INTRODUCTION – Key Changes
The New Companies Ordinance (Cap. 622) (the “New CO”) came into force on 3 March 2014. The previous Companies Ordinance (Cap. 32)(the “Old CO”) has been retitled as the “Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap. 32)”. The core provisions affecting the operation of companies under the Old CO have been repealed, except those provisions relating to winding-up and insolvency of companies and prospectuses.
This note contains a summary of the key changes affecting directors of Hong Kong companies.
|1||Changes affecting directors of HK companies|
|2||Changes concerning share capital, transactions involving share capital and registration of share transfers|
|3||Company administration, procedure and operations|
|4||Registration of charges|
|6||Schemes of arrangement, amalgamations and compulsory share acquisitions|
|7||Abolition of memorandum of association and matters relating to the articles of association|
Part 1 – Changes affecting directors of HK companies
1.1. STANDARD OF DIRECTORS’ DUTY OF CARE, SKILL AND DILIGENCE
New CO references: sections 465 to 466
Position under the Old CO
The Old CO did not contain specific provisions on directors’ duty of care, skill and diligence. General common law and fiduciary duties of directors are based on case law.
Key changes under the New CO
The New CO codifies a director’s duty to exercise reasonable care, skill and diligence.
Section 465 of the New CO requires a director to exercise reasonable care, skill and diligence, meaning the care, skill and diligence that would be exercised by a reasonably diligent person with:
- the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company (an objective test); and
- the general knowledge, skill and experience that the director has (a subjective test).
The new statutory duty applies equally to a shadow director of a company, being a person in accordance with whose directions the directors, or a majority of directors, are accustomed to act. Section 466 retains the existing civil consequences of breach of the duty.
Practical considerations and recommended steps
In carrying out his duties, a director of a Hong Kong company must bring to bear his own general knowledge, skills and experience (the subjective part of the assessment), as well as the knowledge, skills and experience that would reasonably be expected of a director carrying out the same functions (the objective part of the assessment).
If a director has special knowledge, skill or experience, then such director will be subject to a higher standard of care under the New CO compared to a director without such knowledge. Conversely, a director will be expected to meet an objective reasonable standard of care, even if the director is in fact under-qualified for the role.
The New CO does not codify common law fiduciary duties, which remain subject to current case law. These fiduciary duties include the duty to act in good faith in the interests of the company, the duty to exercise powers for their proper purpose, and the duty to avoid conflicts of interest (as explained below, directors are also required under the New CO to disclose material interests in significant transactions of the company). A director may have additional duties and obligations under a company’s articles of association, as well as under the director’s individual terms of engagement. The Companies Registry’s Guide on Directors’ Duties has been revised to reflect the new statutory duty.
Application to Hong Kong listed companies
While section 465 of the Companies Ordinance does not apply directly to the directors of non-Hong Kong companies (i.e. companies incorporated outside Hong Kong), the directors of a non-Hong Kong company which is listed on the Hong Kong Stock Exchange must comply with it since they are required by Listing Rule 3.08 to exercise duties of skill, care and diligence to the standard set by Hong Kong law. It should also be noted that the Exchange’s Guidance Letter HKEx-GL62-13 was recently revised to state that listed company directors are expected to comply with the Companies Registry’s Guide on Directors’ Duties and that failure to do so may constitute a breach of the Listing Rules (at paragraph 2.8).
1.2. The concept of “responsible person”
A number of offences under the Old CO applied not only to the company but also to officers of the company who were in default. This is also the case under the NCO, but the concept of “responsible person” has replaced that of “officer in default” under the OCO. The effect is to lower the threshold for a breach or contravention of provisions of the ordinance.
Under the OCO, an officer of a company who is in default, amongst others, is liable to punishment in respect of offences committed by the company. “Officer in default” was defined under section 351(2) of the OCO as:
- any officer or any shadow director of the company;
- who knowingly and willfully authorises or permits the default, refusal or contravention of the relevant provisions.
Section 3(2) NCO defines a “responsible person” of a company or non-Hong Kong company as an officer (i.e. a director, manager or company secretary) or shadow director of the company or non-Hong Kong company who “authorises or permits, or participates in, the contravention or failure”.
Section 3(3) extends the scope of a “responsible person” to cover an officer or shadow director of a body corporate that is an officer or shadow director of a company or non-Hong Kong company.
There are three key differences between the definitions of “officer in default” and “responsible person”:
- the definition of “responsible person” is wider so that if the officer or shadow director is a body corporate (which includes both Hong Kong and non-Hong Kong companies), the officers and shadow directors of that body corporate are also responsible persons;
- the scope of the offence has been expanded to include “participation” in the contravention, such that omissions or assistance to others in committing offences by officers and shadow directors are also included;
- the definition of “responsible person” removes the mental element of “knowingly and willfully” so that reckless acts and omissions by officers will also be covered
The following are examples of offences under the New Ordinance for which every responsible person of the company is punishable upon conviction:
- failure to provide information to the Companies Registrar;
- failure to notify or register with the Companies Registrar in respect of alteration of the company’s articles, change of the company’s name, return of allotment, alteration of share capital etc.;
- reduction of share capital;
- acquisition of own shares;
- financial assistance by the company or its subsidiaries for the purchase of its own shares;
- breach of requirements in relation to financial statements and reporting documents;
- breach of requirements in relation to company’s auditors
Following the introduction of the new concept, it is likely that the Companies Registry will institute more prosecution actions against directors, managers and company secretaries for infringements of the New Ordinance.
1.3. RATIFICATION OF DIRECTOR’S CONDUCT
New CO reference: section 473
Position under the Old CO
There was no specific provision in the Old CO on shareholder ratification of director’s conduct. Under common law, shareholders can ratify breaches by directors of their fiduciary duties. Ratification means that the company is barred from bringing actions against the director for damages arising from the ratified breach (although a dissenting minority shareholder may still be able to pursue an unfair prejudice or statutory derivative claim). Ratification can give rise to potential conflicts of interest where a majority shareholder is also a director, or is otherwise connected to a director.
Key changes under the New CO
The New CO requires that any ratification by a company of a director’s (including a shadow director’s) conduct amounting to negligence, default, breach of duty or breach of trust in relation to the company must be approved by a resolution of disinterested shareholders.
For the purpose of ratification, votes in favour of the resolution of the following categories of shareholders are to be disregarded:
- a director of the company whose conduct is to be ratified;
- an entity connected with that director; or
- a holder of any shares in the company in trust for that director or connected entity.
If none of the shareholders are disinterested, then approval must be by unanimous consent of all shareholders.
Practical considerations and recommended steps
The independent ratification requirement should provide a more preventative protection for minority shareholders, compared to statutory derivative or unfair prejudice remedies, which would normally be taken by a dissenting minority shareholder after a breach has already occurred. At the same time, the new rule should not impact significantly on small companies that normally take shareholder decisions by way of unanimous written consent.
1.4. LIABILITY AND INDEMNIFICATION OF DIRECTORS
Exempting directors from liability to the company
Any provision which purports to exempt a director from liability owed to the company where there has been negligence, default, breach of duty or breach of trust by the director in relation to the company is void under Sections 468(1) & (2) of the New Ordinance.
Indemnifying directors against liability to the company / an associated company
Similarly, any provision which indemnifies a director of the company, or a director of an associated company of the company, against liability owed to the company or an associated company where there has been negligence, default, breach of duty or breach of trust by the director in relation to the company or associated company is void under Section 468(3) of the New Ordinance.
The definition of “associated company” in the New CO is identical to that of “related company” in the Old CO, which it replaces, and means a company’s subsidiaries, holding companies and subsidiaries of such holding companies.
Indemnifying directors against liability to third parties
There were no specific provisions in the Old CO regulating a director’s right to be indemnified against liabilities owes to third parties. The scope of the right of directors to be indemnified against liabilities to third parties, which had developed in case law, was not clear.
The New CO clarifies the rules on indemnification of directors against liabilities to third parties (i.e. parties other than the company or its associated companies). Section 469 permits a company to indemnify a director against liability incurred by the director to a third party provided that the indemnity does not relate to:
- criminal fines;
- regulatory penalties;
- defence costs of criminal proceedings in which the director is convicted;
- defence costs of civil proceedings brought by or on behalf of the company and in which judgment is given against the director.
Common law continues to govern any potential indemnities that fall outside the statutory prohibitions and exclusions described above.
A company which provides any permitted indemnity to its or its associated company’s directors must disclose the indemnity provision in the directors’ report under section 470 of the New CO. It must also keep a copy of any permitted indemnity at its registered office until one year after its expiry and make it available for inspection by members on request (sections 471 and 472 of the New CO). Failure to retain copies of permitted indemnities at the registered office is an offence for which the company and its responsible persons may be fined.
Purchase of Directors’ Insurance
The New Ordinance does not prohibit a company from purchasing insurance for directors and the Model Articles envisage that directors can be insured against liability in certain situations. Article 32 of the Model Articles (Article 36 for public companies) provides that a company may, at the expense of the company, purchase insurance for a director of the company against:
- primary liability: a director’s liability to any person in connection with any negligence, default, breach of duty or breach of trust (except for fraud) in relation to the company or an associated company;
- costs of proceedings: a director’s liability in defending any proceedings (civil or criminal) for any negligence, default, breach of duty or breach of trust (including fraud) in relation to the company or an associated company.
For listed companies, paragraph A.1.8 of Appendix 14 (Corporate Governance Code and Corporate Governance Report) of the Hong Kong Listing Rules requires a listed company to arrange appropriate insurance cover in respect of legal action against its directors. Compliance with this code provision is not mandatory, but a listed company would need to explain the reasons for any non-compliance in its annual report.
Practical considerations and recommended steps
Companies and their directors should review the scope of any indemnities granted to directors to see if these should now be extended to cover indemnification against third party liabilities.
Although the New CO prohibits a company from exempting or indemnifying a director from liability for negligence, default, breach of duty or breach of trust by the director in relation to the company, it does not prohibit a company from taking out insurance for directors of the company and/or its associated companies against such liabilities (except for fraud) to the company or an associated company. Therefore, any existing directors’ and officers’ (D&O) insurance policies should also be reviewed to see if coverage should be extended.
Permitted exemptions from liability, indemnities for liability to a third party and any undertaking to take out D&O insurance should be clearly set out in a director’s service contract, even if the company’s articles already include standard exemption, indemnification and insurance wording. The articles are a contract between the company and the shareholders, so a director would have difficulty enforcing an exemption, indemnity or undertaking contained only in the articles. Hong Kong courts have also been reluctant to imply provisions from a company’s articles of association into the terms of appointment of a director, particularly if there is a contract between the director and company that is expressed to constitute the entire agreement between the parties. A director should therefore ensure that any provisions in the articles on which he wishes to rely should be expressly incorporated into the terms of the director’s engagement.
The scope of any director indemnity should also be considered, in particular whether it covers only liabilities arising from the performance of the director qua director, or in other capacities (for example, as chief financial officer) or in a personal capacity.
Copies of permitted indemnity provisions to directors must be kept at the company’s registered office and made available free of charge upon request by a member of the company.