Directorships and SGX’s dual roles
How independent are independent directors and should the exchange drop its regulatory role?
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How independent are independent directors and should the exchange drop its regulatory role?
By MAK YUEN TEEN
30 March 2012
The determination of independence of independent directors has come under the spotlight again recently, with China Sky, XMH Holdings and the Singapore Exchange (SGX) being put in an uncomfortable position after it was reported that firms associated with certain independent directors have business relationships with these companies.
In the first two cases, these business relationships posed particularly significant conflict of interest issues which call into question whether those directors should have remained on the board at all.
These episodes are a reminder that the determination of independence of directors is not a one-off matter, and that the independence of directors can change over time as their circumstances change.
It is good to see that the Corporate Governance Council has recommended in the proposed revised code that the nominating committee (NC) should not only determine the independence of directors annually but ‘as and when circumstances require’.
Certainly, for the three companies mentioned above, the NCs could have acted much faster on the independence issue.
One common thread running through these three companies is that the NCs appear rather inactive. According to the most recent annual reports of China Sky and SGX, the NCs in these companies met only once during the last financial year. In XMH’s case, it did not meet at all, although, in fairness, XMH was a new listing and the company disclosed in its annual report that the committees were still to be constituted.
Corporate governance
The apparent lack of activity in the NCs is difficult to understand, given the responsibilities that codes of corporate governance generally place on them.
In a nutshell, the NC has a role to play in the following areas:
Reviewing the size, structure and composition of the board;
Recommending membership of board committees;
Undertaking succession planning for the chairman, CEO and other directors;
Searching for candidates for the board, and recommending directors for appointment;
Determining the independence of directors;
Assessing whether directors are able to commit enough time for discharging their responsibilities;
Reviewing induction and training needs of directors;
Recommending the process and criteria for assessing the effectiveness of the board and board committees and the contribution of the chairman and individual directors to the effectiveness of the board and helping to implement these assessments.
How can the NC adequately support the board of directors in these responsibilities if it meets only once a year?
It is possible, of course, that these NC meetings were day-long affairs, but it is unlikely to be a satisfactory explanation as some of these activities need to take place at different times of the year.
For example, the NC may have to initiate a search for directors early after considering the type of skills and experience needed, and then meet again to consider and recommend candidates to the board, assuming of course that the nomination of directors is not a slam-dunk. The annual assessment of performance of the board, committees and directors would generally take place near the end of the year.
It is also likely that the NCs had informal meetings and discussions outside of formal meetings. However, these should not be a substitute for formal meetings to properly discharge the committee responsibilities. My concern is that many NCs are not doing what they are supposed to do, or they have sub-delegated many of their responsibilities to management and consultants.
The fact that the SGX’s NC held only one formal meeting during the entire financial year is particularly difficult to understand as SGX is subject to additional corporate governance regulations which are rather stringent, including stricter rules on independence of directors and proportion of independent directors.
Currently, those associated with member firms of SGX are not considered independent by virtue of securities regulations dealing with the corporate governance of approved exchanges.
Since listed companies are regulated by the SGX and are also, in effect, customers of SGX, should senior management and directors of these companies really be considered independent? How is this different from a customer serving on the board of a listed company?
Indeed, in this case, SGX is also supposed to be regulating this customer, so the situation is even more tenuous.
While it may be valid to argue that having directors and senior management of listed companies allows SGX to understand the marketplace better, there is nevertheless a potential conflict with its regulatory role.
Let me now turn to the issue of remuneration of senior management of SGX. Interestingly, the remuneration committee (RC) of SGX also had only one formal meeting during the last financial year. Considering the relatively complex remuneration framework and short-term and long-term incentive plans used by SGX, I am equally surprised that it did not meet more often.
As SGX has dual regulatory and commercial roles, remuneration design becomes especially important. A poorly designed remuneration framework can encourage management to pursue the commercial objectives at the expense of its regulatory objectives.
Indeed, when I calculated the correlation between the total annual remuneration and the annual profits of the SGX over the tenure of the former CEO, the correlation was almost perfect - it was 0.98.
It appeared that even though there were regulatory key performance indicators for the CEO, they did not have much of an impact on annual remuneration.
There were, of course, incentives which encouraged taking a longer-term view but they were rather dwarfed by annual remuneration.
In the past, SGX also awarded share options to senior management on the regulatory side. This is rather like financial institutions giving options to those in ‘control job’ functions (such as compliance, risk management, and internal audit), a practice now widely recognised as inappropriate.
Performance shares
SGX has since replaced its share option plans with performance share plans. The good thing about performance share plans is that the payoffs are more symmetric. However, even the performance shares for those on the regulatory side vests purely on medium-term financial indicators.
Since the financial crisis, there are banks which have changed the vesting of performance shares for senior management - not just those in ‘control job’ functions - to be partly based on non-financial measures. In the same way, should not the vesting of performance shares for those in the regulatory side be based on more balanced criteria?
Many of the issues I have raised here for the SGX arise because SGX has dual commercial and regulatory roles. In fact, one may feel a bit sorry for SGX in having to manage the two conflicting roles and having to keep striving to set high standards.
In fairness, SGX has become more vigorous in its regulatory role and has also strived to continue to lift its corporate governance standards as shown by the many accolades it has received in corporate governance awards and ratings.
But, unfortunately for SGX, this may not be enough. As I have pointed out here, the dual roles give rise to pervasive issues across a number of areas.
I really do think that taking the regulatory role out from SGX would make for a higher quality marketplace here - and I dare say ultimately make for a much happier SGX too. Not separating the two roles may actually inhibit the SGX from becoming a truly competitive international exchange, and may pose a significant hurdle in its attempt to grow.