The Securities and Futures Commission in Hong Kong has been conducting more investigations in their aim to make Hong Kong a safe and reputable place to do business. Mr Patrick Perry of Clyde & Co says that not only has the number of cases shot up but the regulator has also taken a varied and flexible approach to enforcement actions too.
After a number of high profile corporate scandals, the Securities and Futures Commission (“SFC”) in Hong Kong is pursuing with vigour its objective of making Hong Kong a safe and reputable place to do business.
Its mission statement is to promote fairness in the market, and protect the investing public, through firm and decisive disciplinary action against listed companies and their directors. Statistics show that it is certainly not shirking that responsibility, and this has a significant impact upon directors and their insurers.
Changes in enforcement actions
In the quarter ended 31 December 2012, there were 123 ongoing or concluded SFC enforcement proceedings. A year later, that figure had risen to 196, a 60% increase. The manner in which the SFC is carrying out its duties, and the enforcement action that it is taking, has also changed considerably over recent years.
The SFC has always sought to utilise the broad ranging powers of investigation granted to it under the Securities and Futures Ordinance 2003 (“the SFO”). This includes the power to demand documents and records under s.173 SFO, and carry out an investigation under s.182 SFO if it has reasonable cause to believe an offence may have been committed or misconduct may have taken place.
Recent landmark ruling
On 22 May 2014, the SFC obtained a landmark ruling against Ernst & Young (“EY”) under the rarely used s.185 SFO, which entitles the SFC to make an application to the court to open an inquiry into a failure to assist with an investigation.
The issue arose from EY’s resignation as reporting accountant and auditor of the PRC based water services company, Standard Water Limited. This led to Standard Water abandoning its IPO listing application.
The SFC commenced an investigation, and as part of that process, required EY to produce audit working papers. EY resisted production, claiming that the working papers were owned by Ernst & Young Hua Ming LLP, a separate legal entity subject to PRC laws. It also argued that disclosure would contravene PRC laws, including the laws on State
secrets.
After 10 days of hearings, the court rejected EY’s arguments, finding that it had an enforceable right under the PRC laws of agency of entrustment to require the documents from Ernst & Young Hua Ming LLP. It also found that EY had failed to establish that the documents contained State secrets or that there was some other legal restriction on their disclosure. Production was therefore ordered. EY has however recently appealed the production order for the papers held in the Mainland.
Varied and flexible approach to enforcement
Whilst the number of investigations that the SFC are conducting has increased, the enforcement action that follows has also developed in nature. We are now seeing regular use by the SFC of the powers granted to it under the SFO, and a considerably more varied and flexible approach to enforcement.
Under s.214 of the SFO, the SFC may make orders disqualifying a person from being a director for up to 15 years for misconduct. In the case of Styland Holdings Limited, the use of this section resulted in the former directors being disqualified for 12 years for entering into transactions which were not in the company’s interests.
There is no express power to order compensation under s.214, but it does allow the Court to “make any other order it considers appropriate”. Utilising this broad provision, the SFC obtained an order that the chairman and his wife pay HK$85 million (US$11 million) in compensation to the company.
Compensation order under s.214 SFO now widely used
The Styland Holdings Limited case was heard in 2012 and was the first time a compensation order was made under s.214 SFO. This provision has since been widely used.
In July 2013, the SFC commenced legal proceedings to seek to disqualify three former senior executives of China Best Group Holdings Limited for failing to disclose a material interest in a proposed acquisition.
As part of the proceedings, the SFC sought an order to recover the interest accrued on a $305 million cash deposit. More recently in April 2014, the SFC commenced proceedings against various directors of Minth Group Limited, seeking disqualification orders and an order for $99 million compensation. It is alleged that an acquisition was made in breach of fiduciary duty and without disclosure that the seller was connected with the chairman.
Another wide ranging ordinance – s.213 SFO
The other often used tool in the SFC’s current armoury is s.213 SFO. This is another wide ranging provision which allows the SFC to take action where a person has breached any SFO provision or certain Companies Ordinance sections.
Under this section, the SFC obtained an Order that Tiger Asia restore $45 million to around 1,800 investors in Hong Kong. In March 2014, the SFC reached an agreement with the former Chairman of Gome Electrical Appliances in resolution of s.213 proceedings, for him to pay $420 million in compensation in respect of an unauthorised share repurchase.
Disclosure to insurers
The activity of the SFC gives rise to numerous issues for directors and their Insurers under D&O Policies. The first major issue that confronts directors faced with an SFC investigation, is the need for secrecy. Under s.378 SFO, it is a criminal offence punishable by up to two years in prison, if a person under investigation reveals that fact to a third party, other than his lawyer. This creates immediate problems of notification under a D&O Policy.
In its published response to Frequently Asked Questions, the SFC has advised that the general nature of the matter of the investigation may be disclosed to Insurers. However, there remain uncertainties over the extent of that disclosure, and ongoing issues with Insurers monitoring defence costs expenditure which may be covered under the D&O Policy.
Uncertainty if D&O will cover fines and penalties
The other significant coverage question is the extent to which any fines and penalties may be insurable as a matter of law. Section 468(4) of the new Companies Ordinance, which came into force on 3 March 2014, confirms that a company can purchase insurance for its directors. Indeed, listed companies have to do so, or explain why not, in their annual reports.
What the legislation has failed to clarify however is the extent to which such insurance can cover fines and penalties. It is anticipated that the Hong Kong courts will follow the UK decision of Safeway v Twigger (2010) and prohibit insurance of criminal fines or civil fines where there is morally reprehensible conduct involved. This is on the basis of public policy that it would dilute the deterrent effect of a fine, if it resulted in no personal payment by the wrongdoing individual.
It can be expected therefore that many of the orders that the SFC obtains will not be insured either on this basis, or because they are orders for restoration of property rather than an indemnifiable loss. Insurers will, however remain exposed to incurring defence costs for what could be a lengthy investigation period.
The flurry of activity by the SFC could therefore be a blessing and a curse. It may drive the demand for D&O insurance in Hong Kong but could equally leave Insurers with difficult coverage issues, and an expensive exposure to defence costs amongst other potential liabilities.
Mr Patrick Perry is a Partner at Clyde & Co.