Daniel Wan, the co-author of the new HKICS guidance note on Hong Kong's connected transaction rules, discusses the important role company secretaries can play in helping directors and managers understand Hong Kong's complex connected transactions regime.

Can you give us an overview of how connected transactions and connected persons are defined under the Hong Kong listing rules?

‘Chapter 14A of the Main Board Rules (or Chapter 20 of the GEM Rules) defines what constitutes a connected transaction and who qualifies as connected persons. The rules seek to ensure that a listed issuer discloses connected transactions to the public and takes into account the interests of the listed issuer and its shareholders as a whole when the listed issuer's group enters into a connected transaction. Connected transactions take place when a person who is able to control or influence a listed issuer (that is owners and senior management of the listed issuer and their respective associates or nominees), enters into a transaction with or involving the listed issuer's group. The rules safeguard against such persons taking advantage of their position. Accordingly, defining who qualifies as connected persons under Chapter 14A is the first key to determining whether connected transactions take place (see 'Defining a connected person’ below). Generally, connected transactions include transactions between a listed issuer's group and its connected persons. On the other hand, independent third parties’ transactions with the listed issuer's group that may confer benefits to connected persons may also be regarded as connected transactions. Connected transactions include both capital and revenue nature transactions. They may be one-off transactions or continuing transactions. Continuing connected transactions are connected transactions involving provision of goods or services or financial assistance, which are carried out on a continuing or recurring basis and are expected to extend over a period of time. They are usually transactions in the listed issuer's group's ordinary and usual course of business.’

What are the requirements for connected transactions?

‘As general requirements, a connected transaction must be in the form of a written agreement, disclosed in an announcement to the public, circulars to the shareholders and annual report, and conditional on shareholders’ approval. Any shareholder who has a material interest in the transaction cannot vote on the resolution approving the transaction. Continuing connected transactions also require annual reviews by independent non-executive directors and auditors of the listed issuer. There are certain exemptions to the general requirements, including de minimis transactions; financial assistance; issue of new securities by the listed issuer or its subsidiary; dealings in securities on a stock exchange; repurchases of securities by the listed issuer of its subsidiary; directors’ service contracts and insurance; buying or selling of consumer goods or services; sharing of administrative services; transactions with associates of passive investors; and transactions with connected persons at the subsidiary level. The exemptions are broadly divided into two categories: fully exempt from shareholders’ approval, annual review (by INEDs and auditors for continuing connected transactions) and all disclosure requirements; and exempt from the shareholders’ approval requirement only.’

What are the consequences of failing to meet the requirements for connected transactions?

‘First of all, it must be clarified that the Exchange is not against connected transactions as long as the issuer meets the relevant requirements. As with some other listing rules, the Exchange adopts a name-and-shame approach to violations of Chapter 14A. Typically, in the case where the Exchange finds that a listed issuer fails to comply with the connected transaction rules, the Exchange would censure or criticise the listed issuer and the relevant directors who are held responsible. The Exchange would also direct the listed issuer to retain an independent professional adviser to conduct a thorough review of, and make recommendations to improve, the listed issuer's internal controls and an independent compliance adviser for consultation regarding compliance with the listing rules. The relevant directors would also be required to undergo training on listing rules compliance, director's duties, notifiable and connected transactions, provided by course providers approved by the Exchange's Listing Department, which includes The HKICS. While a listed issuer who has conducted connected transactions without complying with the listing rules is not subject to criminal prosecution, the connected transaction itself might be considered as inside information, in the sense that failure to disclose a connected transaction may be regarded as failure to disclose inside information, which is now a civil infraction attracting a fine of up to HK$ 8 million under the Securities and Futures Ordinance (SFO). Hence it is important for listed issuers to maintain a rigorous internal control mechanism to ensure directors, senior management and general staff comply with the listing rules.’

Hong Kong's connected transaction rules were last updated in July 2014 – what changes were made?

‘A number of changes were made to improve the clarity and practicality of the connected transaction rules after a consultation was concluded in March 2014. One major breakthrough is that the Exchange has rewritten the previous Chapter 14A in plainer language, including making modifications to various definitions, rearranging rule numbers, etc. That's really good news for market participants as listed companies, company secretaries and other legal professionals find it easier to comprehend and comply with the rewritten rules. Another remarkable improvement is that Chapter 14A can now be read independently of other chapters. Prior to the amendments, various defined terms, such as “listed issuer” and “associate”, made reference to other chapters. Frequently used terms are better defined in the new Chapter 14A. For example, in the old version of Chapter 14A, the “listed issuer” actually referred to the same term used in Chapter 14, which means the listed issuer and its subsidiaries. Now it has been redefined more explicitly as “the listed issuer's group” in the new Chapter 14A. Likewise, “connected persons” previously referred to “directors, chief executives, substantial shareholders and their respective associates”, which definition was contained in Chapter 1, but now they are all defined in the new Chapter 14A for easier reference. With regard to what constitutes a “transaction” and a “connected transaction”, various fine-tuning and simplifying amendments were made. For example, the scope of the “transaction” definition includes the granting of an indemnity, or the giving or receiving of financial assistance. Under the new rules, the term “financial assistance” has been defined to include granting credit, lending money, or providing an indemnity against obligations under a loan, or guaranteeing or providing security for a loan. Note that “an indemnity against obligations under a loan” is added under the new listing rule 14A.24(4). Under the old rules, there were 11 types of connected transactions:

1. any transaction between a listed issuer's group and a connected person
2. acquisition or disposal of interest in a company where a substantial shareholder of that company is or becomes a controller or an associate of a controller of the listed issuer or its subsidiaries
3. acquisition or disposal of interest in a company, where a controller or an associate of a controller of the listed issuer or its subsidiaries is, or will become, a shareholder of that company
4. subscription on favourable terms
5. subscription of different classes of shares
6. financial assistance to or from commonly held entity
7. financial assistance – indemnity, guarantee, etc
8. financial assistance – security over the assets of the listed group
9. options
10. joint ventures, and
11. continuing connected transactions.

There was some confusion under the old rules, in particular type (7), (8), (9) and (10) which are supposed to be covered by type (1) because “transaction” as defined shall have included granting or receiving financial assistance or options to or from connected persons, and setting up joint ventures with connected persons. Under the new rules, types (1), (6) and (11) are retained, type (2) is retained with some simplification, and all other types (types (3), (4), (5), (7), (8), (9) and (10)) have been repealed for simplification and the avoidance of doubt. On the other hand, key changes made to the exemption rules include: increasing the monetary limit for de minimis transaction exemption to HK$3 million from HK$1 million; removing the 1% cap for the exemption on provision of consumer goods or services; and introducing new exemptions for indemnity or insurance against directors’ liabilities incurred in the course of performing their duties. The new Chapter 14A has also relaxed the rules with regard to transactions with persons connected at the subsidiary level. Under the old rules, transactions between a listed issuer's group and persons connected at the subsidiary level are all connected transactions, thereby subject to shareholders’ approval, annual review and all disclosure requirements unless exemption applies. Under the new rules, persons connected with an “insignificant subsidiary” (which means a subsidiary whose total assets, profits and revenue tests are less than 10% for each of the latest three financial years or 5% for the latest financial year) is no longer considered as a connected person, thereby transactions between a listed issuer's group and persons connected with an insignificant subsidiary are no longer connected transactions. The new rules also relaxed the requirements for transactions with persons connected with an “ordinary subsidiary” (which means a subsidiary which does not qualify as an insignificant subsidiary). Under the new rules, transactions between a listed issuer's group and persons connected with an ordinary subsidiary no longer require circular, independent financial advice and shareholders’ requirements and all that is needed is a mere announcement, provided that the listed issuer's board of directors have approved the transactions; and the independent non-executive directors have confirmed that the terms of the transaction are fair and reasonable, the transaction is on normal commercial terms or better, and in the interests of the listed issuer and its shareholders as a whole. Another notable breakthrough under the new rules is that various diagrams and examples have been inserted for easier understanding.’

What is the purpose of the new HKICS guidance note on Hong Kong's connected transaction rules? How is it different from, or how does it complement, the Exchange's guidance on connected transactions?

‘The guidance note published by HKICS is intended to illustrate the connected transaction requirements in even plainer language and guide readers in a more practical way. One major difference of the HKICS guidance note is that we have brought all the individual diagrams into one place in order to give the full picture, showing all the relationship connections among different individuals and entities on one single A3 page. This is especially handy for directors or senior managers who may be less familiar with the listing rules, enabling them to gain a quick, and better understanding of the relational complexity in connected transactions. In other words, the HKICS guidance note takes a practical approach and is meant to facilitate compliance by demonstrating all the relationship connections among different connected individuals and entities in one place.’

Given the complexity of connected transactions, what more can company secretaries do to help companies comply with Chapter 14A?

‘Although the new Chapter 14A and the HKICS guidance note are very much self-explanatory, I recommend them to sit the CPD courses or seminars organised by HKICS on connected transactions. Through the new Chapter 14A, the HKICS guidance note and seminars, I hope that company secretaries can share knowledge with directors and management during induction and ongoing training in order to raise their awareness of connected transaction compliance matters.’

What's your expertise? Who are your clients?

‘I focus on Hong Kong corporate finance and in particular Hong Kong IPOs, pre-IPO investments and restructurings, post-IPO regulatory and compliance matters, and secondary equity fundraisings. My clients include investment banks, investment funds, private and listed companies. Four IPOs I advised on have successfully been listed on the Hong Kong stock exchange in the last few months.’ Jimmy Chow Journalist Daniel Wan is a qualified solicitor in Hong Kong. He co-authored the HKICS 'Guidance Note on Connected Transactions’ with Mohan Datwani, HKICS Senior Director and Head of Technical & Research. This guidance will be available in the Publications section of the Institute's website (www.hkics.org.hk) from mid-January 2016.  

SIDEBAR: Defining a connected person

Recognising who qualifies as connected persons is a key part of complying with Hong Kong's connected transactions rules. The definition of a connected person includes: a director, chief executive or substantial shareholder (that is, someone holding 10% or more of the voting power at any general meeting of the company) of the issuer or any of its subsidiaries, a person who was a director of the issuer or any of its subsidiaries in the past 12 months, a supervisor of a PRC issuer or any of its subsidiaries, an associate of any of the above persons, a connected subsidiary and a deemed connected person. Note that an associate is regarded as a connected person. While directors, chief executives and supervisors as connected persons must be individuals, substantial shareholders can either be individuals or corporate shareholders. For individuals, as a rule of thumb, the rules make it clear that their immediate family members, other family members and certain extended relatives are considered to be associates or deemed connected persons. Note that companies controlled by immediate family members, other family members and certain extended relatives are also regarded as associates. The trustee of a trust where the individual or his immediate family members is a beneficiary is also regarded as associate. For immediate family members, companies in which they, individually or collectively, have 30% or more of the voting power at general meetings or control the composition of a majority of the board of directors, as well as subsidiaries of these companies, are regarded as associates. For other family members and extended relatives, the companies in which they have more than 50% of voting power at general meetings or control the composition of a majority of the board of directors, as well as subsidiaries of these companies, are regarded as associates or deemed connected persons. For corporate shareholders, their subsidiaries, holding companies and subsidiaries of the holding companies are all regarded as associates. The trustee of a trust where the corporate shareholder is a beneficiary is also regarded as associate. Further down the ladder, companies in which the above companies and/or trustees, individually or collectively, have 30% or more of the voting power at general meetings or control the composition of a majority of the board of directors, as well as subsidiaries of these companies, are also regarded as associates. A subsidiary of a listed issuer is not by default a connected person. Hence transactions between a listed issuer and its subsidiary and transactions between a subsidiary and another subsidiary within a listed group are not connected transactions. However, where any connected person(s) at the issuer level can exercise or control the exercise of 10% or more of the voting power at a subsidiary's general meeting, such subsidiary, together with any of its further subsidiaries, would become connected subsidiaries. Transactions between any member of the listed group with a connected subsidiary constitutes a connected transaction. Any person who has entered, or proposes to enter, into (a) a transaction with the listed issuer's group; and (b) an agreement, arrangement, understanding or undertaking (whether formal or informal and whether express or implied) with a director, chief executive or substantial shareholder of the listed issuer or any of its subsidiaries, would be regarded as deemed connected person. Many changes were made to the definitions of connected persons and their associates in response to the feedback to the Exchange's consultation paper in March 2014. Some were made more specific, and some relaxed. For example, under the new rules, the supervisor of the subsidiaries of a PRC issuer are now included as connected persons, while they were not covered previously. A person connected with an insignificant subsidiary, whose total assets, profits and revenue tests are less than 10% for each of the latest three financial years or 5% for the latest financial year, is no longer a connected person. With the exclusion, transactions between a listed issuer's group and persons connected with insignificant subsidiaries would fall outside the connected transaction regime.