports, particularly connected brokers’ research reports, have generated much debate in Hong Kong. A consultation paper was issued in March 2004. Further guidelines may be promulgated in the near future. 4. Management structure and the role of directors a. Board structure Hong Kong companies are managed by a board of directors. They do not have a supervisory board. With the exception of PRC incorporated companies, foreign companies listed on the SEHK, such as those incorporated in Bermuda and the Cayman Islands, do not normally have a supervisory board. Subject to requirements of law or the Listing Rules, all matters may be dealt with by the directors. The directors may delegate their powers to a committee. There is no limit on the size of the board, although a listed company must have at least three independent directors. There are extensive guidelines on the factors to be taken into account in determining whether a director is independent. The following persons may not be regarded as independent: • persons who have any material business relationship with the listed company or its connected persons (including partners or employees of a firm providing professional services to the listed company); • persons holding more than 1% of the issued shares of the listed company; • persons who have acquired securities by way of financial assistance or gift from the listed company or its connected persons; • persons who are family members or close relatives of a director, CEO or substantial shareholder of the listed company; and • persons appointed to the board to protect the interests of a specific person or persons, rather than the interests of the shareholders as a whole. To ensure continuing independence, each independent director is required to file an annual return with the SEHK confirming his independence. The listed issuer is also required to state in its annual report whether a director is independent. b. Election A draft Code on Corporate Governance Practices is currently under consultation. Pursuant to the draft code, it is recommended as good practice that a nomination committee be established comprising a majority of independent directors. There is a proposal that directors be elected based on cumulative voting, but this remains a proposal only. Until recently, a director could only be removed by special resolution (ie, a 75% vote). This has been changed in the case of Hong Kong companies to an ordinary resolution (ie, a simple majority vote). The Listing Rules will likely be changed to reflect this requirement. c. Directors’ duties There is no statutory codification of the duties of a director. Proposals to introduce such a requirement have not been accepted. However, the Listing Rules, the draft Corporate Governance Code and other voluntary codes all contain guidance. The Listing Rules have no statutory backing and are merely contractually binding. A breach of their requirements does not directly give rise to any ground of civil action by a shareholder or the regulators. Where the breach of duty involves fraud, criminal prosecution may be commenced. There are various announcements and corporate communications obliging directors to state expressly that they assume responsibility for the correctness or completeness of the matters stated. Any deliberate or reckless misstatement may result in criminal prosecution under the dual filing regime. d. Indemnification Not all listed companies have insurance cover for their directors, but the larger and more organised companies invariably do. The constitution of a listed company normally provides for an indemnity to directors and officers in relation to third-party claims where they are not guilty of fraud or other exclusionary circumstances. e. Executive officers Based on the draft Corporate Governance Code, the roles of chairman and CEO should be separated. However, a listed company is only required to explain non-compliance with the code so as to enable investors to make their own assessment. Only non-disclosure will be regarded as a breach of the Listing Rules. The appointment of a company secretary is mandatory for listed companies. In addition, a listed company must have a senior management officer, who is a qualified accountant employed full-time to oversee financial reporting procedures, internal controls and regulatory compliance. There is no requirement for a listed company to have a chief legal officer or for that officer to be a member of the board of directors. f. Remuneration The draft Corporate Governance Code requires that a remuneration committee be set up to establish and administer a formal and transparent procedure or policy in relation to executive directors’ remuneration. A majority of its members should be independent non-executive directors and no director should be involved in deciding his own remuneration. Stock options are often used to remunerate directors, but the holding of stock options or shares by independent non-executive directors is less common in Hong Kong than in other jurisdictions. Remuneration of the individual directors must be disclosed in annual reports against their names. g. Operation of the board The draft Corporate Governance Code requires the board to meet at least four times a year, with active participation by a majority of directors. Minutes in sufficient detail should be recorded, but there is no requirement for those minutes to be published or made available to shareholders. Arrangements should be in place to ensure that all directors are given the opportunity to include matters in the agenda for a board meeting. Board committees may be established with specific terms of reference, and they should report to the full board on their decisions or recommendations. Decisions lawfully made by a committee in accordance with its delegated powers will be binding on the company. A listed issuer should have a formal schedule of matters specifically reserved to the board for its decision. An audit committee must be set up comprising a majority of independent directors and chaired by an independent director. The draft Corporate Governance Code requires that a remuneration committee be established. The establishment of a nomination committee is merely a recommended best practice, meaning that if there is a failure to establish this committee, disclosure is encouraged but not mandatory. 5. Disclosure a. General obligations Apart from the periodic reporting of financial results, the following must be announced: • any price-sensitive developments which are the subject of a decision (some companies have begun to issue profit warning statements, but this is not yet an established practice); • the conclusion of notifiable transactions (ie, issuance of shares for non-cash consideration, certain acquisitions and disposals of companies, assets and businesses), or any transaction with a connected person; • where there has been a significant increase in trading volume or price, confirmation of whether there are any price-sensitive developments; • any material change after relevant circulars have been issued, in which case supplementary disclosure is required; and • any changes to the directorate or to the constitution of the company b. Directors’ responsibilities Disclosure requirements under the Listing Rules are basically contractual in nature. Directors must undertake to the SEHK to comply with the Listing Rules. Under the dual filing regime, any intentional or reckless misstatements may attract criminal responsibility. 6. Accounts and audits a. Reporting periods and standards Hong Kong listed companies are required to perform an annual audit and announce annual audited results. They are also required to announce their unaudited half-yearly results. The external auditors are only required to confirm that the interim results have been reviewed in accordance with applicable accounting practices. Quarterly reporting is voluntary, save in respect of companies listed on the Growth Enterprise Market of the SEHK. b. Auditors Auditors retire and are appointed or re-appointed at the annual shareholders’ meeting. There are no special requirements in relation to auditors of listed companies, and they are not subject to any separate registration or regulation. The Corporate Governance Code requires the audit committee to develop and implement a policy on the engagement of external auditors to supply non-audit services. There are no statutory restrictions on such non-audit work. 7. Enforcement Since the Securities and Futures Ordinance came into force, enforcement has been enhanced. As many corporate governance requirements have only been introduced recently and further reform proposals are in the pipeline, it is too early to draw conclusions on the relative importance of actions by ‘self-help’, through regulators or by criminal prosecutions. There are no statutory provisions to reward or protect whistleblowers. 8. Corporate social responsibility Recent corporate governance changes have not filtered through to affect practices for corporate social responsibility or corporate community involvement in any substantial way. 9. Sarbanes-Oxley Hong Kong has a different corporate governance model which is much closer to that in England. It is difficult to reconcile this with the requirements of the Sarbanes-Oxley Act, not so much in terms of its spirit, but more in terms of its procedures, the vast volume of regulations and guidelines, and the need for management to spend a lot of time in compliance review, together with associated costs and exposures. Given the complexity of the regulations involved and the exposures involved – particularly that CEOs and CFOs of foreign companies subject to Sarbanes-Oxley may now be personally responsible for mistakes or omissions in the companies’ reports – careful cost/benefit analysis will be given before a Hong Kong issuer decides to submit itself to Sarbanes-Oxley, particularly when such issuer intends to continue its primary listing in Hong Kong.