Since the collapse of Enron Corp. late last year, a series of cases concerning similar corporate malpractice were gradually unfolded in the U.S. These have dealt a huge blow to public confidence in the corporate governance of the U.S. The U.S. authorities would certainly strive for reform in order to re-build confidence and prevent possible financial crisis. For Hong Kong, the series of U.S. corporate scandals should remind supervisory authorities and public companies of the need to push for reform in corporate governance proactively.

Issues Revealed

A corporation or enterprise is a basic economic entity. Growth and development of enterprises, in turn, is the major growth impetus of an economy. In the U.S., major enterprises mainly rely on the capital market to raise funds from the public for their business needs. Under such an operating mode, most enterprises are listed companies with diverse ownership. The governance structure of these enterprises is built upon the principal-agent relationship among shareholders, directors and the management: The shareholders appoint their board of directors (including independent directors whose primary function is to safeguard the interests of minority shareholders) which set the business objectives and direction, while the day-to-day operation is carried out by the management. While the management is subject to the board's oversight, the board has to report to the shareholders. At the same time, stock market operations and activities of listed companies are supervised by the Securities and Exchange Commission (SEC). Besides, corporate transparency and standardised accounting practices are also emphasised.

Nevertheless, problems in the structure and operation of the governance system have given rise to a series of corporate scandals:

1. Insufficient board oversight - Various corporate scandals revealed insufficient board oversight. In its report delivered in early July, the U.S. Senate stated that though Enron's board might have been misled, it should bear major responsibility for the company's collapse. Specifically, the board failed to query high-risk accounting practices and allowed a board member to earn consultation fee from the company. On the other hand, the turnover rate of Global Crossing's board of directors was found to be particularly high, making it difficult to exercise proper board functions.
   
   
2. Conflict of interests between shareholder and management - While insufficient board oversight is unfavourable to the shareholders, increasing use of stock options in executive remuneration packages further widens the gap between management and shareholder interests. Stock options are meant as an incentive to executives, enabling them to benefit from their efforts to increase shareholder value. However, the unintended consequence was that executives tried to exaggerate earnings and boost stock prices to reap personal gain. Consequently, investors were misled and became ultimate losers.
   
   
3. Loopholes in accounting standards - U.S. accounting standards, known as the Generally Accepted Accounting Standards, were set by the Federal Accounting Standards Board under the authorization of the SEC. Nevertheless, a number of loopholes have been revealed in the series of corporate scandals. For example, special purpose entitites with 3% or more ownership by external parties can be removed from the company's balance sheet, enabling the company to conceal huge debts. Other controversial rules include the mark-to-market accounting practice for financial assets, which may depend on subjective assumptions. Besides, there is no requirement to discount the cost incurred when issuing stock options.
   
   
4. Auditing function hampered - External auditing aims at providing third party scrutiny over a company's operation. The importance of this unique function is beyond doubt. However, some of the auditors of these corporations in question were involved in other business dealings with the client such as acting simultaneously as the client's consultant. Their independent role is thus jeopardized.

Low supervisory efficiency may have also contributed to the corporate scandals. The SEC failed to identify financial problems at an early stage, e.g. there was no thorough investigation conducted on Enron's accounts for at least three years and consent was given twice to waive Enron's submission of detailed financial report.

The inability of U.S. corporate governance to adapt to the "new economy" is another factor. With huge investment required, new businesses that lacked track records have to rely on the creation of a prosperous outlook in order to attract investors. As they failed to generate satisfactory short-term results, they became more inclined to boost their performance figures. Besides, under an optimistic market environment, investors are more willing to accept progressive business forecasts or financial estimates. Supervisory authorities also lacked the basis to query the companies' accounting practices.

Direction of Reform

Despite the series of corporate scandals unfolded which have undermined the credibility of U.S. corporate governance, this does not imply that a complete overhaul of the U.S. corporate system is required.

On the one hand, there is a lack of ideal alternative available apart from the Anglo-American model. The advantage of the Anglo-American model lies on its open market. Investors can invest in different enterprises through the capital market to seek the highest return, and such market forces will make enterprises try to strive for the highest operating efficiency in order to attract investors. As a result, the overall economic efficiency can be enhanced. Besides the Anglo-American model, the Japanese and Continental European models are the two major corporate systems. Both rely on the participation of a few major shareholders, with companies forming a close business network in Japan and more state participation in Continental Europe. Nevertheless, these economies failed to demonstrate the competence of their systems. In fact, they have already started reforms on their corporate systems by making reference to the Anglo-American model.

On the other hand, summing up the various corporate scandals, it cannot be denied that there exists room for further improvement of the existing system. Through implementing thorough reform measures, which also take into account the current economic needs, the authorities should be able to promote economic efficiency.

In view of the direct impact of problems concerning corporate governance on the capital raising ability as well as the risk and return on investment, the private sector has been paying increasing attention to the issue. The New York Stock Exchange has made various proposals on accounting and auditing. The International Corporate Governance Network, managing a total of $ 10,000 billion worth of assets, has planned to check executive pay by their votes. Business Roundtable has urged companies to be aware of their own governance. Some accounting professionals have advocated the superiority of the U.K. or IASB's (International Accounting Standards Board) principle-based accounting system over the U.S. rule-based system, claiming that the former is more effective in preventing malpractice.

U.S. authorities are very concerned about the corporate scandals. Currently, the U.S. Senate and Congress have already reached a consensus about reform and passed the related bill, pending the President's endorsement. The bill is based on the Senate's proposal, suggesting the establishment of an Accounting Oversight Board which has disciplinary powers to bar accounting firms from providing nine types of consulting services for audit clients, to require the CEO and CFO to vouch for the accuracy of the financial reports, to introduce the penalty of 20-year imprisonment for willfully providing misleading financial information etc. The new Accounting Oversight Board will operate independently, but will be overseen by the SEC. Both organizations will coordinate their efforts in conducting investigations.

Implications for Hong Kong's reform

Hong Kong's corporate system basically follows the Anglo-American model. As a former British dependent territory, Hong Kong's company law and accounting system were built on British models. The overall standard of domestic corporate governance has been well recognized. For example, report by Standard & Poors earlier this year suggested that the overall environment in Hong Kong, including the sound legal and regulatory framework, was favourable for the maintenance of good corporate governance.

Nevertheless, although there have not been a host of corporate accounting scandals in Hong Kong, like the U.S., domestic problems in corporate governance should not be overlooked. For traditional reasons, many Hong Kong enterprises are family-controlled. Some estimate the proportion of family-controlled listed companies reached 70-90%. The single controlling shareholder, with its dominating influence over company decisions, is deemed more probable to act against the interests of minority shareholders.

Despite its overall positive comment on Hong Kong's corporate governance, Standard & Poors actually ranked Hong Kong companies below those of Singapore and Australia in terms of corporate transparency last November. Hong Kong companies only obtained scores similar to those of Mainland China, South Korea, Thailand and Malaysia. Three major domestic enterprises were even included in the worst 20 among Asian companies in corporate governance by an investment bank in 2001. Obviously, Hong Kong cannot stay away from reform.

Actually, the SAR Government and the Stock Exchange have been pushing for reform. The Hong Kong Exchanges and Clearing Limited (HKEx) has issued a consultation paper on the amendments to the Listing Rules concerning corporate governance issues early this year. The Standing Committee on Company Law Reform (SCCLR) of the government also issued its consultation paper in July 2001, proposing measures to meet international standards.

On the whole, Hong Kong's corporate governance reform should aim at consolidating our existing system, making reference to the problems unfolded in the U.S. and taking into consideration the domestic situation so as to enable our corporate system generate the highest economic efficiency.

1. Protection of shareholders' interests - Given Hong Kong's high proportion of family-controlled public companies, protection of minority shareholders' interests should be given high priority. Among the suggestions by the HKEx, restrictions over share capital issue under a general mandate as well as its pricing in order to prevent significant dilution of shareholders' interests, and increasing the use of voting by poll are of prime importance. There is also room for more aggressive reform, e.g. in the pricing of share issue under a general mandate.
   
   
2. Strengthening the capability of the board - Representing the shareholders to oversee the management, the board plays an important role in corporate governance. HKEx's proposals to increase the number of independent directors to at least 2 or 1/3 of the board, with at least 1 possessing professional qualifications or experience in finance, as well as the compulsory establishment of an audit committee, should strengthen the board's capability. However, it is important to ensure that independent directors reflect minority shareholders' opinions and protect their interests. This can be achieved through enhancing the participation of minority shareholders in the selection of independent directors.
   
   The HKEx so far has not proposed compulsory segregation of the Chairman and the CEO positions and only recommended to include this in the Code of Best Practice. Yet, with one person assuming both roles, the effectiveness of board oversight may be hampered. More efforts to encourage the segregation of Chairman and CEO are necessary.
   
   
3. Auditor's independence - There are proposals in the U.S. to ban auditors from carrying out consultancy work and to rotate auditors on a regular basis. Hong Kong should try to follow international practice in this area. At the same time, local public bodies or departments should consider hiring different auditors and consultants whenever suitable, particularly those of high quality but not so well- known. This can reduce existing market dominance by a few big firms and train up more professional participants for companies to choose from.
   
   
4. Effectiveness of accounting standards - Since 1993, the Hong Kong Society of Accountants, the statutory body of Hong Kong's accounting profession, has begun to model its Statements of Standard Accounting Practices on ISAB standards and this is near completion. Although the principle-based system adopted by the IASB is now much preferred, there is no guarantee that no fraud will occur under such a system. Actually, the crux lies in whether the principles can be realized. This should be the concern of the accounting profession.
   
   
5. Independent oversight body - The SCCLR proposed to set up a new institution empowered to investigate and deliver orders to amend corporate financial reports, similar to the accounting oversight board proposed in the U.S. While it may not gain much local support in the meantime, it is still advisable to keep an eye on overseas experience in the running of such type of institution. Hong Kong should follow suit in case such reform proves to be effective overseas.
   
   
6. Corporate transparency - Reform in corporate transparency should not be delayed. Quarterly reporting and more timely disclosure requirements are important measures in this area.

Last Defence: Business Ethics

The importance of corporate governance should not be queried. A survey by Mckinsey & Co. this year indicated that over 75% of institutional investors among 31 countries were willing to pay a 12-30% premium for shares of companies with good corporate governance.

Nonetheless, while establishing sound corporate governance system, efforts to enhance business ethics are also indispensable. No matter how coherent, detailed and meticulous the law or system is designed, its actual implementation rests with the people. Therefore, the initiative to abide by the rules and regulations, to observe the principles behind and to maintain high ethical standards are all too significant for good corporate governance. Persistent effort by regulatory authorities, organizations of different sectors and enterprises to promote business ethics can never be spared.