Judy Tsui Dean, Faculty of Business Director, Graduate School of Business

1. Simon School Executive MBA ProgramsInternational Seminar SeriesShanghai, ChinaCorporate Governancein Hong Kong & Mainland China Judy Tsui Dean, Faculty of Business Director, Graduate School of Business Chair Professor of Accounting The Hong Kong Polytechnic University 28 March 2006

2. Why Do We Need Corporate Governance? • Asian financial crisis • Corporate scandals in Hong Kong • Widespread concerns on “earnings manipulation” • Lack of corporate transparency and inadequate financial disclosures • Discretion in choice/procedures of accounting methods – Generally Accepted Accounting Principles

3. What is Corporate Governance? • Corporate governance is the system by which companies are directed and controlled. • Mechanisms whereby suppliers of corporate finance can assure themselves of a return on their investment (Shleifer and Vishny, 1997).

4. Principles underlying Corporate Governance • Openness • Integrity • Accountability

5. Governance: • Structure and process for decision-making, accountability, control and behavior at the top of organizations. (Source: Governance in the Public Sector: A Governing Body Perspective, Study 13, IFAC, Aug 2001) • Governance in Private Sector: •  Focus on board of • directors • Shareholders • Governance in Public Sector:  Focus on boards • Stakeholders

6. Lack of Corporate Governance Background and Economic Incentives – theoretical basis: • Agency theory • Incomplete contracting • Information asymmetry

7. Agency Theory: • Separation of ownership and control • Financiers (shareholders / debt holders) vs. Managers (agents) • Majority shareholders expropriating interests of minority shareholders

8. Incomplete contracting • Formal (legal contracts) and informal contracts (admin. policies) • Contract negotiation, enforcement & monitoring are costly • Not possible to write contracts that cover every contingency

9. Information asymmetry • Managers possess private information that financiers don’t have • Managers’ efforts are not observable • Costly, if not impossible, for managers to reveal true information to financiers

10. Asian Financial Crisis: Corporate Governance Perspective

11. The 1997 Asian market crisis “one of the most devastating economic events” • Stock markets plummeted by an average of 40% • Indonesia and Malaysia more catastrophic than Hong Kong and Taiwan

12. Currencies across the region lost more than 50% of their value • Mainly weak performance in the corporate sector • Essentially a crisis of confidence • Political pressures to maintain high rates of economic growth

13. Government Involvement • Perceived and actual lack of financial transparency in corporate dealings. Political Pressures • Malaysia, United Engineers (United Malay National Organization) (UMNO) forced to make an offer for Renong (UMNO – affiliated company) – much higher than the latter’s market valuation (SCMP, October 19, 1997)

14. Indonesia –“crony capitalism” • Political connection rather than innate efficiency • International investors  Inadequate financial disclosure and corporate transparency

15. “Pressure from multilateral agencies and the global market for more disclosure of financial data is rising. Asian companies that want to tap international capital markets will have to meet more stringent reporting requirements.” (Tripathi, 1998)

16. Ways managers can misrepresent financial transactions: Sales related • Timing of invoices • Phoney orders Expense related • Splitting invoices • Recording prepayments as expenses • Management discretion over timing of expense recognition • Engaging in substantive transactions to affect reported earnings

17. “Creative accounting” devices • Accounts do not present a truthful picture of the underlying economic fundamentals of the company’s financial health

18. Six motivations for earnings management (Dechow, Sloan and Sweeney, 1996): • Managers increase accounting earnings to: • Increase their bonus and compensation (Healy, 1985) • Loosen debt covenant violations (Dhaliwal, 1980) • Encourage investors to buy an interest in the company’s shares as owners, or in bonds as creditors • Increase the value of shares of shareholders • Managers decrease accounting earnings to: • Negotiate union contracts (Liberty and Zimmerman, 1986) • Avoid political or regulatory processes

19. control How do we control managers? • Through corporate governance mechanisms by which: financiers of a corporation (shareholders and creditors) corporate insiders (managers) • Corporate Governance Mechanisms • Weak corporate governance  Incentives for managers and directors in Asian countries - to make inefficient investment decisions and manipulate earnings

20. Corporate governance systems in East Asia are relationship-based as opposed to the arms-length market-based systems in the U.S. “Market-based systems require transparency as a guarantee of protection. … By contrast, relationship-based systems are designed to preserve opacity, which has the effect of protecting the relationship from the threat of competition.” (Rajan and Zingales, 1998)

21. Relationship-based systems • Example: Chaebol in South Korea; Keiretsus and banking ties in Japan; politically affiliated companies in Malaysia and Indonesia; family controlled companies in Hong Kong • Need to recognize legal environment and political constraints • Successful corporate governance - combines legal protection of investors with a monitoring role for investors

22. Insider shareholding reduces agency costs • Non-Executive Directors on the Board provide monitoring of managers • CEO horizon problem: CEOs in final years in office are expected to make inefficient decision • Debt monitoring • Big-5 auditors – higher quality

23. A Real Case of Bad Governance : KCRC Kowloon-Canton Railway Corporation

24. KCRC Saga

25. KCRC Saga Background : • Government’s introduction of separation of roles of oversight and execution to public-sector bodies • A chairman, being non-executive, is appointed by the Government on a part-time basis to oversee the Managing Board

26. KCRC Saga Problems : • Deep-rooted management troubles, bureaucratic • A clash of styles between a hands-on chairman and his chief executive • Classic case of an overintrusive chairman and a resistant chief executive • Unclear division of roles and duties • People are reluctant to accept changes, e.g. transparency, accountability, etc.

27. KCRC Saga Result : • Boardroom saga going public • Pose threats to public interests • Damage corporate image • Resignation of chief executive and dismissal of a senior manager • Damage morale

28. KCRC Saga Lesson : • Delineate clearly the respective duties of chairman and chief executive • Balance of power between chairman and chief executive

29. Splitting the Roles in Public-sector Bodies : SFC Securities and Futures Commission

30. SFC

31. SFC • In line with good corporate governance practice, Government proposes to improve SFC’s governance structure by splitting roles of Chairman and Chief Executive • Role of chairman should be clearly separated from that of CEO by focusing on his supervisory functions over senior management • Non-executive chairman will not be involved in day-to-day regulatory work

32. Corporate Governance in Public-Sector Bodies • Managed by senior officials • No governance bodies • Lack of transparency and accountability • Information inaccessible by public • In-the-box operation • Lead to scandals and disasters

33. Corporate Governance in Public-Sector Bodies • To avoid management failures and to facilitate efficient and effective management of public monies as well as to account for public interest, good corporate governance practice is promoted and introduced to various public-sector bodies in recent years, e.g. Airport Authority, Hospital Authority, KCRC, etc. • PSB (Public Service Broadcasting) is under review for re-vamp

34. Setting a Good Example : CLP China Light & Power

35. Corporate GovernanceA Shared Commitment(5-min Corporate Governance Video)

36. CLP Maintaining a good, solid and sensible framework of corporate governance has been and remains one of CLP’s top priorities

37. CLP Evolution of CLP’s Corporate Governance in 2005 • Adoption of the CLP Code on Corporate Governance • Establishment of a Social, Environmental & Ethics Committee of Board • Addition of two more Independent Non-executive Directors • A majority of Human Resources & Remuneration Committee members are Independent Non-executive Directors • Second member of Audit Committee appointed with appropriate professional qualifications and experience in financial matters • Rolled out development programme for Directors • Implemented formal letters of appointment of Non-executive Directors modelled on UK best practice • Effected fixed-term appointments for Non-executive Directors • Confirmation from Senior Management on compliance with Model Code and CLP Code for Securities Transactions • General Mandate to issue new shares voluntarily reduced from 10% to 5% of the share capital in issue

38. CLP Organization of Board & Sub-committees

39. CLP Organization of Board & Sub-committees • CLP follows a formal, considered and transparent procedure for appointment of new directors • Chairman and CEO are held separately to ensure a clear distinction between Chairman’s responsibility to manage Board and CEO’s responsibility to manage company’s business • Board has appointed a number of Board Committees to oversee particular aspects of company’s affairs

40. CLP Operated in an open and transparent manner • Information such as annual report, corporate governance report, environmental report are widely accessible on website by the stakeholders as well as the general public

41. CLP Best Corporate Governance Disclosure Awards • CLP has won Diamond award (highest honor) in the Hang Seng Index Category for 3 consecutive years (2003-2005) • Comments by Judges • Report was transparent and informative and a reflection of good corporate governance practices • Demonstrated that company has embedded a good corporate governance culture in its organizational structure and operational procedures • Inclusion of a separate remuneration report, which sets out clearly group’s emolument policy • Company supplemented its annual report with a comprehensive and easy-to-follow booklet • A separate booklet, entitled Social and Environmental Report was also published

42. CLP Social Responsibility We have supported social and environmental practices that have added to the quality of people’s lives

43. CLP Social Responsibility • Society • Community Care • Youth & Education • Arts & Culture

44. CLP Social Responsibility • Environment • Energy Resources & Renewable Energy • Generation & Process Efficiency • Air Quality • Water • Global Climate Change • By-Products and Waste Management in CLP • Environment Education

45. My 3 Consultancy Reports Awarded by Financial Services Bureau on behalf of Standing Committee on Company Law Reform of the HKSAR Government. Forms part of “Corporate Governance Review by The Standing Committee on Company Law Reform, A Consultation Paper on Proposals made in Phase II of the Review”, June 2003 1. International Institutional Investors’ Attitudes towards Corporate Governance Standards in Hong Kong 2. Corporate Governance Regimes in Other Jurisdictions 3. Roles and Functions of Audit, Nomination and Remuneration Committees

46. References “Corporate Governance in Emerging Markets: An Asian Perspective”, a chapter with Tony Shieh, in “International Accounting and Finance Handbook”, Third Edition, Edited by Frederick D. S. Choi, New York University, 2003. “Top Executive Replacement Decisions and Financial, Accounting Information: Effect of Organizational Structure”, by Charles J. P. Chen, Zengquan Li, Xijia Su, and Judy Tsui, working paper. “Non-Audit Services, Auditor Quality and the Value Relevance of Earnings ”, by Ferdinand A. Gul, Judy Tsui and Dan S. Dhaliwal. “Discretionary-Accruals Models and Audit Qualifications”, Journal of Accounting and Economics, Vol. 30, Issue 3, December 2000, by Eli Bartov, Ferdinand A. Gul and Judy S.L. Tsui. “Board leadership, outside directors’ expertise and voluntary corporate disclosures ”, by Ferdinand A. Gul and Sidney Leung.

47. References “Auditors’ Behaviour in an Audit Conflict Situation: A Research Note on the Role of Locus of Control and Ethical Reasoning”, Accounting, Organizations and Society, Volume 21, No.1, pp 41-51, 1996, Judy S. L. Tsui and Ferdinand A. Gul. “Auditors’ Ethical Reasoning: Some Audit Conflict and Cross Cultural Evidence”, International Journal of Accounting, Volume 31, pp 121-133, 1996, by Judy S. L. Tsui. “A Test of the Free Cash Flow and Debt Monitoring Hypotheses: Evidence from Audit Pricing”, Journal of Accounting & Economics, Volume 24, No.2, pp 219-237, 1998, by Ferdinand A. Gul and Judy S. L. Tsui. “Shareholding Structures, Related Party Transactions and Corporate Governance in China” by Wei Guo Zhang, The Governance of East Asian Corporations, pp27-44, 2004, Edited by Ferdinand A. Guland Judy S.L. Tsui “State Owned Enterprises”Judy Tsui, Charles Chen, Xijia Su & Zhuang Dongcheng

48. Corporate Governance In Mainland China

49. Corporate Governance in Mainland China Chinese SOE Governance • Inappropriate governance system in Chinese SOEs (State Owned Enterprises) is the major reason for their low efficiency • Take consideration of political, cultural and history factors while improving corporate governance • Objective of improvement is to establish an effective control system and incentive system • Improve transparency of financial statements and audit quality “Corporate Governance, Government Intervention and Performance of Chinese State Owned Enterprises” Judy Tsui, Charles Chen, Xijia Su & Zhuang Dongcheng

50. Corporate Governance in Mainland China Problems : • The co-existence of extremely strong and weak controls by the State make the primary objective of corporate governance, to maximize benefits for the company and the minority shareholders, impossible • State’s controlling position has led to the following problems : • Corporate governance is characterized by the strong influence of the State. Government can exercise their control on listed companies to influence the major corporate decisions • Corporate governance may also be weakly controlled by the State • It is easy for the largest shareholder of the company to collaborate with internal management, increasing the possibility and feasibility of exploiting the interests of the minority shareholders • Lack of motivation for restructuring the business in the case of corporate crisis