Fixed or Floating Charge? House of Lords Decision in National Westminster Bank Plc v.

Spectrum Plus Limited & Others (relevant to Paper 2.2 / F4)

By Susan Leung Lecturer, School of Accounting & Finance Hong Kong Polytechnic University

Introduction In 2005, the House of Lords in National Westminster Bank Plc v. Spectrum Plus Limited & Others [2005] 4 ALL ER 209 unanimously overruled the long standing authority laid down more than 25 years ago in Siebe Gorman v. Barclays Bank Ltd. [1979] 2 Lloyds Law Reports 142. In the Siebe Gorman case, Slade J held that a charge over past and future book debt was a fixed charge if it prevented the chargor from disposing of the uncollected book debts and the chargee allowed the chargor to deal with its debtors and collect the debts. Debt proceeds had to be paid into a designated account with the chargee bank, but the chargor was allowed to draw on the accounts freely for its business purposes. Before the House of Lords, National Westminster Bank Plc (Natwest) asserted that the charge over book debts was fixed and demanded payment of the book debt proceeds from the liquidators of Spectrum Plus Limited (Spectrum Plus). However, the Customs and Excise Commissioners, the Commissioners of Inland Revenue and the Secretary of State for Trade and Industry (Crown Creditors) together resisted Natwests claim that the charge was fixed and argued that the charge was floating so that they were entitled to the proceeds in priority to the bank. The House of Lords reversed the Court of Appeals decision which gave judgment in favour of Natwest and that the charge granted to Spectrum Plus was fixed. Their lordships unanimously upheld the decision of the first instance court which held that Natwests charge only created a floating charge over book debts and that the Crown Creditors had priority to be paid before Natwest and that Siebe Gorman was wrongly decided. This article examines the decision of the House of Lords and considers some of its implications on the banking sector. 02 News Update Summer 2007

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Facts of the Case Spectrum Plus obtained an overdraft facility of 250,000 from Natwest for the purpose of providing working capital to the company. The overdraft facility was secured by a debenture to the bank, which included a fixed charge over all present and future book debts. The debenture was a Natwest standard form which was drafted substantially the same as in Siebe Gorman. The debenture prevented Spectrum Plus, without prior written consent from the bank, from selling, factoring, discounting or otherwise charging or assigning uncollected book debts. The debenture did not prevent Spectrum Plus from dealing with its debtors and collecting its debts. Proceeds, once collected, Spectrum Plus was required to pay them into a designated account with Natwest to reduce the overdraft. Provided the overdraft limit was not exceeded, Spectrum Plus was allowed to draw freely on the account for its business purposes. The charge also required Spectrum Plus, if so requested by Natwest, to execute a legal assignment of the book debts in favour of the bank. Spectrum Plus later went into creditors voluntary liquidation. The liquidator collected the proceeds of the book debts in the account but refused to account for them to Natwest. The bank applied for a declaration that the debenture had created a fixed charge over Spectrum Pluss book debts and that the liquidator should hand over the proceeds. Under s.175(2)(b) of the Insolvency Act 1986, (Hong Kongs equivalent is s.265(3B) Companies Ordinance) preferential creditors are entitled to be paid out of the proceeds of a floating charge realization in priority to the floating chargeholder. On the other hand, the Crown creditors joined in as respondents and argued that the charge created was a floating charge and Siebe Gorman was wrongly decided and that they were entitled to the book debt proceeds in priority to Natwest.

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High Court Decision Natwests Debenture was a Floating Charge In the High Court, Sir Andrew Morrit VC was of the view that since Spectrum Plus had the freedom to deal with and use the proceeds of the book debts in the ordinary course of business through collection and ordinary operation of the bank account, the book debts were under the control of the company. A restriction which allowed collection and free use of the proceeds was inconsistent with the fixed nature of a charge. Spectrum Plus s account with Natwest was an ordinary current account with no restriction on its use for all purposes of the companys business so long as the overdraft limit was not exceeded. Whether a charge was fixed or floating, it did not depend on the intention of the parties. If their intention, properly construed from the language of the instrument, was to grant Spectrum Plus rights in respect of the charged assets which were inconsistent with the nature of a fixed charge, the charge could not be a fixed charge despite the label the parties put on it. Consequently, the charge over book debts granted by Spectrum Plus to Natwest could only have been a floating charge. Sir Andrew Morrit VC held that Siebe Gorman was wrongly decided. Court of Appeal Decision Natwests Debenture was a Fixed Charge Natwest appealed. Lord Phillips MR delivered judgment of the Court of Appeal and overturned the decision of the High Court. He considered the construction given to the debenture in Siebe Gorman correct and that the debenture required the proceeds of book debts to be paid into an account of the chargee bank was of critical importance in Siebe Gorman and could properly fall into the definition of a fixed charge. Lord Philips therefore held that a debenture imposing restrictions on the use of the proceeds of book debts created a fixed charge over book debts. Lastly, even

if the construction of Slade J had been wrong in Siebe Gorman, by customary usage for more than 25 years, he would have held that the form of debenture acquired its meaning and effect as a fixed charge. The appeal would, accordingly, be allowed. House of Lords Decision Natwests Debenture was a Floating Charge The Crown creditors appealed. The House of Lords unanimously reversed the decision of the Court of Appeal and upheld the decision of the High Court to decide in favour of the Crown Creditors. The Law Lords held that the critical question was whether the restriction imposed on the account went far enough for the charge to be fixed. In this case, Spectrum Plus was required to pay the book debt proceeds into its current account with Natwest. So far as the overdraft limit was not exceeded, Spectrum Plus was free to operate on the account for its business purposes. The Law Lords distinguished the present case with Re Keenan Bros Ltd. [1985] I. R. 401 where the Irish Supreme Court held that the charge on the book debts was fixed as their proceeds were to be segregated in a block account where they would be frozen and unusable by the company without the banks written consent. Thus, one of the ways to ensure a charge over book debts is fixed is to prevent all dealings with the debts other than their collection, and to require the collected proceeds to be paid into an account with the chargee bank. That account must then be blocked so as to preserve the proceeds for the benefit of the chargee banks security. Accordingly, a debenture that provides for a truly blocked account will be effective to create a fixed charge. However, in this case, although Natwest could, by notice, withdraw or reduce the overdraft facility and amounts outstanding on the account were repayable on demand, the account was in all respects a current account with an overdraft limit. Pending such a notice, Spectrum Plus was free to draw on the account. Its Summer 2007 News Update 03

Fixed or Floating Charge? House of Lords Decision in National Westminster Bank Plc v. Spectrum Plus Limited & Others (relevant to Paper 2.2 / F4)

right to do so was therefore inconsistent with the charge being a fixed charge and the label placed on it could not make it fixed. The House of Lords therefore ruled that the debenture, although expressed to grant the bank a fixed charge over Spectrum Pluss book debts, in law granted only a floating charge. Overruling Siebe Gorman Lord Phillips MR in the Court of Appeal said that, even if Slade Js construction of the debenture in Siebe Gorman had been erroneous, he would have been inclined to hold that the form of the debenture had, by custom and usage, acquired that meaning and effect. This was because this form of debenture had been used for 25 years on the understanding that this was its meaning and effect. Banks had relied upon this understanding, and individuals had guaranteed the liabilities of companies to banks on the understanding that the banks would be entitled to look first to their charges on book debts unaffected by the claims of preferential creditors. The House of Lords did not agree with this view. In their opinion, banks and financial institutions are sophisticated operators and they should not have regarded the Siebe Gorman case as having finally settled the law in this area. They were well aware of the controversy surrounding the case and since Siebe Gorman was only a first instance decision, it was always liable to be overruled. This view was put forward forcefully by Lord Hope in his judgment: These are powerful considerations, but I am in no doubt that the proper course is for the Siebe Gorman decision to be overruled. But the fact is that it was a decision that was taken at first instance, and it has now been conclusively demonstrated that the construction which [Slade J] placed on the debenture was wrong. This is not 04 News Update Summer 2007

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one of those cases where there are respectable arguments either way. With regret, the conclusion has to be that it is not possible to define the decision on any rational basis. It is not enough to say that it has stood for more than 25 years. The fact is that, like any other first instance decision, it was always open to correction if the countrys highest appellate court was persuaded that there was something wrong with it. Retrospective or Prospective Overruling? When overruling the Siebe Gorman decision, a more controversial issue which had to be resolved by the House of Lords was whether the overruling should take effect retrospectively or prospectively. Natwest contended that if Siebe Gorman was wrongly decided, the House of Lords should overrule that decision only for the future. The bank submitted that the Siebe Gorman decision should continue to apply to all transactions entered into before their Lordships decision in the present case, including the debenture under consideration in this appeal. The bank s submission raised a controversial issue of major importance concerning the power of the House of Lords to give a ruling in prospective form only. The bank argued that the House of Lords had this power. The Crown Creditors were content to assume the House may have this power. Arguments put forward by the House of Lords against prospective overruling in this case was that it was outside the constitutional limits of the judicial function of the courts. It would amount to the judicial usurpation of the legislative function of Parliament. Also, it was said that power to make rulings having only prospective effect was not inherent in the judicial rule of the courts. A court decision which took the form of a pure prospective overruling did not decide the dispute between the

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parties according to what the court declared was the present state of the law. With a ruling of this character the court gave a binding ruling on a point of law but then did not apply the law to the present case as declared to the parties to the dispute before the court. Consequently, making such a ruling would not be a proper exercise of judicial power. It gave a judge too much the appearance of a legislator. Legislation is a matter for Parliament, not judges. The House of Lords also highlighted the practical difficulties of applying prospective overruling as compared to retrospective overruling. The advantages of retrospective overruling included a court ruling on a point of law which applied in all cases past as well as future and the retrospective application of court rulings was straightforward. On the other hand, prospective overruling created problems of discrimination. In civil cases, pure prospective overruling could hinder the development of the law by discouraging claimants from challenging a prevailing view of the law. In selective overruling, persons in like cases were treated differently. For example, the ability to obtain an effective remedy would have to depend upon which of several challenges reached the House of Lords first. Consequently, this would introduce an arbitrary element into the law. After in-depth considerations, their lordships admitted that there could be circumstances where prospective overruling would be necessary to serve the underlying objective of the courts: to administer justice fairly and in accordance with the law. There could be cases where a decision on an issue of law, whether common law or statute law, would have such gravely unfair and disruptive consequences for past transactions or happenings that the House of Lords would be compelled to depart from the normal principles relating to the retrospective and prospective effect of court decisions. Taken altogether exceptionally, if the House of Lords, as the

countrys supreme court, were to follow this course, it would not be regarded as trespassing outside the functions properly to be discharged by the judiciary under constitution of the country. If a legal system were to be operated in a rigid manner, it would deprive its necessary elasticity. However, in the present case, it was miles away from the exceptional category in which prospective ruling would be legitimate. No doubt over the years clearing banks had to some extent relied upon the Siebe Gorman decision when formulating and using their standard forms of charges. But banks who lent money on the security of charges on a company s undertaking were sophisticated operators. There was no reason to suppose the Siebe Gorman decision had led them into a false sense of security. Besides, Siebe Gorman was a first instance decision and cannot have been regarded as definitively settling the law in this field. The House of Lords ruled that if the decision of the present case were given prospective effect only, the result would deprive preferential creditors of existing liquidations their rights and priority given to them by statute. Consequently, the House of Lords rejected Natwests submission that the decision should be given prospective effect only. Unresolved Problems The decision of the House of Lords in this case has caused controversies in the banking sector. Despite their lordships agreeing that it was conceptually possible to create a fixed charge over book debts, they gave little practical guidance as to how an effective fixed charge should be taken. The result of this is that it will be difficult to know how a debenture will be interpreted by the courts when it was being drafted. In order for an effective fixed charge to be created, one view expressed by the House of Lords was that the book debt proceeds had to be paid into a blocked account controlled by the chargee bank and operated as such. However, in practice this may not be a commercially viable solution for the chargor as money may only be released from the blocked Summer 2007 News Update 05

Fixed or Floating Charge? House of Lords Decision in National Westminster Bank Plc v. Spectrum Plus Limited & Others (relevant to Paper 2.2 / F4)

account with the specific consent of the chargee on a case-bycase basis. The chargor may have to face the further uncertainty that cash flow may be disrupted as the chargee has unfettered discretion as to whether to give or refuse consent. Another problem resulting from the decision of this case is that many banks which have relied on the Siebe Gorman type debentures will now find that they have an inferior security than they supposed to have. This will mean that they will have to adopt a new strategy and to re-negotiate some of the terms of lending facilities with their customers. Banks may require directors of these companies to give personal guarantees in order to obtain loans for their companies. This may prove costly to some small and medium companies and deprive them of a valuable source of obtaining business finance.

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Conclusion The Spectrum Plus case has no doubt clarified one important issue that in case of an ordinary secured financing, a charge over receivables will be a floating charge if the company is able to use the proceeds in the ordinary course of its business. Thus, the charge will not be fixed if, in reality, the bank imposes only limited control enabling the company to use the proceeds in its usual course of business. However, one major uncertainty still remains: the House of Lords did not deal with how much control by the chargee is required in order to make the charge operate as a fixed charge. This issue may have to be dealt with by further litigation in the future. Even if subsequent cases clarify the issue, banks will always have an element of doubt as to whether a charge is fixed or floating.

06 News Update Summer 2007

Taxation of Interest, Deduction of Interest and their Relationship under Profits Tax (relevant to Papers 2.3 HKG & 3.2 HKG / F6 & P6)
Patrick KW HO Principal Lecturer FTMS Training Systems (HK) Ltd.
Objective of this paper How interest income is taxable and how interest expense is deductible are two popular questions raised in the professional examination and the daily work in the accounting and taxation professions. The deduction of interest may be found under profits tax, salaries tax and personal assessment. The objective of the article is not to cover all the three types of taxes, but restrict the scope of this article to profits tax. The author will explain in this article the different rules applied to the taxation and deduction of interest and their relationship under profits tax. After reading this article, students are able to grasp the essence of these areas of knowledge and have a good result in the examination and a correct tax treatment in their daily work. Introduction There are different types of interest income. These include: a. interest income derived from deposit, b. interest income derived from loan, c. interest income derived from clients trust money, and d. interest income derived from trade debts. The same type of interest income received by different types of businesses and entities may be differently treated in the taxation and deduction under profits tax. Source Rule Traditionally, the rule governing the taxation of interest income is the provision of credit test. This means that the source of interest income is derived at the place where the money is first made available to the borrower. Although this rule is still of fundamental importance in the taxation of interest income, yet its significance has been faded out gradually with the emergence of new statutes and case law. This is particularly obvious in the money lending business and banking industry after the decision of Orion Caribbean Ltd. v CIR (1997). Interest Income Received on a Deposit This may be, according to the nature of business carried on the

recipient, divided into two categories, namely: a financial institution and a company not carrying on the business of a financial institution. a. Recipient is a financial institution The source of interest income received by a financial institution is governed by section 16(1)(i) of the Inland Revenue Ordinance (IRO). The section provides that a financial institution is taxable on a global basis for the interest income which it receives. This is an exception to the general Hong Kong taxation system which taxes on Hong Kong source profit only. Thus, the interest income received on a deposit by a financial institution is always taxable no matter whether the deposit is placed in Hong Kong or outside Hong Kong. b. Recipient is not a financial institution Interest received on a deposit by a company not carrying on the business of a financial institution is governed by sections 15(1)(f) and (g) of IRO. The interest income received by those entities remains to be taxable on a territorial basis. Only interest income sourced in Hong Kong is taxable. Interest income derived from a deposit placed with a bank outside Hong Kong is exempt from Hong Kong profits tax. Application of the Exemption from Profits Tax (Interest Income) Order Before 21 June 1998, Hong Kong source interest income was chargeable with profits tax. The Exemption from Profits Tax (Interest Income) Order 1998was enacted and took effect on 22 June 1998. That order created a new category of interest income under profits tax. It is the exemption from payment of profits tax. a. Exemption from profits tax If a deposit is placed with a bank outside Hong Kong, the interest income derived therefrom is sourced outside Hong Kong, and it is exempt from profits tax. If a deposit is placed in Hong Kong, that interest income is chargeable with profits tax as it is an onshore income. Summer 2007 News Update 07

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Taxation of Interest, Deduction of Interest and their Relationship under Profits Tax (relevant to Papers 2.3 HKG & 3.2 HKG / F6 & P6)

b. Exemption from payment of profits tax The Order 1998 exempts some Hong Kong source deposit interest income from payment of profits tax if certain conditions are satisfied. If a deposit placed with a bank in Hong Kong is not used as a security pledged against a loan, that interest income is exempt from payment of profits tax. The exemption from payment of profits tax provided in the Order 1998 does not apply to interest income received by a financial institution. c. Exemption from profits tax v. exemption from payment of profits tax Exemption from payment of profits tax applies to offshore interest income while exemption from payment of profits tax applies to Hong Kong source interest income. The position of the charge of profits tax on interest income derived from a deposit may be summarised in the following table:
Deposit As a security Placed with a bank in H.K. Not as a security Recipient not F.I. Taxable Exempt from payment of profits tax Placed with a bank outside H.K. As a security Not as a security Exempt from profits tax Exempt from profits tax Taxable Taxable Taxable Recipient is a F.I. Taxable

(Note: F.I. means financial institution.) Interest Income Received on a Loan This may be, according to the nature of business carried on the recipient, divided into three categories as follows: a. a company not carrying on the business of a money lender nor a financial institution, b. a company not a financial institution but carrying on a business of money lender, and c. a financial institution 08 News Update Summer 2007

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a. Recipient not a money lender nor a financial institution The source of interest income derived from a loan provided by a company which is not a money lender nor a financial institution is governed by sections 15(1)(f) and (g). Only Hong Kong source interest income is taxable. The chargeability is based on the traditional source rule of provision of credit test. b. Recipient being a money lender but not a financial institution During the course of carrying on a money lending business, the income is not derived from the mere lending of money to a customer. The income is also earned as an effort in evaluating the risk of lending such as the repayment power and the creditability of the borrower and the adequacy of security provided and etc. In this situation, the source rule may rely on the operations test as advocated in Orion Caribbean Limited v CIR, 4 HKTC 432. In that case, although the lenders and borrowers were all outside Hong Kong, and the provision of credit was also outside Hong Kong, the judges did not rely on the provision of credit to determine the source of interest income. The judges applied operations test to decide the source of interest income. It was found that the source was in Hong Kong as the taxpayers holding company arranged all the lending and borrowing activities on behalf of the taxpayer in Hong Kong. c. Recipient being a financial institution The source of interest income derived by a financial institution is governed by section 15(1)(i) which provides that a financial institution is taxable on a global basis in respect of its interest income. As this appears to be harsh to the banking industry, the CIR has made a gentleman agreement with the banking industry called compromised package which is specifically applicable to money lending business carried out by a financial institution. Under that arrangement, the CIR does not insist to tax the interest income in respect of a financial institution on a worldwide basis.

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The CIR looks at two factors in the determination of interest income derived from a loan. The two factors are: a. the place where the loan is initiated, negotiated, finalised and concluded, and b. the place where the funds financing the loan are raised. If both factors are located in Hong Kong, all the interest income from that loan is taxable. If both factors are located outside Hong Kong, all the interest income is exempt from profits tax. If either one factor is located in Hong Kong, only 50% of the profit is taxable. The situation may be summarized in the following table:
Where loan is initiated In Hong Kong In Hong Kong Outside Hong Kong Outside Hong Kong Where funds are raised In Hong Kong Outside Hong Kong In Hong Kong Outside Hong Kong Chargeability to tax 100% taxable 50% taxable 50% taxable 100% exemption

Interest Income Received on Clients Trust Money Many professional firms, such as consultants, receive retainer fee from their clients for the provision of services at a later date. These funds are kept in a separate trust account in the name of the professional firm as a trustee while the beneficial owners of such account are the clients. As a matter of practice, interest is derived from such trust account, and it is not often that the professional firms will refund the interest to their clients in view of small amount from the angle of individual client. At certain intervals, the professional firms will transfer the interest unclaimed by the clients to the profit and loss account of the professional firms. Although the interest does not belong to the professional firms, yet it is credited to their profit and loss accounts. The issue is whether such interest is taxable. Based on the decision of CIR v. Lau, Wong & Chan, Solicitors, 2 HKTC 470, such interest income forms a part of the income of the professional firm as a trade practice, thus the interest income is chargeable with profits tax.

reference article The following three situations may arise:

Interest Income Received on Trade Debts According to paragraph 3 Inland Revenue DIPN 13, interest has a Hong Kong source where it forms an integral part of a trading transaction carried out in Hong Kong. In such situation, the interest has the same source of the income as that of the trading transactions. Thus, look at the case where the goods are manufactured in Hong Kong, and the sales are made to an overseas customer. As the source of the trading and manufacturing profit is sourced in Hong Kong, the interest income derived from an extended credit period for the settlement of trade debt is also sourced in Hong Kong. Deduction of Interest Expenses and its Relationship with Interest Income Under the Inland Revenue Ordinance, income under profits tax is assessable under sections 14 and 15 while expenses are deductible under sections 16 and 17. There is no requirement that an expense is deductible only on the condition that the income in respective of such payment received at the other end of the transaction is taxable in Hong Kong. In other words, generally there is no matching of taxability and deductibility under profits tax. However, with the introduction of sections 16(2)(c) and (2A), the concepts of direct matching and indirect matching are found in the deduction of interest expenses under profits tax. Borrowing Money Not From a Financial Institution Section 16(2)(c) provides that, if a business borrows money from a company which is not a financial institution, the interest expense is deductible only when the interest income received by the lender is taxable in Hong Kong. This carries the concept of direct matching. In other words, the chargeability of tax on interest income affects the deduction of interest expense on the loan borrowed.

a. Borrowing from an individual If the money is borrowed from an individual who is usually not chargeable with profits tax, the interest expense paid to an individual is not deductible under profits tax as provided in section 16(2)(c). Summer 2007 News Update 09

Taxation of Interest, Deduction of Interest and their Relationship under Profits Tax (relevant to Papers 2.3 HKG & 3.2 HKG / F6 & P6)

b. Borrowing from an overseas company If the money is borrowed from an overseas company which does not carry on a business in Hong Kong, the overseas company will be exempt from Hong Kong profits tax. Thus, the interest income is not taxable Hong Kong. As a result, the interest expense paid to an overseas company is not deductible under profits tax. c. Borrowing from a Hong Kong company If the money is borrowed from a company which carries on a business in Hong Kong, the interest income received by that company is taxable Hong Kong. As a result, the interest expense is deductible under profits tax. The situations provided in section 16(2)(c) borrowing may be summarised in the following table:
Borrowed from An individual An overseas company A Hong Kong company Interest income Not taxable Not taxable Taxable Interest expense Not deductible Not deductible Deductible

As a side issue, if the borrowing is made from a financial institution, no matter a foreign financial institution or a Hong Kong financial institution, there is no such restriction that the interest income received by the financial institution must be taxable in Hong Kong before the interest paid by the business is deductible. Section 16(2)(c) does not apply to interest paid to a financial institution. Borrowing Secured by a Deposit or another Loan It is provided in section 16(2A) that the chargeability of tax on interest income on a deposit or another loan used for security purposes affects the deduction of interest expense on the loan borrowed. This is referred as indirect matching. If a loan satisfies one of the conditions of sections 16(2)(c), (d) or (e), the deduction of interest has to satisfy the conditions provided by section 16(2A) too. Section 16(2A) provides that in order for an interest expense to be deductible, one of the following conditions have to be satisfied: a. the loan is not secured by a deposit or another loan; 10 News Update Summer 2007

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b. if the loan is secured by a deposit or another loan, the interest income derived from such deposit or loan used as security must be taxable in Hong Kong; c. if the loan is secured by a deposit or another loan, and the interest income derived from such deposit or loan used as security is not taxable in Hong Kong, the amount of interest expenses deductible under profits tax may be reduced in a manner appropriate to the situation concerned (as determined by the CIR); or d. if the loan is secured by a deposit or another loan provided by a person not associated with the borrower, the interest expense is deductible even though the interest income is not taxable in Hong Kong at the hand of the recipient. The situations provided in section 16(2A) borrowing may be summarised in the following table:
Deposit provided by An individual (associated) An overseas co. (associated) A Hong Kong company An individual (not associated) An overseas co. (not associated) Deposit interest income Not taxable Not taxable Taxable Not taxable Not taxable Loan interest expense Not deductible Not deductible Deductible Deductible Deductible

To make the picture complete, students have to note that the CIR refers this as the Secured Loan Test. If the security is not a deposit nor another loan, the interest expense is deductible under section 16(2A). Conclusion Interest expense is incurred for financing the operation of a business and it is very often one of the largest expenses of a company. If a businessman does not pay attention to the deduction of expenses when arranging its borrowing activities, he or she may not get the deduction of interest in the computation of profits tax. This will lead to an increase in the unnecessary profits tax expense. As interest income and interest expense are two popular areas in the examination, students have to exert more effort on those two topics.

Why Corporate Governance a Matter? (relevant to Papers 3.5 & 3.7 / P1)
Clement Chan and Ricky Cheng Horwath Hong Kong CPA Limited

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Corporate governance has been a favourite topic in recent years especially after the Enrons scandal was exposed. Law makers and regulators have been attempting to introduce new rules and regulations to restore investors confidence and public trust on public listed companies. Following the Sarbanes-Oxley Act of the United States enacted in 2002, new stricter corporate governance rules and regulations are also introduced in other countries as well:
2006 June The combined code on corporate governance issued by Financial Reporting Council (first published in 2003 July) in the United Kingdom Code of corporate governance practices issued by the Hong Kong Stock Exchange Principles of corporate governance for listed companies issued by the Tokyo Stock Exchange Corporate governance rules approved by the New York Stock Exchange Principles of good corporate governance and best practice recommendations issued by ASX Corporate Governance Council

Protecting stakeholders interests A company has many interactions with various parties in a typical business environment regarding financial and operational matters. These parties may include investors, creditors, bankers, regulators, customers, employees, etc. Each of these parties has his own interest and agenda with the company. For examples, investors have injected capital into a company and therefore expecting a return which hopefully is above the market average; bankers are lending money to the company on the ground that the company is a going concern and can fulfill its loan repayment commitment; employees are providing their effort in return for a monthly pay check and a career opportunity in the company. However, as these parties are involved in the daily operation of the company, they have very limited knowledge about the company s background and operations. They do not know how well the company is operating and whether their aspirations associated with the company can really come true. They have limited access to the full information of the company they are associated with let alone the knowledge of the adequacy of effective internal control system in place. Even though they have the right to request for information but more often the information they are provided with may be filtered or inadequate. Besides, they might not be able to stop the company from taking high-risk investments or projects which may have impact on the companys future and in turn their interests. Obviously, after the Enrons case, everyone would agree that an effective Corporate Governance system should be in place to safeguard the assets of a company and hence the interests of different stakeholders. This can be achieved, among others, by enhancing the transparency and disclosure requirements of significant financial and operating information. Stakeholders will be able to make decision on a better informed basis and assess the company more meaningfully. 05 Summer 2007 News Update 11

2004 November 2004 April 2003 November 2003 March

Why Corporate Governance? Corporate governance was defined as a system by which a company is directed and controlled in the Cadbury Report, 1992. The report did not clarify the meaning of system, directed and controlled. Instead, it provided detailed descriptions of the structure and responsibilities of the Board, recommend Code of Best Practices, etc. There are a number of reasons to support why a corporate governance system is needed for a company. Among others, the major reasons include: 1. Protecting stakeholders interests; 2. Reinforcing shareholders trust and confidence; and 3. Creating value for stakeholders.

Why Corporate Governance a Matter? (relevant to Papers 3.5 & 3.7 / Paper P1)

Reinforcing shareholders trust and confidence There are normally 2 classes of parties who can exercise their rights to control the operations of a company, they are shareholders and companys management (i.e. the Board of Directors and management team). In a small or private company, owner-manager situation is very common where the owner and management are referring to the same batch of persons. In a large or public listed company, these 2 parties are usually segregated and shareholders tend to have limited rights to control the operations of a company except when there are significant events concerning the company such as merger or acquisition, fund-raising, etc. In the latter situation, there is a segregation of ownership from control. That is, the delegation of authority and responsibilities by shareholders to the companys management for leading and managing the company. Besides, shareholders place trust on the management and believe that the company will be managed to achieve the desired goals and objectives. This is often referred to the principal-agency relationship. Shareholders are principal and management is the agent. Management is accountable to the shareholders and acting in good faith and in their interests. However, in the day-to-day operation, shareholders hardly interfere with management in their daily management of the company. In the absence of an effective monitoring system, the possibility of management inappropriately using their authority to advance their personal benefits will increase. This may be driven by the various reasons such as managements self-interest, financial rewards, meeting business and operational targets, etc. Therefore, a gap exists between the shareholders and management regarding their interests.

ways is to align their interests by introducing a performance-related remuneration package. This can link the companys performance 12 News Update Summer 2007

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such as turnover, profit or other indicators with the management s remuneration and making sure that they are running in the same direction. Another way is to strengthen the corporate governance practices, apart from increasing disclosure, by (i) clearly defining the accountability and responsibilities of management; and (ii) establishing an effective Board of Directors. The latter one is more important. An effective Board can be measured by at least 2 things, one is its composition and the other is its performance. According to the listing rules and Code of Corporate Governance Practices issued by Hong Kong Stock Exchange, a Board of Directors must include at least 3 independent non-executive directors (INEDs). As a best practice, 1/3 of the Board should be made up of INEDs. Besides, a Board should perform effectively by scrutinizing the activities of the company, questioning high-risk investments or projects, monitoring managements integrity, monitoring the results of authority delegation, reviewing regular operational and financial reports. Besides, it is very common for a Board of Directors to establish different board committees to discharge their duties and overseeing responsibilities. These committees include remuneration committee, audit committee and nomination committee. Appointment of committee members should also ensure that they have the relevant experience, knowledge and skill sets. For example, it is a requirement that there should be at least one financial expert in the audit committee. With the above measures, shareholders can place more trust

There are a number of ways to narrow this gap. One of the

and confidence in the management with the increased supervision and participation of an effective Board of Directors and interests among the parties are being aligned.

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Creating Value for Stakeholders An ideal and effective corporate governance system of a company should also include a robust enterprise risk management (ERM) process. Through the implementation of a systematic process throughout a company, ERM can provide a company with reasonable assurance to achieve its goals and objectives. More importantly, it can ensure that the company is operating within the enterprises risk appetite. The ERM should include internal environment, objectives setting, events identification, risk assessment, risk response, control activities, information and communication and monitoring. ERM can create value for stakeholders by linking strategic objectives with relevant risk factors, identifying events such as risk and opportunities, preparing risk responses and viewing enterprise risk factors as a portfolio. The importance is to ensure that these risk management elements are built into the operating business processes and not just being considered on a standing alone basis. In the context of ERM, the role and responsibilities of internal audit function will usually be touched on. Traditionally, internal audit function is viewed as a watchdog and being charged to ensure the effectiveness of the check and balance mechanism within an organization. The personnel to take up this role may also need to involve in operation such as financial reporting process. However, with the increasing importance of corporate governance and risk

management, expectations on internal audit function have been raised to include the following: Becoming a partner to operational departments in assisting them to achieve their process objectives instead of detecting wrongdoings; Independently reviewing business processes on a risk-based approach to identify weaknesses or improvement opportunities rather than looking for non-compliance; Assisting the management to align business operations with corporate or entity-level objectives; and Assisting in reviewing and improving the risk management process to ensure its effectiveness. Finally, corporate governance affects every spectrum of an enterprise from the top management to operations, and not only disclosure or paper work. The successful implementation of corporate governance requires self-discipline, a strong tone-at-thetop and the management with integrity to drive the process. In return, value can be created for stakeholders.
References: 1. Code of corporate governance practices, The Hong Kong Stock Exchange 2. Enterprise risk management framework, COSO 3. Audit Quality Agency theory and the role of audit, The Institute of Chartered Accountants 4. Report of the committee on the financial aspect of corporate governance or Cadbury Report

Summer 2007 News Update 13