Jul 19 Legal Update
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SFC Statement on director duties in acquisitions/disposals
SFC published a Statement on the Conduct and Duties of Directors when Considering Corporate Acquisitions or Disposals.
Broadly, this statement is a follow-up on SFC’s Guidance Note on directors’ duties in the context of valuations in corporate transactions (for details: our May 17 legal update). The statement gave useful examples on recurring types of misconduct, typically involving unfair valuations.
SFC reminds directors of their duty to ensure that forecast/estimate used in a transaction was compiled with due care; underlying assumptions are fair, reasonable, and represent management’s best judgment/estimate, considering all relevant information.
Directors should carefully consider the need to engage an independent valuer, even if not required under the Listing Rules ─ in light of the board’s time, resources, and expertise to perform the necessary work without the assistance of a valuer. Failure to do so risks a finding of misconduct.
However, directors are also reminded that obtaining an independent valuation would not reduce directors’ duties of care, skill, and diligence.
What you should know:
Useful examples of recurring “misconduct”:
- Lack of independent valuation
— E.g. issuers simply announced without further explanation, that there were arm’s length negotiations, taking into account vaguely described factors
- Lack of independent judgment and accountability
— Independent valuation obtained
— Directors simply relied on valuation without performing due diligence or other work
— E.g. valuers simply carried out “mathematical computations” on vendors’ forecasts; failed to exercise independent judgment
— E.g. “cherry-picked” comparables to justify a pre-determined estimate
- Quality of earnings
— Due diligence on forecasts, assumptions, business plans not performed
— E.g. risk factors (historic losses; sudden increases in sales; unjustifiably high margins when compared with peers; suspect non-recurring items; unsustainable sources of revenue)
— E.g. failed to explain paying a hefty premium to enter a new industry with low barriers; instead of starting the business itself at a lower cost
- Fair presentation of comparables
— E.g. “cheery picked” companies with higher trading multiples and disregarded those with poor performance
— E.g. chosen comparables had longer and more profitable track records; without making adjustment
- Impact on financial position of issuer
— E.g. substantial additional funds for acquisition cost, and capital investment to meet the forecasts or sustain the business
- Compensation
— Upfront payment of price, with vendor guarantee (if profit forecasts not met)
— E.g. no verification of ability of vendor to pay; funds not held in escrow
— E.g. vendor guaranteed amount substantially lower than acquisition price
- Suspicious connected parties
— Noteworthy: degree of association not necessarily confined to “Connected Persons” under Listing Rules
— Undisclosed “relationships, arrangements, understandings that cause them to act (or refrain from acting) in a co-ordinated manner to the detriment of the issuer and its shareholders… or distortion of the market for its shares”
— E.g. sales growth driven by a handful of customers; subsequently found to be related with issuer’s directors
What you should watch out for/do:
- Board process in approving transactions — should seriously consider engaging a valuer
- Directors’ duties of care, skills, and diligence in approving transactions — more rigour expected
- Internal controls — embed principles of the SFC Guide and SFC Statement in your company’s policies and procedures.
- The need to engage a valuer; interpretations of “connected parties” not confined to Listing Rules
- Our further observations: valuation is an important, but not the sole consideration of the board in approving transactions. Other factors like risks, strategic fit, alternative investment options are also relevant for directors’ duties
Other Stories
Regulators
HKEX published its consultation conclusions on backdoor listing, continuing listing criteria and other Rule amendments (Click: HKEX press release; SFC press release, consultation conclusions).
It will implement the consultation proposals, with modifications, effective on 1 October 2019. There will be a transitional period of 12 months from the effective date, for the continuing listing criteria.
HKEX also publishes (i) 3 new guidance letters on the application of the amended Rules: Guidance on application of the reverse takeover rules (HKEX-GL104-19), Guidance on large scale issues of securities (HKEX-GL105-19), and Guidance on sufficiency of operations (HKEX-GL106-19), and (ii) a FAQ (057-2019) on the notifiable transaction requirements relating to securities transactions.
As noted in our previous updates, there have been concerns on “shell companies” in recent years. The proposals are not intended to restrict issuers from legitimate business expansion or diversification.
What you should watch out for/do:
“Shell companies” do not fall within our focus area. A detailed summary of the proposed Rule amendments is set out in the HKEX press release.
(Background on the consultation; Click: our June 18 legal update)
Legislation
The Competition Commission commenced proceedings in the Competition Tribunal against six decoration contractors and three individuals for “market sharing” (i.e. allocated customers) and “price fixing” activities in 2017, regarding renovation services at a public rental housing estate in Kwun Tong. (i.e. “cartel actions”, in contravention of First Conduct Rule). (Click: press release).
This is another case on “cartels”; also the third one on renovation services at public rental housing estates. (Click: our May 19 legal update; on the first two decisions delivered on “cartels”).
This case involves bringing action against individuals (seeking penalties; director disqualification order).
What you should know/watch out for:
- “First Conduct Rule” means — parties acting together with an agreement, and/or engaged in a concerted practice, whose object or effect is “to prevent, restrict or distort” competition in Hong Kong
- Reinforces that “cartel actions” i.e. price fixing, market sharing, and bid-rigging, is a priority enforcement area
- This case stemmed from a public complaint. The Commission encourages the public to report suspected cartel practices
- All companies must steer clear of cartel practices. Those already involved in such practices should consider approaching the Commission for leniency