Hong Kong's compliance landscape changed dramatically in March this year with the implementation of the new Companies Ordinance. Ada Chung, Registrar of Companies, highlights the major changes brought in by the new law in an area of particular relevance to company secretaries – the new requirements relating to directors.

The new Companies Ordinance, Chapter 622 of the Laws of Hong Kong, commenced operation on 3 March 2014 to provide a modernised legal framework for the incorporation and operation of companies in Hong Kong. The main objectives of the new Ordinance are to enhance corporate governance, facilitate business, ensure better regulation and modernise Hong Kong's company law. Specifically, the new Ordinance enhances the standard of corporate governance in Hong Kong. The operation of companies becomes more transparent and the accountability of directors is strengthened. This article aims to highlight some of the major issues relating to directors.

Strengthening the accountability of directors

Restricting corporate directorship There were provisions in the old Companies Ordinance prohibiting all public companies, as well as private companies which are members of a group of companies of which a listed company is a member, from appointing a body corporate as their director. There was no restriction for other private companies. The new Ordinance requires, on top of these restrictions, that private companies must have at least one director who is a natural person (Section 457).

Clarifying directors’ duty of care, skill and diligence

There were no provisions on directors’ duty of care, skill and diligence in the old Companies Ordinance and the standard of the duty in the case law of Hong Kong, which focuses on the knowledge and experience which the relevant director possesses (the subjective test), is considered too lenient nowadays. To provide clear guidance to directors, the new Ordinance stipulates that a director has a duty to exercise reasonable care, skill and diligence, and sets out a mixed objective and subjective test in the determination of the standard. The objective test looks at the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions of the director in question (Section 465)

Lowering the prosecution threshold by introducing a new definition of 'responsible person’

The threshold for breach of any provision of the new Ordinance by an officer of the company has been lowered through the introduction of a new definition of 'responsible person’, which targets intentional or reckless conduct rather than willful conduct as under the old law (Section 3).

Enhancing the rules to deal with directors’ conflicts of interests

Expanding prohibitions on loans and similar transactions

To avoid potential conflict of interests, the old law prohibited a company from entering into loans or other similar transactions with a director. For a listed company and a company that is within the same group as a listed company, the reference to 'director’ was extended to cover persons or corporations closely associated with a director. The new Ordinance expands the prohibition to cover a wider category of entities connected with a director. In the case of a 'specified company’, namely, a public company, or a private company or company limited by guarantee that is a subsidiary of a public company, the prohibition also covers, among others, an adult child, a parent, a cohabitee, a minor child of the cohabitee and an associated body corporate (Sections 486 to 488, 491(1), 502 and 503).

Imposing a new requirement on directors’ employment contracts exceeding three years

The new Ordinance introduces a requirement for members’ approval of any long-term employment of a director, so as to minimise the risk that a director may entrench himself in office. It provides that the approval of members must be obtained for a company's agreement to any provision under which the guaranteed term of employment of a director with the company exceeds, or may exceed, three years (Sections 531 and 534). The long-term service contract should be approved pursuant to Section 532 of the new Ordinance, either by resolution of members passed at a meeting or by written resolution. If the company is a public company, the resolution should be passed after disregarding the votes in favour of the resolution by the director with whom the service contract is proposed to be entered into and any member who holds any shares in the company in trust for that director.

Extending prohibitions on loss of office payments

To plug any potential loophole whereby loss of office payments to directors may be made indirectly through other parties, the prohibitions on loss of office payments are extended to include:

• payment to an entity connected with the director, and
• payment to a person made at the direction of, or for the benefit of, the director or a connected entity (Section 516(3)).

The prohibition is also extended to cover payments made by a company to a director or former director of its holding company (Section 521(2)).

Requiring approval of disinterested members for prohibited transactions

Except for some specified transactions (most of which relate to the purchase or redemption of a company's own shares), there were no provisions in the old Companies Ordinance restricting members’ rights to vote, or requiring members to abstain from voting, on transactions in which they have an interest. In the new Ordinance there is a new requirement, primarily for public companies, for disinterested members’ approval for connected transactions, namely, in considering if the relevant resolution is passed, every vote in favour of the resolution cast by interested members would be disregarded (Sections 496(2)(b)(ii) and (5), 515(1)(b)(ii) and (4), 518(2)(b)(ii), (4) and (5) and 532(2)(b)(ii) and (4)).

Widening the ambit of disclosure of material interests of directors

Under the new Ordinance, the ambit of disclosure of material interests of a director is widened to cover 'transactions’ and 'arrangements’ instead of just 'contracts’ (Sections 536(1) and (2)). For a public company, the ambit of disclosure is widened to include disclosure by a director of any material interest of entities connected with the director, except that a director is not required to declare an interest if he is not aware of the interest or the transaction in question (Sections 536(2) and (4)(a)). A director is required to disclose the 'nature and extent’ of the interest instead of just disclosing the 'nature' of the interest (Sections 536(1) and (2)). In addition, the disclosure requirements are extended to shadow directors (Section 540).

Requiring ratification of conduct of directors by disinterested members’ approval

The new Ordinance requires the conduct of directors to be ratified by disinterested member's approval to prevent conflicts of interest and possible abuse of power by interested parties (especially majority shareholders) in ratifying the unauthorised conduct of directors. Section 473 of the new Ordinance provides that any ratification by a company of the conduct of a director which amounts to negligence, default, breach of duty or breach of trust in relation to the company must be approved by resolution of the members of the company disregarding the votes in favour of the resolution by the director, any entity connected with the director and any person holding shares of the company in trust for the director or for the connected entity.

Improving the disclosure of corporate information

Requiring directors’ reports to include an analytical and forward-looking 'business review’

The new Ordinance introduces a requirement for directors’ reports prepared by public companies and those companies which are not qualifiedfor simplified reporting to include an analytical and forward-looking 'business review’ whilst allowing private companies to opt out from the requirement by a special resolution. The review should contain, for example, information relating to environmental and employee matters that have a significant impact on the company. The new requirement is in line with the international trend on integrated reporting (Section 388 and Schedule 5).

Disclosure of information on equity- linked agreements

The Companies (Directors’ Report) Regulation (Cap 622D) (the Regulation) introduces a new requirement for a directors’ report to contain information on equity-linked agreements. Under Section 6 of the Regulation, a company is required to disclose in the directors’ report for a financial year all equity- linked agreements entered into by the company in that financial year, and all equity-linked agreements entered into by the company in the past which still subsisted at the end of that financial year. As it is common nowadays for companies to enter into agreements that will or may result in companies issuing shares, and as the issuance of new shares may dilute existing shareholders’ interests, the disclosure of such information will enhance transparency and the protection of shareholders’ interests. Disclosure of reasons for resignation or refusal to stand for re-election of a director Another new requirement introduced in the Regulation is in relation to the disclosure of the reasons for resignation or refusal to stand for re-election of a director. Section 8 of the Regulation provides that if:

• a director of a company has in a financial year resigned from the office or refused to stand for re- election to the office, and
• the company has received a notice in writing from the director specifying that the resignation or refusal is due to reasons relating to the affairs of the company (whether or not other reasons are specified), a directors’ report for the financial year must contain a summary of the reasons relating to the affairs of the company.

The requirement, which does not apply to companies falling within the reporting exemption, seeks to enhance transparency without unnecessarily increasing the burden or compliance costs for companies.

‘Safe harbour’ to encourage meaningful reporting

To encourage meaningful reporting, Section 448 of the new Ordinance provides a 'safe harbour’ so that directors are liable to the company only in respect of loss suffered by it as a result of any untrue or misleading statement if the directors knew, or was reckless as to whether, the statement was untrue or misleading, and in the case of omissions, the director knew the omission to be a dishonest concealment of a material fact.

Clarifying the rules on indemnification of directors

To clarify the scope of the right of directors to be indemnified against liabilities to third parties, the relevant rules on indemnification are provided for under the new Ordinance. With the exception of certain liabilities and costs, such as:

• criminal fines
• penalties imposed by regulatory bodies
• defence costs of criminal proceedings where the director is found guilty
• defence costs of civil proceedings brought against the director by the company or an associated company in which judgment is given against the director, and
• costs of unsuccessful applications to court by the director for relief a company is permitted to indemnify a director against liabilities to a third party if the specified conditions are met (Sections 467 and 469).

Conclusion

The commencement of the new Ordinance marks a new chapter in Hong Kong's corporate regulation. The new Ordinance clarifies the legal provisions concerning the duties of directors in various aspects and introduces more effective rules to deal with directors’ conflicts of interests. It strengthens Hong Kong's status as a major international business and financial centre and reinforces Hong Kong's competitiveness as a place to do business.   Ada Chung, Registrar of Companies Ada Chung will be speaking in session three of the Corporate Governance Conference 2014 on 'Directors' duties’. Her biography is available in the Conference Guide section of this month's journal (see page 28).