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May 21 Legal Update

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New HKEX disciplinary regime

HKEX published consultation conclusions in relation to proposed changes in its disciplinary regime. (Press release; full document: summary on P.2)

The thresholds for some actions are lowered, and new measures are introduced. There is an emphasis on misconduct by individuals, including directors and (new) “senior management” of listed issuers and subsidiaries.

For instance, as regards public statement that retention of office by a director is prejudicial to the interests of investors” (“PII statements”), “wilful” or “persistent” failure to discharge responsibilities is no longer required. The scope of PII statements is expanded, to cover director OR senior management.

A NEW “director unsuitability statements” against individuals is also introduced.

Follow-up actions (e.g. denial of market facilities), and disclosure are also enhanced.

The revisions will become effective on 3 July 2021.

What you should know/do:

Key changes

  • Lower thresholds
    (No longer requires: “wilful” or “persistent” failure to discharge responsibilities)
    PII statements
    Denying an issuer’s access to facilities of the market
  • Expand scope of restrictions under PII statements
    The individual’s occupying the position of director OR senior management
    — Of a named listed issuer OR any of its subsidiaries
  • (New) “director unsuitability statements” against individuals
    — That, in HKEX’s opinion, the director is “unsuitable” to be a director or member of senior management of a listed company
    — “Serious or repeated failures” requirement
  • Enhance follow-on actions
    — Where individuals subject to PII Statements continue as director/senior management of a named issuer/subsidiaries
    — E.g. denial of access to market facilities to the named issuer
  • Enhance disclosure
    — Directors/senior management subject to public sanctions
    Disclose in issuer’s announcements/communications and/or annual reports
  • (New) secondary liability for Rule breaches
    — “Caused by action or omission or knowingly participated in a contravention of the Listing Rules”
    — “Relevant persons” broadly defined
    — E.g. “senior management”, substantial shareholders
    — E.g.  guarantors of an issuer for its issue of debt securities
  • Definition of “senior management”
    Named positions of CEO, CFO, COO, company secretary, and supervisor OR
    Performs managerial functions under the directors’ immediate authority OR
    Referred to as senior management in issuer’s corporate communications
  • Introduce explicit Rule provisions
    — When responding to HKEX enquiries/investigations
    — Obligation to provide accurate, complete and up-to-date information and explanation


Also in this issue


(i) HKEX’s latest Listed Issuer Regulation Newsletter covers various themes relevant to listed issuers, e.g. guidance on lending transactions (summarized below).

As regards “notifiable transaction” announcements, HKEX previously reminded issuers to disclose significant relationships between counterparties to the transactions (and ultimate beneficial owners) and the issuer’s connected persons. E.g. a connected person may provide loans to the counterparty funding the transaction. This is relevant in assessing if the counterparty should be deemed a “connected person”.

The newsletter explains that HKEX may require issuers to provide a confirmation on any material loan arrangements between the counterparty and connected persons.

HKEX also observed that despite Covid 19, issuers demonstrated a high level of compliance with their financial reporting obligations. Highlights of listed issuers’ spin-off activities are also addressed.

What you should know/do:

Guidance on loan transactions

  • Lending transactions which raise concerns
    — Lack of business rationale/ commercial substance
    Excessive lending in size compared to scale of issuer’s business operation
    Defaults in repayment or full impairments shortly after grant of the loans
  • Example: gaming operator lent money to six independent parties
    Mostly interest-free or at a rate substantially lower than its cost of capital
    Raises question of commercial merit
    — 70% of loans unrecoverable shortly after being made
  • Financial reporting
    Appropriate and supportable estimates to assess loans recoverability to support “impairment” assessment
    Disclosure on material lending transactions in annual report (“MD+A” section)
    (i) major terms (total outstanding loan receivables, maturity profile, interest rates, collateral/ guarantee)
    (ii) discussion on provisions and impairments, bases of impairment assessment, valuations / other supporting evidence
    (iii) (outside ordinary course of business) reasons for granting such loans and how they meet business strategies
  • Proper and adequate internal controls
    Assess and manage credit exposure
    Monitor recoverability of loans
    Monitor adequacy of collaterals
  • Improper discharge of directors’ fiduciary duties
    Should critically assess commercial rationale
    Terms are fair and reasonable
    Use of issuers’ fund in the ordinary and usual course of business and in best interest of company


(ii)  3 HKEX Listing Decisions on directors’ duties

The cases reflect directors’ duties in different context: loans, acquisitions, and joint ventures (“JVs”)

Listing Rules requirements

Rule 3.08: the board of directors is collectively responsible for its management and operations, and the directors are collectively and individually responsible for ensuring Listing Rule compliance.

Every director must apply such degree of skill, care and diligence as may reasonably be expected of a person of his knowledge and experience and holding his office; act honestly and in good faith in the interests of the issuer.


(A) [Loans] decision on Dongyue Limited and named directors (executive, non-executive, independent) (Press release; Statement of Disciplinary Action)

This involves misappropriations by the company’s financial controller, who was responsible for the wealth management business. Transactions involving loans/deposits around RMB 1.5b were entered into over 1.5 years. The amount remains unrepaid or has been forfeited. Significant internal control deficiencies in the wealth management business was found.

The directors had failed to implement effective risk management and internal control procedures to supervise the financial controller or safeguard the company’s assets. Placing trust in senior members of staff is not a substitute for a proper internal control framework.

What you should know/do:

Internal controls deficiencies + failure in directors’ duties include

  • No specific internal control procedures re: wealth management business
  • Financial controller given a freehand re: treasury function enabling him to conduct the problematic loans
  • Monthly management reports
    No separate item for wealth management business
    No evidence that any relevant director made meaningful enquiries
    — No attempt by any director to change the level of details
  • Wealth management reports supplied to CFO only, and on an ad hoc basis
  • No requirement for CFO/directors to review the above reports in detail
  • Despite auditor’s red flags, directors did not review the relevant processes/ procedures or follow through

Audit Committee

  • Never met with internal audit team to discuss issues raised by them/ wealth management business


(B) [Acquisitions] case on named former directors (executive, non-executive, independent) of Huiyin Holdings Group Limited (Press release; Statement of Disciplinary Action)

In 2016, the company sought to acquire 2 companies. However, issues arose and directors failed to establish adequate internal controls to ensure that relevant documentation re: the acquisition was obtained/ retained (e.g. personal guarantee by vendor). Auditor issued disclaimer. There was a subsequent impairment (over $100 m), and significant loss for the company.

The directors failed to establish adequate internal controls in the company to obtain / retain the relevant documentation in respect of the acquisitions.

What you should know/do:

Internal controls deficiencies + failure in directors’ duties include

  • Disclaimer was due to unavailability of relevant books/records, or appropriate evidence to verify the ownership of the subsidiaries
  • Company could not explain various issues which reflect its internal controls inadequacies
  • No formal procedures to take control over the newly acquired subsidiaries


(C) [JV] Decision on Tech Pro Technology Development Limited and named former directors (executive, independent) (Press release; Statement of Disciplinary Action)

The company acquired a 50% interest in a JV, whose principal business was to lease a property from a lessor and sub-lease it to tenants. It appointed 2 directors as representatives on the JV board.

Directors failed to take adequate steps or implement effective risk management and internal controls to monitor the operations of the JV or safeguard its assets. There was an over-reliance on JV partner.

This created an environment for irregularities. E.g. JV partner continued to collect a substantial part of rent on behalf of JV. The outstanding amount due from JV partner was very substantial. JV was unaware of a major lawsuit by the lessor resulting in the loss of its sub-leasing right, a substantial asset.

What you should know/do:

Internal controls deficiencies + failure in directors’ duties include

Executive directors

  • E.g. no protective measures in place for monitoring JV’s business and operations
    — JV partner was able to continue the historical rental collection arrangement
  • E.g. very substantial outstanding amount from JV partner; no risk management measures
  • E.g. inadequate checks and balances re: JV’s operations and cash flows

 Representatives on JV board

  • E.g. lack of involvement in JV’s management and operations
  • E.g. lack of action to address the JV partner’s dominance for a prolonged period

Audit Committee members

  • E.g. neither the company’s management nor audit committee members adequately addressed the company’s obvious lack of control over the cashflows of the JV


(iii) HKEX published new FAQs relating to notifiable/connected transactions.

  • FAQ 073-2021
    — Calculation of “5 tests”: proposed loan to substantial shareholder; percentage ratio based on stand-alone loan amount OR after setting off loan owed by company
  • FAQ 074-2021
    — “Aggregation” principle —acquisition of wealth management products from bank

This Update in PDF