Comments on the Consultation Paper on the Proposals of the SCCLR Made in Phase 1 of the Corporate Governance Review

11. The HKBA expresses no firm view on this issue, given the opposing views expressed by different members which are summarised in paragraphs 12 to 23 below.

Supporting View

12. Some members support SCCLR’s proposal that the exception in Regulation 86 of Table A which allows an interested director to vote on contracts or arrangements in which he is interested should be amended in the manner proposed (para. 7.09(a), (b) and (d)). However, they believe that a mechanism should be devised and enacted to enable the disinterested directors to approve the transactions or arrangements even though they cannot form a quorum. In this way, the expenses and delay in convening shareholders’ meetings to approve such transaction can be minimised. To prevent any abuse, the mechanism should only be available where the transactions or arrangements do not exceed a certain value (e.g. a defined percentage of the net assets).

13. Any de minimis exception should be drafted so as to avoid a transaction which would otherwise fall foul of the rule being structured as a series of transactions each of which falling within the de minimis exception.

14. These members also consider it desirable to mandate the interested director to make a disclosure of his interest on an ad hoc basis (para. 7.09(c)) for the additional reason that given the informal nature of directors’ proceedings, in particular, the absence of any requirement to specify the nature of the business to be transacted at directors’ meetings, it is often impractical or impossible for directors to give advance notice of his interest in a particular transaction.

15. Members holding the opposing view consider the proposal that the law should be amended to impose a general prohibition against directors of both listed public companies or private companies to vote in transactions in which they have an interest (except under certain statutorily exempted situations) to be a major change in the existing law in Hong Kong (2.03(a)). The current emphasis is only on disclosure. The impact of the proposal on private companies particularly warrants further consideration.

16. The flexibility currently afforded by section 162(2) of the Companies Ordinance will be taken away by the proposal under paras. 2.03(b) and 7.09. The proposal requires that an interested director be statutorily required to give an ad hoc notice in addition to a general declaration of interest already given in advance. The rationale given is that an ad hoc declaration of interest would remind the board of directors of possible conflicts when the matter is put forward for consideration. The provision allowing general declarations of interest would apparently then be rendered redundant.

17. The proposal to widen the ambit of section 162 of the Companies Ordinance to cover "transactions", "arrangements" and "connected persons" is yet another move to incorporate into the general regime of company law specific concepts presently applied under the Listing Rules to only public companies listed on SEHK.

18. These concepts are understandably designed to be wide when applied to listed companies in order to maximize protection for the investing public. It is not uncommon that these concepts, in particular "connected persons", create problems, making it necessary for listed companies to seek professional advice.

19. Compliance officers of listed companies may be comforted by the fact that they enjoy the option of consulting with the regulators at SEHK at no extra cost. This option however would not be available to an operator of a private company.

20. It is recognized at para. 3.04 of the Proposals that for private companies, without any mandatory minimum number of independent directors, there may difficulties in having the necessary quorum of disinterested directors. The proposed solution offered is to have the matter put to the vote by shareholders. However, this solution apparently has not taken into account situations where all the shareholders and directors are the same individuals and they are all interested, in their personal capacity, in the contract with the private company that they wholly own and control.

21. Paragraph 13.08 of the Proposals, although entitled "Whether the requirement to abstain from voting should be incorporated into the law", does not address this question. Further consideration should perhaps be given to allow a wider spectrum of exemptions.

22. Generally, the HKBA agrees with the approach of the SCCLR. The HKBA expresses no firm view on the questions posed by SCCLR in paragraph 8.25 of the Proposals but notes:-

23. As to the SCCLR’s proposal at paragraph 8.29(d) in imposing criminal penalties where there is a breach of the proposed statutory provision within one year of liquidation, is this modelled on another jurisdiction’s provision? Is the SCCLR giving general consideration to insolvency situations in the course of its corporate governance review? In particular, is it considering:

25. Generally, the HKBA supports SCCLR’s view that provisions should be made to preserve or enhance the shareholders’ right to nominate and elect directors in the manner proposed in paragraph 10.29 of the Proposals.

26. However, the HKBA believes that any mechanism to enhance the shareholders’ right to nominate and elect directors can easily be defeated by the controlling shareholders (through their nominees) in exercising their power to remove other directors at Board meetings where the articles of association so provides. The HKBA believes that consideration should be given to limit the power of the directors to remove other directors without proper or sufficient cause.

27. The proposal relating to the requirement to set out the biographical details of a candidate for directorship (para. 10.29(b)) should be effected by statute rather than through the rules of SEHK so that public companies whose shares are not listed on SEHK will also be bound by such requirement.

28. In so far as it is proposed that a formal procedure for the nomination of directors be encouraged as a matter of best practice, the HKBA has some the same reservations as those set out in paragraph 10 above. Even if the Code of Best Practice is adopted by the companies and the directors have acted in breach of it, it may be difficult for shareholders to complain about such breach as the Court has persistently refused to consider whether good corporate governance had been observed except where the standards for such governance are laid down by the law, e.g. the Companies Ordinance and the common law fiduciary duties of the directors.

31. Some confusion may be caused by the apparent interchangeable use of "waste of corporate assets" (a US law concept) with "misappropriation of company assets".

32. Should the civil liability of the interested shareholder proposed in paragraph 13.18(g) of the Proposals extend to any situation in which (1) the transaction is not ratifiable or (2) the transaction is not voidable ?

33. As to the criminal (and possibly civil) liabilities, and presumptions, proposed in the event of a liquidation within one year of the transaction, please see the comments at paragraph 23 above.

34. Provision should also be made for the situation where there are insufficient disinterested shareholders to vote on the approval of a transaction.

35. Is the new statutory derivative action intended to be in addition to or in substitution for the common law procedure? Paragraph 15.25 of the Proposals suggests it will be additional, whereas paragraph 15.27 suggests that it will be a substitution.

36. Given the objective of producing a simpler procedure, it is submitted that the new action should be a replacement for the common law, although the new action should be capable of being developed by case law. It would be confusing and undesirable to simply create additional avenues for complaint.

37. It is understood that the SCCLR proposes the following statutory "derivative" action:-

38. The proposals apparently suggest not simply a new procedure / wider locus standi, but a new substantive action, in so far as the proposals set out the grounds for the action. If the SCCLR only proposes a new statutory procedure for the determination of whether leave should be given to bring a derivative action, this should be clarified.

39. However, if the proposals are understood correctly, they appear to suggest that shareholders, directors and officers may commence actions on behalf of the company where they perceive a wrong to have been done to the company, without there being any determination of their standing.

40. Is it right to permit anyone other than a present shareholder to bring the action?

41. To give standing to anyone other than present members will open the floodgates for interference with management, and (in smaller companies) possibly fetter the conduct of business whilst management deal with the actions.

42. It is submitted that at some stage of the proceedings when the allegations or issues have been clearly stated, the Court should be required to consider whether the plaintiff(s) should be permitted to continue with the action. For instance, one important issue is whether it is in the company’s interests generally (rather than just the plaintiff’s interests) that the action be continued. For the avoidance of doubt, it is not suggested that there be a preliminary issue or mini-trial to determine standing, but that the issue be reviewed by the Court at a convenient point in the proceedings. It may be necessary to coordinate with the Civil Justice Reform, in which a proposal (#24) has been made to adopt a procedural provision governing derivative actions.

43. In a particularly meritless and/or vexatious case, the company may rely on the Court’s existing jurisdiction and seek to strike out the action at an earlier stage, prior to the consideration by the Court contemplated in paragraph 42.

44. The consultation paper does not address the question of against whom the new action will be available.

45. As to the grounds for the application, (on the basis that the derivative action is intended to allow interested persons to apply to the Court on behalf of and/or for the benefit of and/or in the interests of the company where some wrong has been done to the company where the company is unable or unwilling to make its own application), it is suggested that:-

46. Jurisdiction in relation to overseas incorporated companies should be made clear, particularly if the derivative action is to become a statutory substantive remedy.

47. It would be helpful to state clearly the relationship between this derivative action and s.168A(2)(b).

49. In so far as it is suggested that it is a difficulty or disincentive that a successful derivative action will produce damages for the company and not the plaintiff shareholder, it is submitted that no change should be made. The incentive for the derivative action is to correct a wrong done to the company in which the shareholder, as an owner, has an interest.

50. The HKBA supports the introduction of an express power to the Court to order that the company indemnify the applicant as to costs, and inspection of documents. The power to indemnify the applicant as to costs should be unfettered and can be exercised at any stage of the proceedings to ensure that the applicant does not have to bear the burden of financing the costs of the action.

51. The HKBA invites the SCCLR to consider introducing ADR in derivative and unfair prejudice actions.

52. It is suggested that detailed procedural rules be introduced as part of the rules of Court, with only the principal rules being introduced by company legislation. Such procedural rules could include notice requirements, consideration of leave to continue, access to information, costs, ADR etc. This may permit more flexibility in amendment. Additionally, as a principal downfall with existing shareholder remedies is that they are lengthy and costly, the ability of the Court to exercise judicial control at various stages would be valuable.

53. In so far as a minority shareholder is concerned that there has been a wrong done to the company, which the company itself will not pursue by action, the shareholder must consider whether the derivative action or the unfair prejudice remedy is the best way forward. To what extent is it possible to clarify by statutory amendment (including the introduction of the new derivative action) the appropriate procedure to remedy the corporate wrong?

54. As stated above, if the wrong is to the company, then it is the company who should receive compensation (although the shareholder plaintiff’s expenses, in particular legal costs, ought to be indemnified by the company). An award of damages in favour of a shareholder rather than the company should not be available pursuant to s.168A where the wrong is to the company rather than the particular shareholder.

55. If damages are an available remedy, against whom can the orders for damages be made? It may be difficult to justify a damages award against the company (to the detriment of the shareholders generally, no doubt).

58. Is there any merit in attempting to streamline the unfair prejudice procedure by the creation of statutory presumptions as recommended by the Law Commission of England & Wales i.e. (1) a presumption of unfair prejudice where there has been exclusion from management of a person with more than 10% of the voting rights in a company which is, or is substantially, an owner-managed company and (2) a presumption that the valuation of minority shares should be on a pro rata, not discounted, basis? As noted by the Law Cmn., the presumptions would shift the burden of showing otherwise on to the persons likely to be in the best position to bear the burden of proof.

59. Is there any merit in proposing new articles of association for adoption by private companies e.g. an exit article, an arbitration article, a valuation procedure article?

60. The SCCLR’s recommendation for clarification of the law is noted. The HKBA supports the desirability of avoiding a duplicity of actions in respect of the same wrong.

61. The HKBA agrees that there should be a facility for inspection of company records but has some reservations about the proposal.

63. The two-fold requirement of satisfying the Court that the shareholder is "acting in good faith" and the inspection is "for a proper purpose" appears to be too onerous and may be subject to abuse by directors who do not want shareholders to have access to the company records. The HKBA therefore recommends that the shareholder should only be required to satisfy the Court that the inspection is made "for a proper purpose" and not further or otherwise.

64. The shareholder should be able to recover the costs of the application for inspection if it is shown that the inspection is required for a proper purpose. This is easier to justify where the company has already had an opportunity to provide the documents voluntarily.

65. The SCCLR’s proposal in respect of giving the Court a general power to grant injunctions against any contravention of the Companies Ordinance or any breach of fiduciary duties on the application of any affected person or a relevant authority appears too wide.

66. The proposal that the Court should also have a general power to order a person to pay damages to any other person, in addition or in substitution for the grant of an injunction requires more consideration or explanation. A cross-undertaking to pay damages for an injunction improperly obtained is understandable. An order for damages resulting from breach of an injunction is also understandable. However, a power to order damages in favour of any person requires more consideration, particularly in the corporate context, where the envisaged wrongs are corporate wrongs so that the company itself should prima facie be entitled to compensation. The company can of course pursue compensation on its own behalf, or by derivative action.

67. As indicated above, the proposal to permit the Court to order that a shareholder’s costs be indemnified by the company in derivative and unfair prejudice actions is supported.

71. The proposal that private companies with limited liability should file their financial statements with the Companies Registry (CR) for public inspection is to be welcomed. It gives traders and creditors more confidence to trade with Hong Kong private companies. Litigants can also decide whether to pursue a claim against a private company with the benefit of the information from its financial statements.

72. The proposal that private companies ought to file their financial statements with the Companies Registry for public inspection is premised on the objective of allowing their suppliers/creditors to have better access to their financial information. As a result, better risk assessment can be achieved.

73. In practice, suppliers and creditors of private companies generally would require and rely on personal guarantees by directors or shareholders or other security. This practice in fact resulted from the not uncommon fact that the private company in question is only a business vehicle for a specific project. Requiring it to file annual accounts may often not reveal anything of substance.

74. Investors, creditors or suppliers of listed companies already have access to the financial position of these companies because they are obliged under the Listing Rules to publish their accounts with elaborate disclosures and notes at regular intervals. Such financial information is also complemented by mandatory disclosure of details of "notifiable transactions" as well as, where appropriate, forecasts and other business plans as may be required under the Listing Rules.

75. There is no good reason why the Companies Ordinance should not have enabling provisions for auditors to include in their reports on the financial statements any inconsistencies between the audited financial statements and financial information contained in other sections of the annual report. Indeed, the SCCLR may consider making it compulsory for auditors to record such inconsistencies in their reports on the financial statements.

76. The provision of an accounting reference date, an accounting reference period and financial year will be an improvement with the benefit of certainty and consistency.

78. The setting up of a body with authority to investigate financial statements and enforce compliance is essential in giving effect to the various measures proposed to improve corporate reporting.

79. There is in principle no objection to possible improvements to the mechanism for monitoring the quality of audit practice.

80. As disclosure of information is a continuous process, the proposals set out in paragraph 29.10 of the Proposals are to be welcomed.