Board of directors plays an essential role to promote good corporate governance

Hong Kong – In 2014, the Stock Exchange amended the Code and the requirements of the Corporate Governance Report by changing the provisions on risk management and internal control and by requiring the listed companies to “comply or explain”. The amended Code took effect from 1 January 2016. These amendments had been implemented for three years. Grant Thornton analyzed the 2018 annual reports of 470 HSCI companies. Grant Thornton’s Corporate Governance Review 2019 (the “Review Report”) found that 50% of the Hang Seng Composite Index (“HSCI”) companies declared full compliance with the Corporate Governance Code (the “Code”) issued by Hong Kong Exchanges and Clearing Limited (“HKEx”), representing an improvement in the level of compliance compared with the previous year; meanwhile, 49% declared that they did not comply but explained the reasons for non-compliance and the remaining 1% had neither complied nor provided an explanation for non-compliance.
 
Furthermore, notable progress has been made towards greater board diversity compared to past 10 years; however, Hong Kong is still playing catch-up in the race and is moderately lagging behind its global counterparts. Grant Thornton believes that a board consisting a good mix of age groups, gender, as well as skills and experience, can lead to better decision making and enhance the corporate performance, contributing to Hong Kong’s overall competitiveness.
 

Effective board of directors and their commitment would be the key driver of good corporate governance

HKEx published the conclusion of its consultation on the Code and related Listing Rules along with “Guidance for Boards and Directors” (“Guidance”) on 27 July 2018. The revised Code implemented 5 new measures including promoting board diversity. In fact, the benefits of a board of diverse members are increasingly recognized worldwide. In this review, Grant Thornton also examined the board diversity of Hong Kong-listed companies in terms of gender, age, length of service, type of directors, professional qualifications and educational background.
 
With the growing discussion on gender equality within the workplace, gender inequalities continued to be pronounced in the boards of HSCI constituents. 11% of board members in HSCI constituents was composed of women, which was consistent with the trend of Grant Thornton’s past statistics. Among the business industries, companies in consumer services sector was making the greatest efforts to promote gender diversity, where women held 15% of the board seats. On the contrary, women only made up 7% of board members in the energy companies, which was the lowest comparing to other sectors.
 
Regarding the age of directors, during the year under review, the 51-60 age group remained the majority while under 30 age group consisted the least percentage of directors. Small-cap companies had more young directors with the possible reason that most of it were founded by young people. The age of 7% of directors in small-cap companies, were or below 40, while the percentage in large-cap and mid-cap firms were 4%.
 
In terms of length of services, a mix of experienced directors and newer directors in a board could lead to a more balanced decision-making process. In 2018, 44% of the directors of the HSCI companies had served the board for one to five years, and only 4% of them had served for 21 years or above.
 
Additionally, professionally qualified directors could also help to improve corporate standards.  A quarter of the HSCI constituents disclosed the professional qualifications of their directors. It is noteworthy that the disclosure rate of HSI constituents (29%) was higher than that of HSCEI constituents (19%) by 10 percentage points. 56% of the disclosed professional qualifications obtained by the directors in HSCI constituents was accounting. On the other hand, directors in HSCEI constituents had higher education level than directors in other indices. It is worth noting that 45% of directors who pursed master’s degree had been awarded an MBA. 
 
Grant Thornton also studied the prevalence level of early adoption in relation to the new requirements of the revised CG Code. Results showed that Hong Kong companies are less transparent in the election of independent non-executive directors and the disclosure on chairman’s meetings with independent non-executive directors. Less than 10% of the HSCI constituents disclosed the process used for selecting independent non-executive directors, and only 15% disclosed their chairman at least annually held meetings with the independent non-executive directors without the presence of other directors.  Besides, only 11% illustrated the board matrix summarizing the skills in their annual reports. Since many companies had prepared their annual reports before the publication of the Guidelines, the low disclosure ratios above were not surprising. Grant Thornton hopes to see more companies adopt the new disclosure requirements in its next Review Report.
 

Internal audit function plays a significant role to assist the directors in ensuring the effectiveness of a company’s risk management and internal control system

Risk management and internal control systems are the fundamental and vital element which can be used effectively to strengthen the corporate governance frameworks. Disclosing risk related information in annual reports could help investors understand the companies’ effectiveness on risk and internal controls when making investment decisions.
 
Our study showed that 71% of the companies disclosed their material risks in the annual reports and 67% disclosed the mitigation measures for addressing those risks. Further to this, the top disclosed principle risks faced by HSCI constituents were market risk (84%) and financial risk (72%), followed by operational risk (61%) and regulatory & compliance risk (49%). Regarding the changing landscape of key risks and risk appetite, the disclosure rate were relatively low at only 11% and 7% respectively.  We look forward to seeing more listed companies would provide more voluntary disclosures in their annual reports to help investors get a better understanding of its risk management framework and how they manage the risks.
 
Besides, it is encouraging to see that 99% of the HSCI constituents disclosed that they had an internal audit function during this year while co-sourcing internal audit function had become a new trend, with the disclosure rate rising from 17% in 2016 to 37% in 2018.
 

Good ESG reporting would engender investor confidence in the long-term prospects of companies

The Review Report examined on the disclosure of Environmental, Social and Corporate Governance (“ESG”). According to “Review of the Environmental, Social and Governance Reporting Guide and related Listing Rules” published by HKEx on 17 May 2019, the percentage of HSCEI constituents that had formed a team dedicated to ESG reporting surged from 6% in 2017 to 27% in 2018. Grant Thornton found that 49%, 79%, 67% and 12% of the HSCI constituents followed “Materiality”, “Quantitative”, “Balance” and “Consistency” reporting principles respectively, which were set out in the “Step-by-step guide to ESG reporting” published by the HKEx in November 2018. Only 17% of the HSCI constituents disclosed that they had received assurance from independent parties.
 

Accelerate the disclosure of IT strategic and cybersecurity initiatives to enhance investor confidence

IT has become more integrated into companies’ business operations. With the new technologies, companies may expose the businesses to a wide range of threats. Although HKEx has yet to impose any affirmative duty on issuers to disclose measures adopted for IT security protection; Grant Thornton once again conducted studies of IT system and security disclosure made by HSCI constituents this year.
 
The findings revealed that 30% of the HSCI constituents disclosed they had improved their IT systems, and only 12% of HSCI constituents disclosed that they had improved their IT security.
 
With the impact of cyberattacks, only 6% and 4% of HSCI constituents disclosed that they had adopted measures to conform to the industry security standards, General Data Protection Regulation (“GDPR”) and ISO 27001 respectively. Nevertheless, Grant Thornton believes that the industry security standards such as GDPR and ISO 27001 will become more popular in the coming years.
 
Eugene Ha concluded, “Good corporate governance relies heavily on the board of directors. Therefore, an effective board of directors and their commitment would be the key driver of good corporate governance in achieving sustainable business operation and enhancing shareholder value. Investors see the annual reports and ESG reports as reliable sources of information to understand the companies’ risk management and internal controls as well as its strategic directions, policies and performance with respect to environmental and ethical standards. Detailed disclosures in their annual and ESG reports could help attract capital and maintain investors’ confidence in capital markets.”