Corporate Governance :

The Effectiveness of Self-Regulation



Dr. G.Y.C. Mok has recently conducted a doctoral research on Corporate Governance and has discovered that listed company directors are in desperate need of training to counter the general lack of knowledge about their legal duties and obligations, and that certain HKEx code provisions and recommended best practices should be converted into mandatory rules



The quest for good corporate governance practices in Hong Kong is one of those challenges that continue to arouse the interest of accountants, company secretaries and lawyers even in a time characterised by cynicism about corporate law reform.


In Asian countries, poor corporate governance – i.e. the lack of corporate transparency and an effective regulatory framework – is widely viewed as one of the structural weaknesses that were responsible for the onset of the Asian financial crisis in 1997 (Choi, 1998). It is generally accepted that the crisis has resulted in a wider recognition of the importance of both internal and external governance (Gillan, 2006), corporate transparency and disclosure of financial dealings (Choi, 1998; Rahman, 1999). In contrast with other developed countries such as Canada, England and the USA, most large corporations in Asia are owned and controlled by families with family members holding key managerial positions. As such, major agency problems exist between the management (the controlling family) and the minority shareholders (Agrawal & Knorber; Jensen & Meckling, 1976).


The existence of large shareholders is not, by itself, a cause for concern. Many empirical studies show that companies with large shareholders tend to perform better because these companies are strongly incentived to closely monitor their businesses and are less likely to suffer from the free-rider problem (Jensen & Meckling, 1976; Shleifer & Vishny, 1997). However, problems arise if there is inadequate separation of powers between the large shareholders and the management, or if there is a lack of proper corporate governance mechanisms or a legal regulatory framework to enable the outside or minority shareholders to effectively check misbehaviour of the controlling owners. Much of the corporate governance literature considers that independent boards do not improve performance and that boards with too many outsiders may, in fact, have a negative impact on performance (Romano, 1996 & 2005; Bhagat & Black, 1999), although empirical evidence has been mixed (Boyd, 1994; Kren and Kerr, 1997) with some studies reporting significant positive outcomes (Lambert, 1993; Dyl, E. 1998).


In general, the corporate control of large family-controlled companies has been inadequately supervised or monitored by outside or minority shareholders, boards of directors, creditors, financiers-bankers, and/or the markets. The controlling family owners have been able to pursue their private interests with ease, often at the expense of minority shareholders or the company’s profits which would otherwise have been distributed to shareholders by way of dividends. Corporate management has lacked transparency because of inadequate, either mandatory or voluntary, disclosure standards (Carse, 2002). It is, therefore, necessary to direct greater or additional efforts towards enhancing managerial transparency by improving and strengthening disclosure requirements, in order to have better and stronger corporate governance.


According to Tricker (1984), the study of corporate governance concerns the ways in which directors perform their roles in relation to the distribution of power among directors and shareholders. It is the uneven distribution of such power that causes the problems associated with corporate governance.


The board of directors of a company is empowered to hire, fire, manage and monitor the management. The shareholders, being the ultimate owners of the business, have the power to influence decisions of the board by exercising their voting rights. If the shareholders are involved in the management of the company they can exercise their power in more direct ways. Other stakeholders who can influence the decisions of the board include non-managerial staff, customers, creditors, trade unions, regulators, social pressure groups, government and the local community.


There are notable distinctions between corporate management and corporate governance (Watson, 1998). Put simply, managers are responsible for the day-to-day running of the company and directors are responsible for setting strategy and monitoring and controlling operations (Stiles & Taylor, 1996). As submitted by Hilmer (1994), the board should not take over the managerial function of a company, even if management fails to carry out its duties satisfactorily. Instead, the board should seek to rectify the behaviour of management.


As indicated in Table A, directors have two major sets of roles. The first relates to performance, ‘in which the board is focusing on strategic and policy issues for the future, setting the corporate direction and contributing to the performance of the business’. The second relates to conformance, ‘in which the board is ensuring that the company is conforming to the policies, procedures and plans laid down by the board and being properly accountable for its activities’: Tricker (1994 & 1996).


Table A: Two Primary Functions of the Board



Directors are not only expected to monitor the performance of the incumbent management, they are also required to ensure that significant changes in the business environment are handled adequately and in good time.


  There is, unfortunately, no consensus as to how much effort directors should put into the performance and conformance functions (Short, 1998). More often than not, directors’ performance is gauged by the market share price trend and, accordingly, directors will normally prioritise the performance roles as their primary function. According to Monks and Minow (1991), the pragmatic obsession with ‘results’ has lead to a lack of accountability to shareholders.



The Problem


The absence of an ordinance directly addressing corporate governance, such as the Sarbanes-Oxley Act in the USA, or a generally tougher legal regulatory framework sets the stage for further corporate scandals. However, a danger of over-regulation is that companies may assume that it is the regulators’ responsibility to ensure proper disclosure of governance practices rather than their own, and companies may even seek out legal loopholes in order to avoid complying with strict rules. The Chairman of South Africa’s Committee on Corporate Governance, Mr Mervyn King, captured the essence of the problem when he said: ‘You can have all the bloody rules in the world, but you cannot legislate honesty. And I will tell you, as a corporate lawyer, I have found it much easier to get around a rule than a principle.’ At present, most publicly-listed companies apply self-discipline in the exercise of good corporate governance, but is this sufficient to support and maintain Hong Kong’s standing amongst the world’s leading financial centres?


This article examines how the problematic issue of non-compliance is monitored and whether there is a need to tighten up governance regulations and disclosure and publication requirements, and to what extent these and other measures may improve market efficiency and functioning. It is submitted that it is inappropriate for Hong Kong to introduce a dedicated corporate governance ordinance at this stage: further education is needed to help boards of directors to appreciate and understand the importance of self-regulation, as opposed to mandatory rules on governance practices. The success or failure of such efforts will have important policy implications for ongoing corporate governance reforms in Hong Kong, as well as for the management of listed companies, company secretaries and regulators who would like to see an improvement in the quality of governance practices, and, finally, for other emerging markets which are considering the introduction of a code of corporate governance. The following questions are apposite :-


·                            What are the factors affecting willingness to voluntarily adopt corporate governance mechanisms?

·                            How effective is self-regulation of corporate governance practices under the existing prescriptive legislation?

·                            Would the introduction of a corporate governance ordinance (CGO) support Hong Kong’s standing as a premier international financial centre?

·                            How do directors view corporate transparency as affecting market functioning, efficiency and share prices?

·                            Are listed companies willing to voluntarily adopt corporate governance code provisions and recommended best practices?

·                            What has motivated listed companies to voluntarily adopt such corporate governance measures?


Are the existing voluntary corporate disclosures adequate and effective and do they meet the needs of stakeholders and investors?



The Concept and History of Corporate Governance


The Asian financial crisis in 1997 helped many of us to appreciate the need for more effective corporate governance and protection of minority shareholders, although Hong Kong was lucky enough to suffer lesser consequences compared with most of Asia. Most policymakers learn their lessons not from theories but from history, and this was no exception. However, although corporate governance has succeeded in attracting a great deal of public interest globally, it is often poorly defined as a concept because it covers a great number of distinct economic phenomena. Basically, corporate governance is a system by which business corporations are directed and controlled (Cadbury, 1992) or, as the definition can be further developed, corporate governance in a commercial and profit-making organisation is about promoting fairness, transparency, accountability and responsibility (Mok, 2002).


From a broad perspective, Zingales (1998) views governance systems as the complex set of constraints that shape the ex post bargaining over the quasi-rents generated by a listed company. However, Shleifer and Vishny (1997) define corporate governance as the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment. From a wider perspective, Gillan and Starks (1998) define corporate governance as the system of laws, rules and other factors that control operations at a company. John and Senbet (1998) further enlarged the concept to include stakeholders and define corporate governance as the mechanism in which the stakeholders of a company exercise control over corporate insiders and management so that their interests are protected.


Our understanding of the history of corporate governance is mainly derived from agency theory that was developed in western countries more than a century ago. Corporate governance problems in those places originally arose from the non-separation of powers between the controlling owners/directors and the minority shareholders within a business organisation, which gave rise to informational asymmetries and agency costs (Fama & Jensen, 1983; Healy & Palepu, 2001), as well as from inadequate legal protection for both domestic and foreign investors (La Porta, 1997 & 1999). The essence of the agency problem, according to Coase (1937), Jensen and Meckling (1976) and Fama and Jensen (1983), is the separation of management and finance, or, in more standard terminology, ownership and control. Corporate governance now encompasses the interests of stakeholders as well as shareholders.


Apart from stakeholder theory, there are however two other theories of corporate governance, namely the stewardship theory (Donaldson & Davis, 1991) and the resource dependency theory (Pfeffer, 1982).


Stewardship theory assumes that directors, as the stewards of the shareholders, will protect their interests. This theory developed on the assumption that job satisfaction and a sense of the responsibility would counter or negate directorial selfishness. According to Tricker (1994), the concept that directors are good stewards of the shareholders is one of the basic principles of our company law. Donaldson and Davis (1991) took the theory further by arguing that monitoring and incentive arrangements for the directors are not really necessary :-


‘The executive manager, under this theory, far from being an opportunistic shirker, essentially wants to do a good job, to be a good steward of corporate assets. Thus, stewardship theory holds that there is no inherent, general problem of executive motivation and that performance variations arise from whether the structural situation in which the executives is located, facilitates effective action by the executives.’


Stewardship theory, in contrast to agency theory, suggests that there is no inherent conflict of interest between directors and shareholders, and the latter should have faith in directors who possess the professional expertise required to run the business. In this regard, Turnbull (1997) has argued that whether stewardship theory holds will depend upon the cultural context:


‘The inclination of individuals to act as selfless stewards may be culturally contingent. The “company man” in Japan may place his employer before his family. The voluntary resignation of executives is not uncommon when a company is disgraced and instances of suicide are still reported.’


Another study by Donaldson and Davis (1991), on the effects of CEO duality (where the top executive is also the chair of the board) on shareholder returns, also supported stewardship theory. Research based on a sample of US corporations found that shareholder returns, in terms of returns on equity, were superior when there was CEO duality. This is clearly contrary to what is suggested by agency theory, which is that companies will perform better if different persons take up the positions of CEO and chairman. Stewardship theory implies that self-regulation by directors is far more important than external regulation of their conduct. There is no doubt that self-regulation is more effective in the sense that externally-imposed retrospective punishment for wrongdoing by a director will usually be of no benefit to shareholders who may have already suffered heavy losses, whether to their share price, in litigation costs or elsewhere. Self-regulation serves to prevent actions by directors that are detrimental to shareholders’ interests. Numerous past incidents have suggested that self-regulation should be supplemented by laws and regulations in order to curb potential malpractice by ‘bad’ directors.


Resource dependency theory suggests that organisations are not self-sufficient and that they require resources from outside channels. The managers of organisations have to find ways to cope with these external constraints (Pfeffer, 1982); in order to reduce dependence on a particular resource channel, managers should consider diversifying their business. For example, they may use a strategy of absorption in which the external parties are combined with the organisation to reduce the potential impact of dependence on these parties. This is one of the rationales behind merger and takeover activities, particularly in backward (acquiring suppliers) or forward (acquiring product distributors) integration. The other option advanced by Pfeffer is a co-option strategy, involving the invitation of representatives from external organisations, such as major creditors or suppliers or bankers, to serve on the board of directors.


Resource dependency theory is helpful in explaining divergence in the composition of boards of directors, as well as the distribution of powers among them. For example, for those companies which rely on external borrowing as a key source of finance, representatives of financial institutions or banks will usually have a greater influence on decisions of the board. According to Tricker (1996), such close co-operation at the top can significantly strengthen relationships and alliances between companies. Stearns and Mizruchi (1993) have found that the presence of financial institution representatives on a company’s board increases the institution’s willingness to lend to the company since close monitoring is in place.


Resource dependency theory can also help to explain interlocking directorship. Generally, two or more companies will engage in such co-operation if they have high interdependence stemming from exchange of technology, financial or informational resources and related skills or specialised knowledge.


The simple balance sheet model of a company, as shown in Table B, captures the essence of both internal and external governance mechanisms. The board of directors, at the apex of internal control systems, is charged with advising and monitoring management and has the responsibility to hire, fire and compensate the senior management team (Jensen, 1993). The management, acting as the shareholders’ agent, decides in which assets to invest and how to finance those investments.


The need to raise capital has led to the further introduction of external governance (Ross, 2005; Gillan, 2006). In listed companies, a separation exists between capital providers and those who manage the capital. This separation creates the demand for corporate governance structures.



Table B: Corporate Governance and the Balance Sheet Model


文字方塊: Debt holders文字方塊: Shareholders


According to the principles formulated by the Organization for Economic Co-operation and Development (OECD) to guide its member countries, corporate governance is a system involving a set of relations between a company’s management, its board, its shareholders and stakeholders. The relationship forms a structure framing the company’s mission and objectives, also providing a framework for achieving results, monitoring performance and making improvements.


Governance can be divided into internal and external, as elaborated in Table C. Although the management of a company rests with the board of directors, the activities of a listed company can be affected or influenced by market players who exert external governance on the company (Gillan & Starks, 1998). The degree to which companies adopt and observe good governance practices is becoming a major factor in business and investment decisions.



Table C : Influence of Stakeholders (Market Players) on Corporate

                     Governance of a Listed Company


In the US or European markets, where many large corporations are owned and controlled by families with family members holding key managerial positions, conflicts are mainly between the directors/controlling shareholders and the minority shareholders (Ho, 2000). Equally, in Asian countries including Hong Kong, the protection of minority shareholders’ rights is a key concern (Ho & Wong, 2001). A serious agency problem arises unless there is a separation of powers between the large shareholders and management, or unless there are proper corporate governance mechanisms or legal regulatory frameworks enabling minority shareholders to effectively check misbehaviour of the controlling owners (Ang, Cole & Lin, 2000). Corporate management has lacked transparency because of inadequate mandatory and voluntary disclosure standards. Strong governance requires greater efforts towards enhancing managerial transparency by improving and strengthening disclosure requirements (Eccles & Mavrinac, 1995).


Good corporate governance, complemented by a sound business environment, can strengthen private investment, corporate performance and economic growth (Hart, 1995). With better transparency and public awareness of minority investors’ and stakeholders’ rights, the behaviour of directors in the boardroom will gradually change. The change in board behaviour will ultimately affect the corporate decisions made by top management, which should have regard not only to corporate fairness but also corporate social responsibilities. Until then, publicly-listed companies rely on self-discipline in the exercise of good corporate governance. Looking further ahead, the eventual introduction of a corporate governance ordinance may serve to even out varying standards and support Hong Kong’s standing as an international financial centre.


Is the Self-Governing Approach Working?


With a view to ascertaining the effectiveness of self-regulation of corporate governance practices, a survey was conducted with listed companies and speakers and delegates at the International Conference on Corporate Governance. The following questions were, inter alia, asked :-


a.                        With the existing prescriptive legislation, self-regulation of corporate governance (CG) is effective.

b.                        The introduction of a corporate governance ordinance (CGO) will support Hong Kong’s standing as one of the world’s leading international financial centres.

c.                        Corporate transparency (CT) will contribute to market functioning, efficiency and will increase share prices.

d.                        Listed companies are willing to voluntarily adopt CG best practices.

e.                        Existing voluntary corporate disclosures are adequate and effective and have met the needs of stakeholders and investors.


The responses are shown in Table D.


Table D: Effectiveness of the Self-Governing Approach


This research shows that family-controlled listed companies which have high retained earnings or which have little need for additional capital are less likely to adopt additional governance standards without mandatory requirements. Further, the willingness to adopt additional governance practices will be affected or influenced by the size of the company, with multi-national companies more willing to voluntarily adopt additional governance practices, and other listed companies willing to voluntarily adopt governance mechanisms if they need to raise or obtain additional capital from the market. Some also do so on the realisation that a reputation for strong corporate governance has benefits such as reduced operational costs, for example insurance premiums, and greater confidence among foreign investors looking to invest in their companies. Given the divergent views expressed, an approach of pure self-regulation may not be effective. A combination of strict regulations and best practice codes and guidelines is likely to achieve better overall results.


The following chart shows the relative levels of preference for mandatory or optional governance mechanisms.














This indicates that self-regulation should not entirely replace prescriptive legislation. It can, however, play a major role in encouraging higher standards of corporate governance through the operation of disclosure to the market. The introduction of a GCO with criminal sanctions for non-compliance is not seen as imperative at this stage and, although it would undoubtedly encourage good governance, companies would seek out legal loopholes to avoid its provisions, and it would generate higher operating costs eating into shareholder returns.


In order to gauge the level of voluntary compliance and the willingness of listed companies to implement corporate governance mechanisms without mandatory regulations, the 2006 annual reports of all blue chip, red chip and H-share companies, plus 150 randomly selected listed companies, were examined. The findings were as follows :-


(a)                      Overall Compliance with Code Provisions

As indicated in Table E, the level of voluntary compliance of 43 out of 45 code provisions increased in 2006 compared with 2005. After conducting t-test on these data, one can conclude that the small percentage increase is statistically significant. The levels of full compliance by blue chip, H-share and red chip companies are 52.5%, 71.8% and 32.5% respectively, which are much higher than the percentage of 29.3% for the random sample. The results confirm that benchmark blue chip and large H-share companies place a high value on their public image and are therefore willing to adopt the code provisions without mandatory regulations.


However, in order to maintain Hong Kong’s standing as a leading global financial centre, it is recommended that mandatory rules are introduced separating the roles of chairman and CEO, and requiring the chairman of the board and the committee chairmen to attend the AGM in order to answer to shareholders.



Table E: Overall Compliance with Code Provisions in 2005 and 2006 by Group


No of code provisions complied with

2005 overall (HKEx report) *

2006 overall (random sample)

Blue chip companies

H-share companies

Red chip companies

40 or less

3.7 %

2.0 %

0 %

1.3 %

1.3 %


9.1 %

6.0 %

0 %

1.3 %

1.3 %


15.1 %

9.3 %

2.5 %

1.3 %

10.0 %


22.3 %

24.7 %

12.5 %

3.8 %

25.0 %


22.7 %

28.7 %

32.5 %

20.5 %

30.0 %

45 (full compliance)

27.0 %

29.3 %

52.5 %

71.8 %

32.5 %

Sample size







*       The HKEx report did not include code provision C.2. However, for easy           comparison, it is assumed that all 515 companies had adopted this code during           2005.


(b)                      Overall Compliance with Code Provisions

Table F shows the overview of compliance with the most significant five

recommended best practices without mandatory rules for all blue chip,

H-share and red chip companies plus 150 randomly selected companies in




Table F: Compliance Level for Top 5 Recommended Best Practices in 2006


As Hong Kong Exchange and Clearing Ltd (HKEx) has not previously conducted research in this area, the results have important policy implications for ongoing corporate governance reform in Hong Kong. The following points are demonstrated.


·                       Listed companies are, in general, willing to voluntarily adopt corporate governance best practices.

·                       Most companies are reluctant to adopt recommended best practices if they have cost implications, such as A.1.9 (insurance cover in respect of legal action against its directors), A.5.5 (provision of a continuous professional development programme for all directors) and C.1.4 (publish quarterly financial results within 45 days).

·                       The compliance level for the five most significant recommended best practices is below 50%, which is unacceptable if Hong Kong is to maintain its place as a leading global financial centre.

·                       Voluntary adoption of recommended best practices numbers B.1.7 (disclose details of any remuneration payable to members of senior management on an individual and named basis) and C.1.4 would contribute to market functioning and efficiency.


The listing rules and/or the Hong Kong Companies Ordinance (Cap 32) should be revised and amended to make compliance with recommended best practices numbers A.1.9, A.5.5, B.1.7 and C.1.4 compulsory, as most companies are otherwise unwilling to adopt such practices if they involve sensitive information or have cost implications.




In addition to the above results, the following findings can be gleaned from the surveys conducted.


·                        Many listed company directors in Hong Kong do not know enough about company and commercial law and their legal duties and obligations, and formal training is needed.

·                        Pure self-regulation of good governance practices may not be sufficiently effective in Hong Kong, although it has a major role to play, as different companies may have different internal standards. A combination of strict regulations and best practice codes and guidelines would achieve better results.

·                        The introduction of a CGO in Hong Kong would enhance corporate transparency and encourage good governance, consolidating Hong Kong’s position as an international financial centre with international-grade corporate governance standards. In the long term, such an ordinance will provide better protection to minority shareholders and market players. However, in the short term, the drawbacks of forcing companies into a rigidly prescriptive regime and forcing them to incur higher operating costs to ensure compliance provide an argument against immediately taking such measures.


Hong Kong cannot afford, ethically or economically, to fail to provide a proper legal regulatory framework for corporate fairness, transparency, accountability and responsibility for publicly-listed companies. The absence of such regulations and effective enforcement, or of a dedicated corporate governance ordinance, creates an environment conducive to further corporate scandals: see Enron, WorldCom and Xerox in the US; Morgan Granfell, Cable & Wireless and Guardian IT in Europe; Peregrine, Euro-Asia and more recently, Ocean Grand Holdings Ltd in Hong Kong. At the moment, most publicly-listed companies are self-disciplined in the exercise of good corporate governance, but the introduction of stricter rules or a CGO would serve to deter double standards and encourage the good governance that Hong Kong both needs and deserves.



                                                     Dr. GYC Mok, PhD, MBA, FCIS, FCMI, FHKIOD

                                                       Barrister & Solicitor



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