Complex though they may be, Hong Kong’s connected transaction rules can be better understood if the basic principles behind the regulations are grasped. This month, CSj looks at the rationale behind the rules and at the role of the company secretary in ensuring compliance.

Just like water that can both float and sink a boat, connected transactions are neither good nor evil by nature, their effect depends on the motive behind them. They are considered abusive or harmful only when, for example, the price is unfair to the company by reference to the price the company would have received from an unrelated party dealing at arm’s length.

Simply put, connected transactions are transactions that take place between an issuer and the persons or parties it has a relationship with. Chapter 14A of the Main Board Listing Rules (or Chapter 20 of the GEM Rules) has well-defined descriptions of who connected persons and associates are, and what conditions constitute a connected transaction.

By and large, the objectives of the rules on connected transactions are to ensure that a listed issuer takes into account the interests of shareholders as a whole when it, or one of its subsidiaries, enters into connected transactions; and to provide safeguards against directors, chief executives and substantial shareholders (or their associates) taking advantage of their positions.

This is achieved by requiring immediate disclosure and prior shareholders’ approval of material connected transactions. In addition, issuers are required to disclose their connected transactions in annual reports. Continuing connected transactions are also subject to annual review by independent non-executive directors (INEDs) and auditors.

The regulatory framework

In Hong Kong a large number of companies are controlled by a dominant shareholder so connected transactions is a major area of potential concern. In this context, Grace Hui, Managing Director and Chief Operating Officer (Listing), Listing and Regulatory Affairs, Hong Kong Exchanges and Clearing Ltd (the Exchange), says a robust approach to connected transactions is critical to the corporate governance framework in Hong Kong.

‘We review the connected transaction rules from time to time to ensure that they have addressed developments in the market and international best practices, and also represent acceptable standards which help ensure investor confidence. We believe that our current rules meet the purpose as intended,’ she says.

She adds that scrutiny of connected transactions by independent directors provides an important means to ensure that such transactions are fair to all shareholders. ‘Our current approach gives independent shareholders the right to vote against material connected transactions that they consider unfair. This is in line with the practices in a number of Asian countries and other developed markets (for example, the PRC, Singapore, the UK and Australia),’ she explains. She adds that relaxing the requirements and relying only on company disclosures would undermine investor protection against connected transactions in Hong Kong.

Dr Maurice Ngai, CEO, SW Corporate Services Group Ltd, and HKICS Immediate Past President, points out that Hong Kong’s connected transactions regulatory regime is among the most complicated in the world. ‘Such complexity and extensive coverage of the rules cause listed companies to think twice before they engage in connected transactions. Given the technical complexity and stringent rules, I think the current regulatory regime is reasonable and acceptable.’

In addition to the board and independent directors, he points out that the audit committee and internal/external auditors are also required to play a significant role in monitoring and curbing abusive connected transactions.

‘While the audit committee and internal/external auditors, as gatekeepers, should double check whether a connected transaction has taken place and provide necessary advice in hindsight, equally important is raising the awareness of the management and internal departments in the gatekeeping process before the occurrence of a connected transaction,’ he says.

He adds that the company secretary also has a key role to play – in particular the company secretary is responsible for ensuring that procedural safeguards are in place and effective. As an example, Dr Ngai cites the need for listed companies seeking to carry out continuing connected transactions to establish a framework specifying the connected parties it is going to trade with, business nature, number of transactions, pricing criteria, duration, along with other terms and conditions.

Such continuing connected transactions framework has to be approved by the board and independent directors, who are presumed, prima facie, to exercise independent judgement; and also has to be disclosed to and ratified by the general meeting of shareholders. Moreover, each continuing connected transaction must meet the criteria and be within the limits stipulated, or else it has to be treated as a separate connected transaction, which is subject to a separate set of approval and disclosure procedures.

The company secretary, along with the company’s internal departments, such as the sales and finance departments, needs to ensure that the internal control processes designed to safeguard against abusive connected transactions are effective. For example, the finance department knows key figures, such as the company’s issued capital and shareholding figures, and they can validate if a deal crosses the pre-defined thresholds. Salespeople should also be aware if they are trading with connected parties, such as spouses of the company’s directors.

‘The company secretary is the one charting the territory including all the routes for the parties to follow. It’s like a map all parties can follow to identify connected persons, their associates and thresholds that would require disclosure as connected transactions. The company secretary must have a clear understanding of the structure of the “private group”, from the parent or holding company and associates of the holding company, down to the listed issuer,’ Dr Ngai says.

Strengthening the role of independent directors

It will be clear from the foregoing that independent directors play a key role in monitoring and curbing abusive connected transactions, but are they effective in this role?
David Webb, shareholder activist and Founder of, points out that, because the controlling shareholders and other directors are allowed to vote on the election of INEDs, listed companies with a high shareholding concentration can usually determine who should be “independent” of them in the board room. ‘It’s like having a parliamentary democracy in which the ruling party picks the members of the minority party,’ he says.

INEDs, Webb argues, would need to be independent of management and controlling shareholders if they are to effectively perform their monitoring role for connected transactions. As a way to strengthen the independence of INEDs, Dr Bryane Michael, a fellow at the University of Hong Kong’s Law Faculty, suggests that a voting scheme for independent directors should be introduced into the Code of Corporate Governance such that shareholders not among the top 10% shareholders can nominate at least one independent director.

Mohan Datwani, Senior Director of HKICS, makes the point that on independence of INEDs, the current rules simply focus on certain business and professional conflicts, and do not truly assess the independence of mind which is the essential challenge. ‘Does this then mean that if the minority shareholders have the right to nominate that this issue is addressed? More importantly, the ramifications flowing from tangential inroads to the “one share, one vote” principle has to be considered,’ he says.

The enforcement challenge

The Exchange primarily operates a ‘name-and-shame’ system to enforce Hong Kong’s connected transactions regime. The sanctions available to the Exchange for breaches of the regime include public censure, public criticism, private reprimand and a statement that in the opinion of the Exchange, the retention of office (of a current director) is prejudicial to the interest of investors.

Grace Hui believes that this remains an effective way to police conflicts of interests arising from connected transactions. ‘In our experience, directors take the possibility of sanctions very seriously,’ she says. ‘The Exchange may also give directions for the issuers to take remedial actions and improve future conduct, such as requiring the issuers to appoint advisers or requiring the directors to undergo training. These actions are designed to enhance the corporate governance of the issuers that have acted in breach of the rules.’

As part of its effort to improve the regulation of issuers, Hui says the Exchange is conducting a review of the disciplinary powers and sanctions under the listing rules to make the disciplinary regime more effective and responsive to market needs and expectations.

David Webb believes that all the listing rules, including the connected transaction rules in Chapter 14A, be moved under the Securities and Futures Ordinance (SFO) to be administered by the Securities and Futures Commission (SFC). Currently, the SFC can get involved in connected transaction cases where an issuer’s business or affairs have been conducted in a manner prejudicial to the interests of shareholders, such as where there has been asset misappropriation and fraud through undisclosed connected transactions.

‘The Exchange should not be regulating anything and the regulating functions should be moved to the SFC,’ says Mr Webb. He adds that this would enable the SFC to seek remedies from the courts under the SFO. Possible remedies include, among others, an order restraining (or requiring) the carrying out of a specific act, requiring the issuer to commence legal proceedings for recovery of damages, disqualifying a director and other orders for regulating the conduct of the company’s business and affairs.

Dr Ngai, however, warns about the effect that criminal sanctions may have on business activity in Hong Kong. While the possibility of abusive connected transactions cannot be ruled out, he suggests, neither would it be practical to criminalise violations of the connected transaction rules by moving them under the SFO. He adds that the ‘arm’s length’ standard can be exceedingly difficult to apply. Often, the pricing of transactions, including compensation arrangements, is complex and requires the exercise of judgement by directors, which regulators and courts are reluctant to second guess.

Under the radar?

Respondents to this article all agree that connected transactions is an extremely complex area to police. Where such transactions are not disclosed, it could take substantial research to distinguish them from usual commercial decisions in the normal course of business – particularly if the audit trail has been deliberately obfuscated.

Dr Michael points out that Hong Kong’s rules on connected transactions are very similar to other developed countries, but the problem is where companies do not disclose connected transactions. ‘The connected transaction rules are okay, as long as companies actually disclose, but I think many do not. That’s why the system needs better policing. In the cases where self-dealing and self-serving connected transactions are covered up, this type of malpractice constitutes fraud against shareholders,’ he says.

Mohan Datwani’s views on the assertion that there may be lack of disclosures by listed issuers are that this is difficult to assess in the absence of empirical evidence and understanding of the applicable exemptions which were invoked for the non-disclosure. He adds that regulators are increasingly looking at the quality of disclosures and using regulatory tools like Section 179 of the SFO.

One way to remedy this situation would be to recruit other players to monitor compliance with the connected transaction regime. Two other players which could be gatekeepers in this respect are minority shareholders and whistleblowers.

1. Minority shareholders

In the past, minority shareholder oversight of corporate governance issues has been weak in Hong Kong due to the cost of performing this role. Will the growth of institutional investors, with their access to greater resources, change this dynamic?

Unlike in the US where the increased presence of pension funds has had a strong influence on firm-level corporate governance, pension funds and institutional investors still represent a small part of total equity investment in Hong Kong – giving them little bargaining power to militate for better corporate governance. While investment by the MPF schemes has increased over the years in local equities, such schemes still represent a very small proportion of the market and they do not, therefore, have much influence over governance.

Moreover, Dr Michael points out that the duty of trustees under Hong Kong’s trust law towards their beneficiaries may not extend to using investment criteria which would potentially lower returns and incur additional costs. Within the confines of Hong Kong law and practice at present, he recommends alerting trustees to the risks of investing in companies with high shareholder concentrations. The SFC already issues regular warnings about the risks of high equity ownership concentration. Last week, MSCI Inc, a provider of securities markets indexes and analytics, announced that companies over which SFC announced a high concentration would not become MSCI index constituents.

Dr Michael also suggests that regulators should provide constantly updated information on these kinds of risks and the rights of shareholders to the investment committee members of these schemes.
This would give them a better understanding of their rights as shareholders and ways to exercise them while serving their beneficiaries’ interests.

2. Whistleblowers

The first people to become aware of fraudulent practices within companies are often the officers and employees of the company. Dr Michael points out that there will often be individuals close to problematic connected transactions who wish to protect the company for which they work. He therefore sees whistleblowing as an important potential safeguard against harmful connected transactions in Hong Kong.

He recommends adopting whistleblower protection provisions in Hong Kong’s Code of Corporate Governance. He points out that amending the Code would be a speedier process than going down the statutory route. It would also help prepare companies for the inevitable whistleblower protection legislation that will come. He adds that many companies operating in Hong Kong already have to comply with whistleblower protection laws in their home jurisdictions in the form of Sarbanes-Oxley and/or the Public Interest Disclosure Act.

Jimmy Chow

The new HKICS guidance note on Hong Kong’s connected transaction regime will be available from
mid-January in the Publications section of the Institute’s website:


SIDEBAR: Why the connected transactions rules matter

As the main article makes clear, there is nothing inherently wrong with connected transactions. Problems clearly do arise, however, where such transactions enable insiders to take advantage of their position to act in their own interest rather than in the interests of the company. A recent paper – Last of the Tai-Pans: Improving the Sustainability of Long-Term Financial Flows by Improving Hong Kong’s Corporate Governance – by Dr Bryane Michael and Say Goo, Fellows of the Law Faculty at the University of Hong Kong, indicates that connected transactions tend to reduce shareholder value.

Citing statistics from previous studies in Hong Kong, the paper suggests that when connected parties engage in takeover activity, firm value decreases by about 30%. Asset sales between connected parties tend to reduce firm value by about 20%. Such transactions should have the aim of increasing firm value of course. Lack of information about connected transactions also tends to result in the destruction of firm value in Hong Kong. The paper cites statistics that indicate an average fall by about 10% in cumulative annual returns when a company provides no information about a connected transaction. When the financial adviser involved in the transaction provided no report, firm value fell in the sample they cite by about 30%.

While these figures indicate clear damage to the interests of shareholders, the paper also points out that inadequate policing of connected transactions could seriously undermine Hong Kong’s reputation as an international financial centre. ‘Self-dealing (either real or imagined) acts as a severe brake on domestic and foreign investment in Hong Kong’s companies,’ the paper states.