Corporate Governance

1. Corporate Governance BBA 361 Business Ethics and Corporate Governance Lecture 9 Department of Business Administration

2. What is Corporate Governance 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 interests of other legitimate stakeholders (Stone, Hurley, and Khemani 1998). The systems by which the corporations are directed and controlled (OECD 1998) (Organisation for Economic Co-operation and Development ) It is about the processes used to direct and manage business affairs which are consistent to the company objective and Balance of expected corporate behavior and social expectation Accountability to relevant stakeholders

3. Today’s Drives on Corporate Governance Fast Changing Market Environment Effective corporate governance mechanism is necessary to respond to various challenges and constant changing. Intense interaction among stakeholders Stakeholders are increasingly active in exercising their ownership right. High demand for a good practice of corporate governance to deliver transparency and accountability.(recent PCCW votes for selling ownership) 3. Change of Shareholders’ values Shareholders are more willing to invest on a business with a higher standard of corporate governance. Directors are nowadays expected to contribute to increasing shareholder’s values.

4. Today’s Drives on Corporate Governance Change in Regulatory Framework It is essential to comply companies with the increasingly regulated business environment. Compliance with law and regulation can ensure better corporate governance which prevents companies suffer from reputation damage due to malpractice, Capital Market International capitals are more interested to go into the companies which have good practice of governance and disclosure mechanism, where their capital could be properly invested and protected.

5. Importance of Corporate Governance Corporate Governance stresses transparency and accountability, Enhance healthy financial and quality stature which attract investment interests Establish early warning of potential and critical risks Build credibility and trust with stakeholders Promote brand image and reputation, confidence Important to co’s sustainable growth,which makes company become competitive

6. Society-wide promotional forces to corporate governance Support from Government Regulatory forces Securities and Futures Commission, HK Exchanges and Clearing Ltd amend requirements in corporate governance on listed companies. Financial institutional forces Banking Ordinance’s restriction on banking sector owing significant part of corporate sector Institutional investors, life insurers, pension fund

7. Society-wide promotional forces to corporate governance Practitioners Professional advisors, such as directors are well informed of their responsibilities and professionalism by various training and forums Independency of practitioners Educational institutes Incorporate importance of corporate governance into programmes and courses Professional bodies HK Society of Accountants has a corporate governance committee and published guidelines on disclosure in annual reports, HK Institution of Directors specialized in programmes for director professionalism.

8. Issues of Corporate Governance for Listed Companies Board Composition Allow different mixes of executive and non-executive directors Minimum three Independent Non-Executive Directors (INEDs 獨立非執行董事) for listed companies Family Interests and Control Concerns about family controlled interests among listed companies in checks and balances, i.e. controlling shareholders may affect the overall interest of all shareholders. Listing rules and the takeovers code help to address inter alia concerns particularly about equitable treatment for all shareholders.

9. Issues of Corporate Governance for Listed Companies Forms of Corporate Governance Roles of Chairman and CEO Trend of separation between Chairman and CEO, i.e. Chairman and CEO of Kowloon Canton Railway Independent Non-Executive Directors (INEDs) Increased number to three INED in listed companies. HKEx amended Listing Rules to include more guidelines to determine independence of INEDs to protect minority interests. Training to qualified INEDs on dedication, courage, knowledge and skills

10. Issues of Corporate Governance for Listed Companies Remuneration Correlation of executive directors of listed company with company performance and related scrutiny mechanisms. Listing Rules requires disclosure of directors’ remuneration on an individual basis. Corporate Reporting Disclosure of financial information in accordance with HK accounting and auditing standards Audit Committee and Internal Controls Required a Audit Committee comprising of at least 3 non-executive directors, one should be qualified in financial reporting. Internal controls covering financial, operational and compliance controls and risk management.

11. Issues of Corporate Governance for Listed Companies Transparency and Disclosure Any stringent change of interest need to notify Stock Ex. Disclosure of annual financial reports High level of transparency and disclosure is a conscientious act of accountability Shareholder Activism Attendance and questions raised by shareholders during annual general meetings indicates minority shareholders rights, transparency and corporate governance.

12. General non-statutory Duties of BOD (http://www.hkex.com.hk/listing/dirduty/Non-Statutory.htm) Principle 1: Duty to act in good faith for the benefit of the company as a whole A director of a company must act in good faith in the best interests of the company. This means that a director owes a duty to act in the interests of all its shareholders, present and future. In carrying out this duty, a director must (as far as practicable) have regard to the need to achieve outcomes that are fair as between its members.

13. General non-statutory Duties of BOD (http://www.hkex.com.hk/listing/dirduty/Non-Statutory.htm) Principle 2: Duty to use powers for a proper purpose for the benefit of members as a whole A director of a company must exercise his powers for a “proper purpose”. This means that he must not exercise his powers for purposes that are different from purposes for which they were conferred. The primary and substantial purpose of the exercise of a director’s powers must be for the benefit of the company. If the primary motive is found to be for some other reasons (e.g. to benefit one or more directors and to gain control of the company), then the effects of his exercise of his power may be set aside. This duty can be breached even if he has acted in good faith.

14. General non-statutory Duties of BOD (http://www.hkex.com.hk/listing/dirduty/Non-Statutory.htm) Principle 3: Duty not to delegate powers except with proper authorization and duty to exercise independent judegement Except where authorized to do so by the company’s memorandum and articles of association (the “constitution”) or any resolution, a director of a company must not delegate any of his powers. He must exercise independent judegement in relation to any exercise of his powers. Principle 4: Duty to exercise care, skill and diligence A director of a company must exercise the care, skill and diligence that would be exercised by a reasonable person with the knowledge, skill and experience reasonably expected of a director in his position. In determining whether he has fulfilled this duty,the court will also consider whether he has exercised the care, skill and diligence that would be exercised by a reasonable person with any additional knowledge, skill and experience which he has.

15. General non-statutory Duties of BOD (http://www.hkex.com.hk/listing/dirduty/Non-Statutory.htm) Principle 5: Duty to avoid conflicts between personal interests and interests of the company A director of a company must not allow personal interests to conflict with the interests of the company. Principle 6: Duty not to enter into transactions in which the directors have an interest except in compliance with the requirements of the law A director of a company has certain duties where he has a material interest in any transaction to which the company is, or may be, a party. Until he has complied with these duties, he must not, in the performance of his functions as a director, authorize, procure or permit the company to enter into a transaction. Furthermore, he must not enter into a transaction with the company, unless he has complied with the requirements of the law.

16. General non-statutory Duties of BOD (http://www.hkex.com.hk/listing/dirduty/Non-Statutory.htm) Principle 6: (con’t) -The law requires a director to disclose the nature of his interest in respect of such transactions. Under certain circumstances the constitution may prescribe procedures to secure the approval of directors or members in respect of proposed transactions. A director must disclose the relevant interest to the extent required. Where applicable, he must secure the requisite approval of other directors or members. Principle 7: Duty not to gain advantage from use of position as a director A director of a company must not use his position as a director to gain (directly or indirectly) an advantage for himself, or someone else, or which causes detriment to the company.

17. General non-statutory Duties of BOD (http://www.hkex.com.hk/listing/dirduty/Non-Statutory.htm) Principle 8: Duty not to make unauthorized use of company’s property or information A director of a company must not use the company’s property or information, or any opportunity that presents itself to the company, of which he becomes aware as a director of the company. This is except where the use or benefit has been disclosed to the company in general meeting and the company has consented to it. Principle 9: Duty not to accept personal benefit from third parties conferred because of position as a director A director or former director of a company must not accept any benefit from a third party, which is conferred because of the powers he has as director or by way of reward for any exercise of his powers as a director. This is unless the company itself confers the benefit, or the company has consented to it by ordinary resolution, or where the benefit is necessarily incidental to the proper performance of any of his functions as director.

18. General non-statutory Duties of BOD (http://www.hkex.com.hk/listing/dirduty/Non-Statutory.htm) Principle 10: Duty to observe the company’s memorandum and articles of association and resolutions A director of a company must act in accordance with the company’s constitution. He must also comply with resolutions that are made in accordance with the company’s constitution. Principle 11: Duty to keep proper books of account A director of a company must take all reasonable steps to ensure that proper books of account are kept so as to give a true and fair view of the state of affairs of the company and explain its transactions.To avoid breaching the fraudulent trading provisions in section 275 of the Companies Ordinance (Cap. 32), a director must not allow the company to incur further credit knowing that there is no reasonable prospect of avoiding insolvency.

19. Background of Enron: Energy Giant • The world’s biggest energy trading company which provide modern energy management service • Head Office：Houston of US • Range of Business：3500 branches in over 40 countries • Number of Employees：more than 21000 • In 2000 total assets was US$66.5 billion, sales turnover more than US$100 billion. US’s 7th giant corporate.

20. Enron’s Business • Wholesales and risks management services • Energy Services (wind, coal, oil business) • Broadband Services • Transportation Services (gold, chemicals, papers, plastics, etc.)

21. Enron‘s Reputation and Brand • Consecutively elected as “the most creative company in US” for 6 years since1996 • In 2000, Enron was awarded “the Energy Company of the Year” and “the most successful investment strategy company” by the Financial Times • Elected as the first 100 best company in the world

22. Before it was Enron • Set up Houston Natural Gas in 1983 • Kenneth Lay became CEO in 1984, planned to merge with 英特北(Inter North), changed the name to Enron Corp.

23. Energy release from US • US Gov’t released energy control in late 80’s • Jeffrey Skilling joint in1989, suggested the plan for Gas Bank (瓦斯銀行) • Started a new business model “Natural Gas Futures Transaction” (天然氣期貨交易), thus became a new competitive business in the market

24. New business model and aggressive expansion • Utilized new financial tools to increase the flow of the energy products , make these products more “financialized”. However, the fluctuation of retail prices, stock price, interest rates and other currency changes would impose higher risks to these energy products. Dramatic increase in revenue and profits

25. Aggressive Expansion • Enron established it’s the first overseas electric power station in England in 1991 • Moved its business to South America (Argentina) in 1992 • In 1992 Enron extended its business to Europe and Russia and gradually pushed itself from a biggest energy company in the US to the World. Over expansion

26. India ‘s Dabhol Electricity Company • Approved by Indian government to establish electricity power station in 1992. • Indian currency depreciated in 2002 and price of natural gas increased. Enron’s only customer refused to purchase its electricity, business suspended. • Indian government discontinued partnership relationship with Dabhol in 2001 because its over high operation costs. Started getting slump

27. US’s Azurix Corporation • Purchased water sewerage company (Wessex) in England in 1998 • Lack of experience, purchased water related assets at too high prices, but the British government reduce the water prices in 2001. • Started getting losses Started getting losses

28. Development to E-Business • November 1999: establishment of Enron online • Establish a electronic platform for E-business, transaction of natural gas, electricity, materials like paper, metal through internet. • Its outstanding sales performance made Enron the best E-Business in the world. Non-stop increase in stock prices

29. Broadband market • Established broadband services in 2000 • Invested US$1,000 million in purchasing broadband facilities, servers and networks. • Loss US$109 million in broadband business in 2001 Dramatic losses

30. Hints of Loss • From 1999 to 2001, the management started selling company shares which amounted US$110 millions, without telling the public. • 14 August 2001, sudden resignation of the CEO due to personal reason.

31. Exposure of Crisis • Economic depression in 2001, leading to dramatic drop in Enron’s share prices, in 16 Oct 2001 annual report revealed a loss of 618 millions US$ • Invested by Securities & Investments Commission in 8 November, Enron admitted its faults accounting statement in the past 4 years. • Sought for financial help

32. Dynegy Inc’s merger failure case • In 2001, Dynegy made a white knight US$8 billion takeover bid for Enron, which was saddled with $13 billion in debt and whose stock had plummeted. • But the deal began unraveling two weeks later as Enron revealed even larger financial losses and more debt than previously reported. • On 27 November 2001, S&P rated the credit rating of Enron to junk level. Enron’s share price reduced by 85% in a single trading day. • Dynegy withdrew its merger offer on November 28. Dismissed

33. Reasons for ENRON’s Failure • Insider trading, conflict of interests of BOD • Lack of independent accounting executive oversight the board • Lack of independency of Auditors. Objective financial statement could not be given • Lack of transparency • Over expansion • Complex business

34. ENRON’s Impact • Rise of awareness of corporate governance • Given this reason, World.com and other business being discovered cooked the books. • Rise of independency of auditors, board of director

35. Why Is Corporate Governance Important? • Good corporate governance helps to prevent corporate scandals, fraud, and potential civil and criminal liability of the organization • It is also good business. A good corporate governance image enhances the reputation of the organization and makes it more attractive to customers, investors, suppliers and, in the case of nonprofit organizations, contributors.

36. Is Perception Important? • The perception of good corporate governance is an important ingredient of the image of an organization, whether public, private, or nonprofit. • For example, when The Nature Conservancy, a not-for-profit organization, was perceived to have poor corporate governance, the public contributions to this organization were substantially reduced (Same case in the Chinese Red Cross). • Private, including family-owned, companies that have a poor reputation for corporate governance are less likely to be welcomed at financial institutions and will appear less attractive to venture capitalists and private equity funds. Some investment and private equity funds will not purchase the securities of public companies that have low corporate governance ratings.

37. Is corporate governance costly? • Good corporate governance can be performed in a cost-efficient manner by focusing efforts on the significant risks facing the organization rather than attempting to cover any possible theoretical risk, and by installing the best cost-efficient practices within the organization. • Resources must be concentrated in areas that have the greatest potential benefit, such as improving the corporate culture and establishing an effective internal audit function. • Creating an ethical, law-abiding culture provides the greatest benefit for the organization compared to the relatively minimal cost of establishing such a culture. • The benefits of good corporate governance, by avoiding governmental investigations, lawsuits, and damage to the reputation to the organization, should significantly outweigh the cost of good corporate governance.

38. Is corporate governance costly? • The benefits of good corporate governance are longer term, whereas the costs of good corporate governance are incurred in the short term. • Executives who are focused on short-term results may see only the costs and not the benefits. Consequently, management tends to be skeptical of incurring these costs and tends to do no more than is legally required.

39. Can you rely on the outside auditor? • Many audit committees rely almost exclusively on the outside auditor in performing their task of monitoring management and providing good corporate governance. • Unfortunately, there is a serious disconnection between what directors believe the outside auditor is responsible for and what the outside auditor believes. • Given the large number of corporate scandals that have occurred at organizations audited by a "Big Four" auditor, it is difficult to understand how any board of directors can place exclusive reliance on its auditor.

40. Principles of corporate governance • Contemporary discussions of corporate governance tend to refer to principles raised in three documents released since 1990: The Cadbury Report (UK, 1992), the Principles of Corporate Governance (OECD, 1998 and 2004), the Sarbanes-Oxley Act of 2002 (US, 2002). • The Cadbury and OECD reports present general principals around which businesses are expected to operate to assure proper governance.

41. Principles of corporate governance: Rights and equitable treatment of shareholders • Organizations should respect the rights of shareholders and help shareholders to exercise those rights. • They can help shareholders exercise their rights by openly and effectively communicating information and by encouraging shareholders to participate in general meetings.

42. Principles of corporate governance: Interests of other stakeholders • Organizations should recognize that they have legal, contractual, social, and market driven obligations to non-shareholder stakeholders, including employees, investors, creditors, suppliers, local communities, customers, and policy makers.

43. Principles of corporate governance: Role and responsibilities of the board • The board needs sufficient relevant skills and understanding to review and challenge management performance. • It also needs adequate size and appropriate levels of independence and commitment

44. Principles of corporate governance: Integrity and ethical behavior • Integrity should be a fundamental requirement in choosing corporate officers and board members. • Organizations should develop a code of conduct for their directors and executives that promotes ethical and responsible decision making.

45. Principles of corporate governance: Disclosure and transparency • Organizations should clarify and make publicly known the roles and responsibilities of board and management to provide stakeholders with a level of accountability. • They should also implement procedures to independently verify and safeguard the integrity of the company's financial reporting. • Disclosure of material matters concerning the organization should be timely and balanced to ensure that all investors have access to clear, factual information

46. Reference: Stone, Andrew, Kristin Hurley and R. Shyam Khemani. 1998. “The Business Environment and Corporate Governance: Strengthening Incentives for Private Sector Performance.” Background paper for the World Bank’s 1998 Annual Meetings Program of Seminars.