In a recent speech given by Mr. Carlson Tong, Chairman of the Securities and Futures Commission, Mr. Tong pointed out that companies can improve corporate governance by attaching higher importance to the role of their board of directors as an internal gatekeeper. Mr. Tong said that this can be done more easily by having effective independent non-executive directors (INEDs) on the board.
It is widely understood that INEDs are involved in the “non-executive” side of the business. They are not involved in the company’s daily operations but mainly serve a role in overseeing the chief executive and senior management. Their duties in law, however, may not be much different from those of the executives. INEDs owe the same duty of care, skill and diligence as any other members on the board. The new Companies Ordinance which came into force on 3 March 2014 does not differentiate INEDs from executive directors. The Corporate Governance Code issued by The Stock Exchange of Hong Kong Limited also makes clear that non-executive directors have the same duty of care and skill and fiduciary duties as executive directors. In Law Wai Duen v Boldwin Construction Company Limited and Chan Shiu Chick & Others  HKCU 842, the Court of Appeal commented (in the context of a private company) that executive directors and non-executive directors have the same responsibility in law as to the management of a company’s business, and that the law does not have any regard to whether a director holds an executive position within the company.
The fact that the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited (or the Listing Rules) require that every board of directors of a listed company must include at least three INEDs, who must represent at least one-third of the board, tells us that the INEDs play an additional and important role – to act independently. INEDs are regarded as a vital component of corporate governance. A classic example to demonstrate the importance of INEDs would be the corporate failure of HIH Insurance, which used to be one of the biggest insurance companies in Australia. Whilst the collapse of HIH happened years ago, it is worthwhile reviewing the lessons of the case , particularly in light of the increasingly active regulatory environment. The SFC has recently stated that it will be more proactive in overseeing corporate conduct of listed companies going forward.
HIH was listed on the Australian Stock Exchange in June 1992. It ended up being placed into liquidation in 2001, after a period of rapid growth throughout the 1990s. In April 2003, the HIH Royal Commission led by the Commissioner, the then Mr. Justice Owen, released a report inquiring into the reasons for the collapse of HIH (the Report). Mr. Justice Owen concluded that “HIH’s collapse related more to vanity and inflated egos, poor systems and lack of monitoring rather than systematic fraud.” It was found that the board of HIH made decisions to engage in extremely high-risks practices in competitive markets, without any checks and balances from independent directors. There were independent directors on the board who had professional qualifications. However, Mr. Justice Owen commented that the presence of several “independent” directors on the board of HIH provided little protection against the folly of management.
In the Report, Mr. Justice Owen helpfully summed up the role of an independent director. He commented that the key to understanding the notion of independence is that “independence significantly reduces the prospect that performance will be inhibited by considerations other than the best interests of the company as a whole. This is because an independent director can bring to bear upon the issues confronting the company a mind that is not materially influenced by other considerations. An independent director needs to be engaged with the company – in terms of being an inside participant – but free of impediment to the exercise of objectivity of judgment”.
Then, how can one ensure an INED’s independence? Rule 3.13 of the Listing Rules sets out a number of factors to assist listed companies in their assessment of the independence of non-executive directors. It provides that independence is more likely to be questioned if, inter alia, the individual holds more than 1% of the total issued share capital of the listed company, or is a director, partner or principal of a professional adviser which provides (or has within one year immediately prior to the date of his proposed appointment provided) services to the listed company, or is or was connected with a director, the chief executive or a substantial shareholder of the listed company within two years immediately prior to the date of his proposed appointment. Rule 3.13 does not purport to provide an exclusive list. Like the SEHK, the Australian Securities Exchange Corporate Governance Council has also identified similar factors which help determine the independent status of non-executive directors. However, these objective criteria for an INED may not necessarily make corporate governance work.
Mr. Justice Owen expressed concerns in the Report that an attempt to be unduly prescriptive might impose undesirable rigidity, and distract attention from the critical issue of freedom from possible influences, many of which may be subtle and not susceptible to a “check-list” approach. For example, it was not immediately clear why a substantial shareholding in the company should be regarded as compromising independence as such shareholding may provide greater incentive to focus on the interests of the company. In addition, a close personal association with the chief executive may be destructive of independence, but it is still difficult to assess objectively or on a “check-list” basis whether an INED is truly independent. The critical question, as Mr. Justice Owen put it, is whether an INED is subjectively capable of exercising independent judgment, and not whether he fulfils certain objective criteria for assessing independence.
The Guide for INEDs published by the Hong Kong Institute of Directors largely echoes Mr. Justice Owen’s views: “Independence… is more than a checklist with all the boxes ticked… Independence is a state of mind and only you [the INED] will know upon reflection in good faith whether you can or will act independently. At a minimum independent judgment is judgment formed after a fair consideration of all relevant information available and made free from the influence of your personal interests whether direct or indirect. You will need to be honest with yourself in answering whether motives of personal gain, no matter how derived or in what form, will interfere with the exercise of your judgment.”
In 2012, Korn Ferry, an executive search firm, conducted a study on the role of INEDs built on the comments of chairmen and board members, which in our view also give some guidance as to how INEDs should act. First and foremost, INEDs should be independent so as to bring about objective scrutiny of the executives in the organization on behalf of the shareholders. They should challenge the executive team’s decisions whilst being supportive. Whilst they are not actively running the business, they should have a deep understanding of the business and be well versed in identifying and managing operational, financial and reputational risks. In other words, INEDs have no excuse for not knowing the business and operations well or for letting the executives do whatever they think fit.