Dr Gao Wei FCG HKFCG(PE), Institute Vice-President, offers recommendations for companies listed in Hong Kong and the Mainland on the governance of connected transactions.
Connected transactions refers to transactions between a company or its subsidiaries and the related parties who directly or indirectly hold interests or have a stake in the company’s affairs. In corporate operations, it is an extremely important legal concept that involves a series of issues such as financial supervision, information disclosure, and the protection of minority shareholders’ rights and interests. Connected transactions are tools for transferring interests, and detailed provisions on connected transactions can be found in laws, listing rules and accounting standards in various countries.
Nowadays, more and more companies are dual-listed in Hong Kong and the Mainland, and they need to comply with the securities regulations and listing rules regarding connected transactions in both places. Relevant listed companies include A+H-share companies listed in both Hong Kong and the Mainland, as well as listed groups whose parent companies are listed in Hong Kong or the Mainland, and whose subsidiaries are listed in the Mainland or Hong Kong. A+H-share companies and H-share companies registered in the Mainland also need to comply with other laws of the People’s Republic of China, in particular, the PRC Company Law.
Recently, the State Council of China issued a Decision to Abolish Some Administrative Regulations and Documentation, and the China Securities Regulatory Commission also promulgated the Trial Measures for the Administration of Overseas Securities Offering and Listing by Domestic Enterprises and supporting guidelines, which came into effect on 31 March 2023. In the future, H-share companies or A+H-share companies should refer to the Guidance for Articles of Association of Listing Corporation to formulate their company charters. Below, I will explain the regulatory differences between Hong Kong and the Mainland regarding connected transactions and share compliance strategies.
Comments on related regulations in Hong Kong and the Mainland
From a comparative perspective, the Mainland and Hong Kong are perhaps the jurisdictions that use more legal measures and apply stricter standards than elsewhere. The logic behind the listing rules of the two jurisdictions is essentially the same, with both categorising transactions through a size test and adopting methods such as information disclosure and shareholder approval. However, there are differences in the indicators and quantitative standards used.
Article 1 of the Fifth Judicial Interpretation of China’s Company Law stipulates: ‘Article 21 of the PRC Company Law stipulates that in a claim against controlling shareholders, actual controllers, directors, supervisors or the senior management of a company, the defence that they have fulfilled their obligations in relation to information disclosure and shareholder approval arising from legal or administrative requirements, or the company’s articles of association, would not be a defence supported by the People’s Court.
Mainland Chinese law supports post-review by the court, even if the relevant transaction has been approved by the regulatory process.
In addition, there have been a large number of cases in which listed companies and related parties have been sued under securities law based on Several Provisions on the Trial of Cases of Civil Damages for False Statement Infringement in the Securities Market (commonly referred to as the Judicial Interpretation on Securities False Statements).
According to relevant documents, from 1 January 2020 to 11 November 2022, there were a total of 206 cases of disputes over liability for false statements in relation to connected transactions, usually with joint liability shared by related parties and listed companies.
The mainstream opinions and recommendations from Chinese scholars on revisions to the PRC Company Law are set out below.
‘Where a connected transaction complies with the relevant regulatory procedures, the party claiming that the transaction is unfair and seeking damages shall adduce evidence to prove that the transaction substantially jeopardises the interests of the company; where a connected transaction does not follow the regulatory procedures stipulated in the preceding article, the parties to the transaction shall adduce evidence to prove that the result of the transaction is substantially fair, or else they shall be liable to the company for damages for the unfair transaction.’
Therefore, Mainland law aims to pursue ‘substantial fairness’ in connected transactions and compliance with procedures can shift the burden of proof to relevant parties in judicial proceedings.
In Hong Kong, connected transactions are mainly regulated by the Listing Rules, which mainly deal with the definition of connected parties, the scope of connected transactions, and the procedures for contract signing, disclosure and approval.
Since the Listing Rules are not law, breaches of the rules do not constitute a violation of the law. However, the conduct of connected transactions itself may constitute a violation of the law, and there is a risk that connected persons may be subject to civil or even criminal liability as a result of the conduct of connected transactions.
For example, in the Convoy Global Holdings case, two former executive directors and two co-defendants were sentenced to four to seven months in prison and were found guilty of conspiring to defraud Convoy Global Holdings, its board of directors and shareholders, and the Stock Exchange of Hong Kong by seeking personal gain and evading the Listing Rule provisions on connected transactions. The two former executive directors were also disqualified from serving as company directors for three and two years respectively.
In the TP-Link case, three former directors were found to have caused or allowed multiple subsidiary companies to enter into transactions that were not genuine commercial transactions, transferring HK$622 million to a company owned by the chairman’s family to purchase shares of TP-Link. They were jointly and severally ordered to pay HK$622 million to TP-Link as compensation for the losses suffered as a result of their misconduct and failure to act in the best interests of the company.
Comparing the regulatory and judicial cases of the two places, disclosure of information, due process and fairness of results should be common principles of Mainland China and Hong Kong, with differences possibly existing in the specific law or rules.
Recommended compliance strategies
In light of the current judicial and enforcement landscape, connected transactions have become one of the most significant compliance risks faced by directors, and boards of directors, of listed companies.
1. Conflict of interest is a matter that directors and boards must prioritise. Rule 3.08 of the Listing Rules of the Stock Exchange of Hong Kong requires that directors of listed companies ‘act honestly and in good faith in the best interests of the company’, ‘avoid actual and potential conflicts of interest and duty’, and ‘disclose fully and fairly their interests in contracts with the listed company’.
2. Connected transactions are not just a procedural matter under the Listing Rules. In the recent Securities and Futures Commission (SFC) proceedings against Li Hejun and four independent non-executive directors (INEDs), the four INEDs were ordered to be disqualified from directorship for three to four years on the basis, among other things, that they had failed to raise objections to the company’s unusual business model (connected transactions with the controlling shareholder). This was despite the fact that the relevant connected transaction contracts had been approved by the company’s independent shareholders. Therefore, procedural compliance does not relieve directors of their statutory obligations. Directors should still fulfil their duty to exercise the requisite skill, care and due diligence.
3. Companies must strictly comply with the approval and disclosure requirements under the Listing Rules of the Stock Exchange of Hong Kong when entering into connected transactions. The Listing Rules set out detailed requirements for the conclusion, approval and disclosure of connected transaction contracts and the related contents, which should be strictly complied with unless a waiver has been obtained from Hong Kong Exchanges and Clearing Ltd (HKEX) in advance.
4. Companies should also pay close attention to the complexity of connected transactions and the transfer of interests, maintaining commercial vigilance and guarding against behaviours that circumvent connected transaction rules. Directors have a duty to conduct due diligence on connected transactions, identify the structure of counterparties and other related parties, and determine whether there are complex structures to hide connected transactions.
In November 2019, the SFC issued its Statement on the Disclosure of Actual Controllers or Beneficial Owners of Counterparties to a Transaction, pointing out that ‘special purpose entities are being misused as part of wider schemes to engage in illicit activities, to perpetuate market misconduct or to avoid laws, rules or regulations.’ In the same month, HKEX required listed companies to disclose the identity of connected parties in announcements under Rule 14.58 of the revised Listing Rules, and in December 2020, published further Guide on Connected Transaction Rules, emphasising the need to disclose any significant relationships between parties (and their ultimate beneficial owners) and related parties, such as loans lent/borrowed to related parties before the transaction, related parties providing funding for connected parties’ pre-existing M&A plans, etc.
5. Judgments on the commercial nature of connected transactions cannot simply rely on the opinions of independent financial advisors. Reports issued by independent financial advisors based on contractual terms may not fully reflect the commercial nature and potential risks of transactions, and directors and boards may not be able to fully rely on such reports to defend themselves against legal liabilities.
In May 2017, the SFC issued guidance on directors’ duties regarding transaction valuation, emphasising that directors must act honestly in the best interests of the company and exercise appropriate and reasonable levels of prudence, skill, and due diligence when considering, proposing, or approving company transactions. They must conduct independent due diligence on the relevant assets or target companies and should not blindly or unquestioningly accept financial forecasts, assumptions or business plans provided by the management of the sellers or target companies.
6. As not only the directors and senior management, but also the major shareholders and subsidiaries, as well as the directors and senior management of a listed company, are involved in the decision-making and execution of connected transactions, the scope of the training on the relevant laws and the rules should be extended to the above mentioned persons in order to enable the listed company to comply with the Listing Rules.
Dr Gao Wei FCG HKFCG(PE)
Vice-President, Hong Kong Chartered Governance Institute
Dr Gao has served as the Institute’s Vice-President since 2014, and is in charge of the implementation
and supervision of the Institute’s China strategy.