Mohan Datwani FCIS FCS(PE), the Institute’s Senior Director and Head of Technical & Research, looks at two recent decisions of the Listing Committee of The Stock Exchange of Hong Kong Ltd that reiterate the importance of full compliance with the law in the fulfilment of directors’ duties in Hong Kong.
Director duties now stand at the core of regulatory philosophy of Hong Kong Exchanges and Clearing Ltd (HKEX) relating to listed companies. A company is a legal creation and directors are its agents. It is therefore incumbent upon directors to perform their duties prescribed by law to discharge the trust and confidence placed upon them. Systemically, this underlying regulatory philosophy of HKEX as to the proper discharge of director duties is critical to Hong Kong’s position as a quality market where listed companies abide by high standards of corporate governance. HKEX therefore takes compliance with director duties seriously.
Under Rule 3.08 of the Main Board Listing Rules (and GEM Board equivalent), the legal position is reiterated – directors are both individually and collectively responsible to fulfil fiduciary duties and the duties of skill, care and diligence required of them to at least the standards required under Hong Kong law. Directors need to act honestly and in good faith for proper purpose. Directors must be answerable for the application of assets, avoid actual or potential conflicts of interest and duty, and disclose fully and fairly any interest in contracts with listed companies. In short, doing the right thing for the company as principal in the context of the trust and confidence placed on them as agents for the listed company.
Checks and balances
On 22 January 2018, the Listing Committee of The Stock Exchange of Hong Kong Ltd (Listing Committee) censured RCG Holdings Ltd (now known as China E-Wallet Payment Group Ltd) and a number of its current and former directors for breaching the listing rules and/or the director’s undertaking. This decision is a good lesson as to what not to do in terms of being a director. It also illustrates how the Listing Committee views explanations as to failings in the discharge of director duties as enforcers of the listing rules.
In summary, the company announced a loss of HK$12 million in its interim financial results and the market reacted to the negative news. The share price and trading volume of the company’s shares dropped 13% and 37%, respectively. One month later, the company issued a clarification that it had in fact made a profit of HK$281 million. This was a HK$293 million swing, which affected the fair value of the company’s assets. It was stated that this was due to an error in the recognition of an investment. The share price then went up 18%, settling at a 9% increase for the day. The trading volume was up 2.1 times. This sequence of events naturally drew regulatory scrutiny from HKEX and eventually resulted in the Listing Committee sanction decision.
The Listing Committee decision stated that the investment portfolio of the company was managed by an executive director, who was the chief executive officer of the company (the responsible director). He had authority to invest 5% of the company’s assets without board approval. In this regard, he was sole signatory of a subsidiary used to invest the company’s funds in listed shares. He was the only person who was authorised to receive the relevant statements and who had electronic access to the trading account.
In terms of checks and balances, there was an investment committee with another executive director/managing director of the company (the other director). This investment committee was briefed in summary manner by the responsible director after investments were made. The accounting records would be posted by the responsible director to the chief financial officer (CFO), who would then prepare monthly management accounts. For some six months, the responsible director missed reporting the fair value changes of the investments to the CFO, which led to the reporting error.
There were no requirements to report to the board, except for half-yearly investment reports. Apparently, the investment committee would also self-report where there was a 40% decrease in investment value to the board that the board did not know about. The board took this ‘hands-off’ approach reportedly because the investments were apparently only a small part of the group’s business. At least, this was the explanation proffered.
The problem as to why there was the error in financial reporting turned out to be that the responsible director was not well and the board did not know this. Because of his illness, after the statements were mailed out from China where the responsible director resided, the responsible director forgot to call the CFO about the large profit. This was because he was hospitalised from an undisclosed illness. It was asserted that, once the responsible director realised the mistake, he informed the CFO.
In the context of these facts, the Listing Committee found deficiencies in the internal controls of the company. Specifically, there was no effective monitoring system of investments, given that there was only a half-yearly reporting regime to the board. The check-and-balance system was therefore deficient. This was in the context that the investments were found, in fact, to be significant to the company – an earlier announcement stated that the trading of investments was one of the company’s core businesses.
As to the responsible director’s excuse that he was sick, this was found to be unacceptable to the Listing Committee as an explanation for the error. As a director, the Listing Committee found that the responsible director must exercise his duties as a reasonable director would have done. He cannot just be concerned with formal meetings only. He must take an active interest in the company’s affairs. In this connection, the Listing Committee referred to the Companies Registry’s published guidelines on director duties, which state that directors need to keep accounting records with reasonable accuracy. The other director on the investment committee was similarly in breach of director duties. As to the other independent non-executive directors (INEDs) and audit committee members, they were also in breach for failure to monitor the integrity of the financial statements.
Under the decision, the Listing Committee expressed certain regulatory concerns. These included that shareholders should have accurate information that is not misleading, otherwise there could be prejudice to their interests. The directors must therefore ensure announcements are accurate and complete in all material respects. Further, no individual should be given complete control of a part of the company’s business without appropriate measures, under a proper reporting system, to maintain appropriate checks and balances as part of the internal controls of a listed company.
Aside from the public censure of the directors, the company had to put into place a number of remedial steps. These included the hiring of a professional consultant for a review of the internal controls. Also, a qualified accountant had to join the accounting team. The external auditors would assist the company to prepare future financial results and statements. The responsible director and the other director on the investment committee were required to attend 24 hours’ training within a specified
period. The former directors were required to attend training should they desire to become directors of other listed companies.
The decision shows that the Stock Exchange and its Listing Committee are determined to enforce the legal requirements for the fulfilment of directors’ duties in Hong Kong. That is, executive directors who are parties to breaches of directors’ duties under the listing rules can expect public censure and other consequences in the absence of cogent reasons.
The decision also reiterates that INEDs should be concerned with the systems of checks and balances that a listed company has in place. Further, they should not allow delegation of a part of the company’s business to any individual director without adequate reporting as part of their regulatory oversight of the affairs of the company. All directors must take an active interest in the affairs of a listed company and understand what is going on.
Conflicts of interest
On 30 January 2018, the Listing Committee censured Chen Jing in absentia for failing to fulfil his fiduciary duties and duties of skill, care and diligence to a standard at least commensurate with the standard established by Hong Kong law.
Mr Chen was a former executive director of TC Orient Lighting Holdings Ltd, and also president of another Chinese company. He signed a guarantee, without the knowledge of the board, in which a subsidiary of the listed company became a guarantee of his and his Chinese company’s borrowings.
The company only learned about these arrangements when the group was sued under the guarantee. In fact, under the listing rules, the guarantee was a major and connected transaction of the company requiring shareholders’ approval prior to its entry into force. When the company was sued on the guarantee, the executive director and his Chinese company repaid the borrowings and reported the matter to the relevant Mainland authorities. When HKEX commenced investigations on the matter, it received no response from the executive director.
This case is highly disturbing as the executive director had wanton disregard for the listing rules and his duties to assist in regulatory investigations in accordance with his director undertakings filed with HKEX to support his directorship.
The Listing Committee found breaches to Listing Rules 3.08(a), (d) and (f). Specifically, these relate to the duties of directors to act honestly and in good faith, to avoid actual and potential conflicts of interest and duty, and to apply such degree of skill, care and diligence as would be reasonably expected of a director with the knowledge and experience and holding an office within the listed company.
The Listing Committee commented that the company and its subsidiaries could have derived no benefit from the guarantee. The exposure was significant in terms of financial liabilities and was not brought to the attention of the board. Apparently, the only explanation given was that the third parties who lent the executive director money coerced the executive director into providing the guarantee.
The Listing Committee also specifically commented on the breach of the fiduciary duty of the executive director in terms of his conflict of interest under Rule 3.08(d). The director should have disclosed and abstained from voting at the time of provision of the guarantee. Also, in terms of the duty of skill, care and diligence under Rule 3.08(f), the director should have known that he was a connected person and that shareholders’ approval was required. The guarantee would be a notifiable and connected transaction. The director was accordingly censured and his suitability to be director of the listed company was called into question.
Lessons to learn
The two Listing Committee decisions discussed above are certainly instructive as to the interpretation of directors’ duties requirements in Hong Kong. Company secretaries and governance professionals should arrange periodic training for directors on their duties and responsibilities. We should remind them that, under Hong Kong law, directors are agents of their listed companies. Therefore, they must faithfully adhere to common law principles relating to their fiduciary duties, including not being in a position of conflict, along with their statutory duty under Section 465 of the Companies Ordinance to exercise reasonable skill, care and diligence as with any reasonable director, or a higher standard where they have specific skill sets and experiences. In all cases, their conduct must be that of a reasonable director under Hong Kong law.
Fundamentally, we must remind directors that, under Hong Kong law, all directors serve as directors to a unitary board. That is, they all have duties and responsibilities irrespective of the designation as executive, non-executive and/or independent directors. INEDs, because they are not concerned with the day-to-day implementation of business affairs of the company, must be particularly diligent in carrying out their function as a check and balance on executive decisions, including ensuring that there are systems of controls to deal with risk mitigation and over-concentration of powers.
Directors of companies listed in Hong Kong may come from jurisdictions with different laws and regulations on directors’ duties, but they must at least comply with Hong Kong legal standards. They should know that HKEX does take its regulatory functions seriously, and when things do go wrong, directors’ actions and inactions will be scrutinised by HKEX and its Listing Committee. This mean that directors, aside from carrying out day-to-day functions, should be mindful of the governance aspects relating to the running of listed companies, supported no doubt by the company secretary as governance professional.
Mohan Datwani FCIS FCS(PE),
Senior Director and Head of Technical & Research
The Hong Kong Institute of Chartered Secretaries
More information is available on the HKEX website: www.hkex.com.hk.