The Relevance of Independent Directors and Audit Committee

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

Contents • The characteristics of Asian companies • The role of independent directors • Are they functioning properly? • What need to be done?

Role of Corporate Governance • External mechanisms • Institutional Investors • Outside block holdings • Takeover activities • Internal mechanisms • Insider shareholders • Board membership and characteristics

Source: McKinsey, 2001 Independence and performance Shareholder environment Concentrated ownership “Insider boards” Reliance on family and state finance Incentives aligned with core shareholders Inefficient corporate governance INSTITUTIONAL CONTEXT Underdeveloped and illiquid investment market CORPORATE CONTEXT Limited disclosure Limited market for corporate control Inadequate minority protection Capital market liquidity What are the Characteristics of Asian Companies? (I) Transparency and accountability

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?”

Box 1: Hong Kong’s Experience • According to a survey done by the Hong Kong Society of Accountants

Box 1: Hong Kong’s Experience

Box 1: Hong Kong’s Experience • 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

Box 1: Hong Kong’s Experience • 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

Box 1: Hong Kong’s Experience • Remuneration committee • Nomination committee • Audit committee. In 1995, 2% of HK listed companies have audit committee.

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

Box 2: Connected Parties Transactions in Hong Kong • 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).

Box 2: Connected Parties Transactions in Hong Kong • 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.

Box 2: Connected Parties Transactions in Hong Kong • 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.

Box 2: Connected Parties Transactions in Hong Kong • Asset acquisition • Asset sales • Equity sales • Trading relationships • Cash payments • Cash receipts • Subsidiary relationships • Takeover & joint-ventures • J V stake acquisition • J V stake sales

Box 2: Connected Parties Transactions in Hong Kong • 2 times more assets acquisition than asset sales; cash from listed companies to its controlling owners • 3) 3.5 times more in providing cash assistance to third parties as opposed to receiving assistance • 4) Terms are unfavorable (acquiring at a premium or selling at a discount) for most deals when information are available

Box 2: Connected Parties Transactions in Hong Kong • 15% did not disclose the value of transaction in filing. • 2.7% did not attach a report by independent financial advisors • 3.4% violated a previously granted waiver • 7% had taken place in the past but had not disclosed to the exchange • 4.9% constitute an outright breach of listing rules

Box 2: Connected Parties Transactions in Hong Kong Blue: Size & MB adjusted CARs Red: Size adjusted CARs

Box 2: Connected Parties Transactions in Hong Kong Returns are • Negatively related to percentage ownerships by the main shareholders • Negatively related to proxies for information disclosure • Value of transaction • Independent financial advisor • Big 5 as auditing firm

Box 2: Connected Parties Transactions in Hong Kong • 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

Box 2: Connected Parties Transactions in Hong Kong • Variable of Corporate governance do not have any impact • Audit committee • Number of independent non-executive directors • CEO duality

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

Do Hong Kong Investors Care about Corporate Governance? • OECD is internationally recognized • HKEx guidelines comprehensively covered • 168 public companies surveyed

Do Hong Kong Investors Care about Corporate Governance? • 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

Do Hong Kong Investors Care about Corporate Governance? MTBV

Do Hong Kong Investors Care about Corporate Governance? • 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

Conclusion • Quantity and quality are both important • Quality is more important than quantity • The composition of audit committee

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.

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.

The Relevance of Independent Directors and Audit Committee