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THE HONG KONG INSTITUTE OFCHARTERED SECRETARIESSuggested AnswersLevel : ProfessionalSubject : Corporate GovernanceDiet : June 2009The Suggested Answers are published for the purpose of assisting students in theirunderstanding of what may be expected from a good candidate in the time allowed foreach paper. They are in no way exhaustive nor model answer to the questions. They donot reflect the opinion of HKICS.1

1. (a) The interests of directors or managers, who have effective control over a company andwho manage the company’s day-to-day operations, may differ from the interests ofshareholders, who supply the company with finance capital.When the directors (the agents) put their personal best interests first regardless of thebest interests of the shareholders (the principals), the agency problem arises. Forexample if the directors draw excessive remuneration they thus reduce a company’searnings for distribution to all shareholders.An agent (director/manager) takes decisions and acts on behalf of a principal(shareholder). The principal may be forced to accept the consequences of the agent’sactions even if the agent has not acted in the principal’s interest.Conflicts of interests between shareholders, the board and individual directors are at thecentre of many of the issues that arise in corporate governance.(b) Rotation of audit partners is a system whereby a company keeps the same firm ofexternal auditors for as long as it wishes, but the partner in charge of the annual auditchanges at regular intervals.Audit partner rotation has been suggested as a method of safeguarding auditorindependence, which could be put at risk by the personal relationships between the auditpartner and the company’s senior management.Proponents of audit partner rotation argue that effective Chinese walls can be set up sothat a past audit partner who previously worked on a company’s audit is effectively keptaway from the current audit work. They further argue that this keeps costs low as thefirm as a whole already has an understanding of the company’s business, whilstmaintaining independence.(c) Section 172 stipulates that a director of a company must act in the way he considers, ingood faith, would be most likely to promote the success of the company for the benefit ofits shareholders as a whole.Directors should have regard to the sustainability and likely consequences of anydecisions in the long term; business relationships with suppliers and customers; theimpact of the company’s operations on communities and the environment; and theinterests of company’s employees when making business decisions.This duty aligns with the enlightened shareholder approach to corporate governancewhich advocates that directors of a company should pursue the interests of the equityshareholders in an enlightened and inclusive way.(d)Board performance evaluation helps to:check the board has a suitable balance of skills and other attributes and focus theattention on the attributes required in any new director(2)find out if individual directors are continuing to contribute to the Board effectively andto focus on any inadequacies(1)2

(3)(4)(5)(6)(e)identify strategic prioritiesdevelop skills, knowledge and understanding in the individual directors and theircommitment to the role (for example, in terms of time spent in carrying out thedirector’s duties, attendance at board and committee meetings and so on)review board practices and procedures and thus to become more efficient andeffectivejustify recommending re-election of each director immediately during the retirementby rotation every three years (where appropriate)AccountabilityIndividuals or groups in a company, who make decisions and take actions on specificissues, need to be accountable for the decisions they make and the actions they take.Mechanisms must exist and be effective to allow for accountability. These provideshareholders and investors with the means to query and assess the actions of the boardand its committees.IndependenceIndependence is the extent to which mechanisms have been put in place to minimize oravoid potential conflicts of interest that may exist, such as dominance by a strong chiefexecutive or major shareholders. These mechanisms range from the composition of theboard, to appointments, to committees of the board, and external parties such as theauditors. The decisions made, and internal processes established, should be objectiveand not allow for undue influences.FairnessFairness refers to the principle that all shareholders should receive equal consideration.The systems that exist within the company must be balanced in taking into account allthose that have an interest in the company and its future. The rights of various groupshave to be acknowledged and respected. Minority shareholders interests must receiveequal consideration to those of the dominant majority shareholders.Social responsibilityA well-managed company is aware of, and responds to, social issues and places a highpriority on ethical standards. It maintains a culture of corporate ethics, providing a codeof conduct that all directors and employees are expected to follow. There is also agrowing recognition that companies need to consider social and environmental issuesfor commercial, governance and ethical issues. Many shareholders (includinginstitutional shareholders) and customers expect companies to show concern for socialand environmental issues. A good corporate citizen is increasingly seen as one that isnon-discriminatory, non-exploitative, and responsible with regard to environmental andhuman rights issues. A company is likely to experience indirect economic benefits suchas improved productivity and corporate reputation by taking those factors intoconsideration.(f) Independent external auditor examines the company’s accounting systems andcomments on whether the published financial statements fairly represent the financialposition of the company. Its responsibility is to express an opinion on the company’sconsolidated financial statements based on the audit conducted in accordance withInternational Standards on Auditing (“ISA”). It has to plan and perform the audit in the mostindependent, objective and reliable manner to obtain reasonable assurance as to whetherthe financial statements are free from material misstatement so as to provide investing3

public with the level of assurance enabling them to make decisions on the basis of thesefinancial statements. Misleading published financial statements make it difficult for investorsto reach a reasoned judgment about the financial position of the company. If themanagement uses questionable accounting practices in order to improve the company’sreported performance, the auditor should either insist that more conservative accountingpolicies must be used, or should report their concerns to the shareholders if managementdoes not follow their advice.Auditor helps to spot any “window-dressed” financial statements (through the use ofgenerally accepted accounting principles) which disguise the true performance of thecompany. Investors and stakeholders are then able to “see through” these financialstatements and use them to assess the company’s financial health, prospects, performanceand value. Even though investors may not have the ability or opportunity to validate thecompany’s activities, auditors can attest to the company’s financial health and providesufficient assurances to the investment community about the reliability of the company’sfinancial statements. This public watchdog function demand that the auditor maintain totalindependence at all times.When planning and performing audit procedures and evaluating and reporting the results,the auditors would –(i)consider the risk of material misstatements in the financial statements resulting fromfraud and error. When the auditor identifies a misstatement resulting from fraud orsuspected fraud or error, the auditor would consider the auditor’s responsibility tocommunicate that information to management, those charged with governance and, insome circumstances, to regulatory and enforcement authorities. (ISA#240) ;(ii) recognize that non-compliance by the company with laws and regulations may materiallyaffect the financial statements. The auditor should either communicate with the auditcommittee, the board of directors and senior management or obtain evidence that theyare appropriately informed regarding non-compliance that comes to the auditor’sattention.(ISA#250); and(ii) communicate audit matters of governance interest arising from the audit of financialstatements with those charged with governance of the company. (ISA#260)By working closely with the members of the Audit Committee and in liaison with internalauditors, auditor facilitates :(i) a more effective oversight of the financial reporting process by the board of directors; and(ii) the board of directors to (a) fulfil their responsibilities for the preparation and the true andfair presentation of the consolidated financial statements in accordance with InternationalFinancial Reporting Standards; (b) comply with the disclosure requirements of the applicablelaws; (c) design, implement and maintain internal control relevant to the preparation and thetrue and fair presentation of financial statements that are free from material misstatement,whether due to fraud or error; (d) select and apply appropriate accounting policies; and (e)make accounting estimates that are reasonable in the circumstances.4

(g) The audit committee should: make sure that the appropriate audit plans are in place at the start of each annual audit,discuss with the auditor the nature and scope of the audit and reporting obligationsbefore the audit commences;consider the auditor’s overall work plan (including the materiality in planned levels, theadequacy of human resources to carry out the audit and the proposed audit timetable)and whether it is consistent with the scope of the audit engagement, whether the agreedaudit plan and pre-established deadlines have been met and the reasons for anychanges;assess the audit team’s seniority, expertise and experience and the technical quality ofthe auditor’s service and whether the audit partner can devote sufficient time toengagement;review the findings of the audit work with the external auditors and:(i)discuss the major issues that arose during the audit and see whether theseissues have been resolved(ii) review key accounts or judgments made during the course of the audit(iii) discuss whether there were any significant audit adjustments, what the causesof the errors were and whether they require further investigation(iv) review any errors identified during the audit and obtain explanations on thereasons of any errors which remain unadjusted(v) unadjusted audit differences that were the subject of discussion or dispute withmanagement(vi) review any changes in accounting policies and practices(vii) discuss the compliance with the Stock Exchange Listing Rules and other legalrequirements in relation to financial reporting(viii) ensure coordination between internal and external auditors(ix) to review the company’s financial control, internal control and risk management(x) to review the company’s financial and accounting policies and practices review audit representation letters from management before the signing by the executivedirectors and, based on the committee’s knowledge, consider whether the informationprovided is complete and appropriate;review the management letter from the auditors (the matters identified do not usuallyconstitute material weaknesses that would have caused the auditors to modify theiropinion expressed in the audit report) to focus on whether unusual weaknesses havebeen highlighted (such as the collectibility of receivables, saleability of inventory,significant post-balance sheet date events, or susceptibility to fraud or illegal acts), andthe responsiveness of the management to the findings and recommendations from theauditors and to establish whether the auditors’ recommendations have been acted onand to provide reasons if they have not been;review and monitor the external auditor’s independence and objectivity and theeffectiveness of the audit process in accordance with applicable standards;ensure non-audit services does not impair the external auditor’s independence, toconsider the nature of non-audit services, the related fee levels and the fee levelsindividually and in aggregate relative to the audit firm.5

(h) Chartered Secretaries have a very important role to play in ensuring that the governancesystem in the corporation is effective. This role has gone beyond the compliancefunction.Chartered Secretaries are the conscience of the corporation and have an advisory andimplementation role.They have to advise the board of directors of the evolving corporate governanceprinciples and practices, whether these are appropriate for adoption, whether they aregoing to be adopted, and if so, how. Moreover, they have to make sure that theprinciples and standards are practically and effectively implemented in substance, notjust in form.Chartered Secretaries should give constant updates on the progress of implementationto the board and monitor feedback from stakeholders, in particular shareholders, tomake sure that the adopted practices are what they want.Other responsibilities of Chartered Secretary also help to enhance corporategovernance:establishing an effective working relationship with the chairman and CEO, withaccountability to the board (through the chairman) for all matters relating todirectors’ duties as an officer of the company;ensuring the smooth running of the board and board committees’ activities byhelping the chairman to set agendas, preparing papers and presenting papers tothe board and board committees, advising on board procedures and ensuring theboard follows them;keeping under close review all legislative, regulatory and corporate governancedevelopments that might affect the company’s operations, and ensuring that theboard is fully briefed on these and that it has regard to them when taking decisions;ensuring the concept of stakeholders (particularly employees) is in the board’smind when important business decisions are being taken, monitoring thedevelopments in corporate social responsibility (CSR) and advising the board inrelation to its policy and practices with regard to CSR;to act as a confidential sounding board to the chairman, non-executive directors andexecutive directors on points that may concern them and to take a leading role inmanaging difficult inter-personal issues on the board;to act as a primary point of contact and source of advice and guidance for,particularly, non-executive directors as regards the company and its activities inorder to support the decision making process;to act as an additional enquiring voice in relation to board decisions whichparticularly affect the company, drawing on his/her experience and knowledge of thepractical aspects of management including law, tax and business finance;to ensure, where applicable, that the standards and/or disclosures required byListing Rules are observed;to ensure compliance with the continuing obligations of the Listing Rules andTakeovers Code, such as ensuring publication and dissemination of annual reportsand interim reports, timely dissemination of announcements to the market andensuring that proper notification is made of directors’ dealings in securities;managing relations with investors, particularly institutional investors, with regard tocorporate governance issues and the board practices in relation to corporategovernance;6

to induct new directors into the business and explain their roles andresponsibilities;ensuring that the board is fully aware of its responsibility to ensure that it does notmislead the market by putting out or allowing the release of misleading informationabout its financial performance or trading condition, or by omitting to state informationwhich it should state, or by engaging in a course of conduct which could amount tomisleading the market;ensuring compliance with all statutory filings and regulatory disclosures; andarranging and managing the annual general meeting and establishing, with theboard agreement, the items to be considered at the meeting, including resolutionsdealing with the governance matters.(i) If a director has a material conflict of interest in a matter to be considered by the board,the matter should be dealt with by a properly held board meeting and should not be dealtwith by way of circulation of written resolutions or by a committee of the board (except ifan appropriate board committee is set up for that purpose pursuant to a board resolutionpassed in a properly convened board meeting) to obtain board consent.Independent non-executive directors who, and whose associates, have no materialinterest in such a transaction should be present at such board meeting to consider suchmatter (HK Code A.1.8).Arrangements should be made to encourage active participation at the boardmeeting/meetings of board committees convened for the purpose of considering thetransaction, either in person or through other electronic means of communication, of amajority of directors entitled to be present.Reasonable notice should be given to all directors/board committee members and letthem have an opportunity to attend (HK Code A.1.1 to A.1.3).Listing rules requirements (Rule 13.44 and note 1 to Appendix 3) on the quorum andvoting prohibitions for such meetings should be complied with.No director shall vote on any matter in which he or she has a material and direct interest.In the event of such an abstention, the abstaining director shall state the reason for theabstention, which shall be noted in the minutes of the board of director.Minutes of the meeting should record in sufficient detail all the matters considered anddecisions reached, including concerns raised by directors or dissenting views expressed(HK Code A.1.6).(j) The stakeholder approach to sound corporate governance urges the directors to run thecompany in a way that balances the interests of the equity shareholders while alsohaving regard for the interests of other stakeholders including employees, suppliers,customers, banks and lenders, regulators and the environment and the community atlargeIn the traditional shareholder view, shareholders are the owners of the company.Directors owe a fiduciary duty to the company as well as its shareholders for profitmaximization and are accountable for the stewardship of the resources of the company.7

The stakeholder approach argues that the interests of others, including governmentbodies, political groups, trade associations, trade unions and the public at large, shouldbe recognized in the decisions and activities of the company.Corporations must address the interests of their stakeholders – groups and individualswho can affect or are affected by the corporation’s activities. Stakeholder approachproposes extending the focus of manager beyond the traditional interest group ofshareholders in order to understand the needs expectations and values of groupperceived to be external to the corporation. This approach views the corporation as anentity that serves corporate and social interests.The Companies Act 2006 (UK) has also adopted the stakeholder approach and requiresdirectors to consider both the interests of shareholders and stakeholders when makingcorporate decisions.8

SECTION B2. (a) Many restructured stated-owned enterprises (SOEs) and sizeable privately ownedenterprises are going public and are now listed on capital markets. These enterprisesneed to take into account the interests of their minority shareholders and the corporategovernance expectations of a wider group of stakeholders.Unfortunately, not every CEO (nominated by the founder or controlling shareholder)seems to distinguish between the en

THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES Suggested Answers Level : Professional Subject : Corporate Governance Diet : June 2009 The Suggested Answers are published for the purpose of assisting students in their understanding of what may be expected from a good candidate in the time allowed for each paper.