Reviewing the development of Hong Kong corporate governance enables the researcher to un- derstand the rights and responsibilities of a company’s directors to protect the interests of stake- holders in Hong Kong and how these affect the structure and composition of the board and the AC, thereby the effectiveness of their oversight effort. It is noted that Hong Kong’s corporate governance started to develop in the early 1990s (Jones, 2015; Dempsey, 2014; Kam, 2006; Standard and Poor, 2002). In 1993, the Stock Exchange introduced a requirement into its Listing Rules that every board of directors of a listed company must include at least two independent non-executive directors (Kam, 2006) and laid down guideline rules to ensure their independence (Kam, 2006). A Code of Best Practice was also established in 1993 in order to enhance the ac- countability of directors of listed companies to their shareholders (; Jones, 2015; Dempsey, 2014). Since 1999, the Code of Best Practice recommended that listed companies establish and disclose the existence of the AC (Dempsey, 2014). However, the requirements of good corporate govern-
ance were only found in non-legal and regulatory requirements, generally characterised as ‘best practice’ (Jones, 2015; Chau and Leung, 2006).
In 2004, the Hong Kong Stock Exchange issued a draft of Code on Corporate Governance Prac- tices. According to this Code, companies are required to comply with ‘code provisions’ or ex- plain why they do not follow ‘recommended best practices’ which are for guidance only (Cheng, Lui and Shum, 2015; Jones, 2015; Cheung et al., 2011). The Code’s structure and contents were similar to the Combined Code implemented in the UK (Dempsey, 2014). The Code was imple- mented in 2005, commonly referred to as the Old Code. This was applicable to all companies listed on the SEHK (Dempsey, 2014). The Listing Rules required the mandatory establishment of the AC comprising of only non-executive directors and the appointment of at least three non- executive directors to the board with at least one having appropriate professional qualifications or experience in financial matters (Kam 2016; HKEx Appendix 14).
The Old Code was amended and renamed the Corporate Governance Code, which came into ef- fect on 1 April 2012 (Lee and Barnes, 2017). It recommended significant changes to the corpo- rate governance requirements in the Listing Rules and Corporate Governance Code (Lee and Barnes, 2017; Jones, 2015), including requirements for at least one third of the board to be inde- pendent non-executive directors (Jones, 2015; Dempsey, 2014).
The Corporate Governance Code made specific requirements and recommendations regarding the composition of the board of directors and its committees (HKEx Appendix 14; Lee and Barnes, 2017). The board of directors is a group of elected or appointed members who are collec- tively responsible for overseeing the functioning of a company (PwC, 2017; HKEx Appendix 14). The directors are required to fulfil their fiduciary duties and have the requisite levels of skill, care and diligence (Dempsey, 2014; HKEx Appendix 14; Standard and Poor, 2002). The board should also regularly review the performance of each director, who should act in the best interest of company (Dempsey, 2014; HKEx Appendix 14; Standard and Poor, 2002). It should also pre- sent a comprehensive assessment of a company’s performance (Jones, 2015; HKEx Appendix 14) and ensure that the company maintains an effective internal control mechanism in order to safe- guard the shareholders’ investments and its assets (PwC, 2017; HKEx Appendix 14; Jones, 2015). It should also establish a formal and transparent arrangement to consider how it applies financial reporting and internal control principles whilst maintaining an appropriate relationship with a company’s EAs (PwC, 2017; Dempsey, 2014; HKEx Appendix 14).
In order to effectively perform the oversight duties stated above, the board of directors should contain a balanced composition of executive, non-executive and independent non-executive di- rectors in order to enable the board to exercise independent judgment (Cheng, Lui and Shum, 2015; Ching, Firth and Rui, 2006; HKEx Appendix 14). There should be a clear division be- tween the roles of the chairman, who is responsible for leadership of the board, and the chief ex- ecutive, who is responsible for running a company, so as to maintain a balance of power and au-
thority. The directors should have appropriate professional qualifications, more specifically ac- counting or associated financial management expertise. Directors should be provided with timely and appropriate information to help them make informed decisions (Dempsey, 2014; HKEx Ap- pendix 14). The requirements for the structure and composition of board of directors and AC committees are as follows (Dempsey, 2014; HKEx Appendix 14):
A company must appoint at least three independent non-executive directors who should rep- resent at least one third of the board.
At least one of the independent non-executive directors must have appropriate professional qualifications or accounting or related financial management expertise.
A company must establish an audit committee comprising of non-executive directors only
AC committees should have specific written terms of reference.
The Code also establishes a number of principles, followed by code provisions and recommend- ed best practices (PwC, 2017; HKEx Appendix 14; Jones, 2015). Since then, companies must state in the corporate governance report as to whether they have complied with the code provi- sions (PwC, 2017; HKEx Appendix 14). The code provisions are not mandatory rules and the Code provides that deviations from them are acceptable if a company considers that it is more
suitable not to comply with the Code (PwC, 2017; Dempsey, 2014; HKEx Appendix 14). Each company needs to consider its individual circumstances, the size and complexities of its opera- tions as well as the nature of the risks confronted by it (Jones, 2015; Dempsey, 2014). It must also provide compelling reasons to explain why good corporate governance is achieved by means other than strict compliance with the code provisions. The investors and stakeholders who read the corporate governance report should then judge the explanation.
Prior studies conducted in Hong Kong concurred that the quality of corporate governance is posi- tively associated with audit quality as reflected in heightened market values or higher earnings quality. For instance, using data from 2003 to 2005, Cheung et al. (2011) found that firms exhib- iting improvements in the quality of corporate governance displayed a corresponding rise in market valuation. The quality of corporate governance was measured in the areas of rights of shareholders, equitable treatment of shareholders, role of stakeholders, disclosure and transpar- ency and board responsibilities. Using data from 2002 to 2005, Cheung et al. (2010) noted that firms with concentrated ownership structures are associated with low quality corporate govern- ance. They also observed that the quality of corporate governance was positively associated with market returns. Using data from 2001 to 2009, Lei and Song (2012) observed that the quality of board structure and internal corporate governance mechanisms was positively associated with firm value. Board structure was measured as its independence, balance of power and conflicts of interest. Internal corporate governance mechanism was measured using thirteen corporate gov- ernance attributes, such as a percentage of issued shares and number of substantial shareholders.
Using data from 1993 to 2000, Ching, Firth and Rui (2006) observed that independent directors and outside block shareholders constrained earnings management in family-controlled firms.
In summary, the importance of effective corporate governance has been highlighted since 1994. The rights and responsibilities of the board and AC have been strengthened with a view to safe- guard the interest of stakeholders. While board of directors is responsible for the overall running of a company, the AC is its sub-committee that is responsible for specialising in ensuring high quality of its financial statement and audit (Chan et al., 2011; Chau and Leung, 2006). Therefore, next section discusses the developments of the AC in Hong Kong.