Introduction

In the recent case of Miu Hon Kit & Ors v The Stock Exchange of Hong Kong Ltd [2020] HKCFI 675, the non-executive directors (the “NEDs”) and the independent non-executive directors (the “INEDs”) of Kong Sun Holdings Limited (“Kong Sun”), a company listed on the Main Board of the Stock Exchange of Hong Kong Limited (the “SEHK”), applied for judicial review of the decision of the Listing Appeals Committee of the SEHK to impose the sanction of public censure on them. The applications were dismissed by the Court of First Instance (the “CFI”).

Background

The chief operating officer (“COO”) and the financial controller (“FC”) of Kong Sun authorised Kong Sun and its subsidiaries (together, the “Group”) to issue around RMB1.523 billion worth of loans to Zhongke Hengyuan Technology Co Ltd and its subsidiaries (together, the “Zhongke Group”) without the approval from the board of directors of Kong Sun (the “Board”) between 26 November 2014 and 15 March 2016 (the “Pre-March Loans”). The Pre-March Loans were interest free, not secured with collaterals and without fixed term of repayment. In a board meeting on 15 March 2016 (the “March Board Meeting”), the Board became first aware of the Pre-March Loans, which should have been subject to disclosure and shareholders’ approval requirements as “major transaction” and “an advance to an entity”, and thereafter instructed the COO, FC and chief financial officer (“CFO”) of the Group to cease all loans to Zhongke Group. No other further action or disciplinary action was taken to prevent the COO and FC from authorising further loans. The COO and FC continued to make further loans to Zhongke Group in the amount of around RMB84.72 million without the Board’s knowledge and approval between 18 March 2016 and 11 May 2016 (the “Post-March Loans”). Kong Sun failed to publish announcement and the financial reports of 2015 and 2016 in a timely manner and failed to seek shareholders’ approval of both the Pre-March Loans and the Post-March Loans (together, the “Loans”).

On 21 December 2017, the Listing (Disciplinary) Committee of the SEHK (the “LDC”) found that the NEDs and the INEDs (who also formed the audit committee) of Kong Sun had breached Rule 3.08(f) of Rules Governing the Listing of Securities on the SEHK (the “Listing Rules”) and their directors’ undertaking contained in Part 2 of Appendix 5 to the Listing Rules (the “Undertakings”) by failing to perform their duties as a director with reasonable skill, care and diligence and to:

1.        use their best endeavours to procure Kong Sun to comply, and themselves comply, with the Listing Rules in relation to (a) Kong Sun’s breaches with respect to the Loans, and (b) the publication of the financial reports within the specified time limits (the “Specific Breaches”);

2.        take sufficient or effective action to stop the COO and FC from authorizing further loans to the Zhongke Group after the Board had become aware of the Pre-March Loans (the “Prevention Failure”);

3.        ensure that Kong Sun had established and maintained effective and appropriate internal control procedures and risk management systems (the “ICRM system”) particularly when the COO and FC were given immense power over Kong Sun’s operations and funds (the “Internal Control and Risk Management Failure”); and

4.        ensure that Kong Sun’s staff had received adequate and appropriate training with respect to the Listing Rules (the “Training Failure”).

As such, the LDC imposed the sanction of public censure on each of the NEDs and INEDs but they requested for a review of the decision of LDC. On 6 June 2018, the Listing (Disciplinary Review) Committee of the SEHK (the “LRC”) upheld the decision of the LDC. The NEDs and INEDs requested for a further review of the LDC’s decision. On 23 January 2019, the Listing Appeals Committee of the SEHK (the “LAC”) also upheld the decision of LRC and conveyed the same by way of letter together with a copy of news release approved by the LAC to the lawyers of the NEDs and INEDs. The NEDs and INEDs applied for a judicial review of LAC Decision on the ground that, among other things, (a) the LAC failed to give adequate reasons for their decision; (b) there is an error of law and (c) the INEDs and NEDs suffered procedural unfairness.

Decision

No failure to give reasons

The INEDs argued that the LAC’s letter only set out what it had considered and its conclusion. There was no reasoning whatsoever, including the reasoning as to the legal approach in assessing the director’s responsibility. The CFI concluded that the reasons given by the LAC were proper and adequate. It considered that the letter and news release sent to the lawyers of the NEDs and INEDs should be treated and read together as constituting the entirety of the reasons for the LAC’s decision. In the news release, it was expressly stated that the LRC upheld the decision of the LDC, and the LAC upheld the decision of the LRC, and thus the CFI considered it to be clear that the LAC must, in the circumstances, have upheld and endorsed the decision of the LDC, including both the findings of breach and the reasons for those findings.

The INEDs argued that the LAC had not engaged the core issues raised by the INEDs, including but not limited to (1) the INED’s duty may be materially different from other members of the Board and (2) nothing shows that the Board’s order that the loans should cease would not be carried out or would be ineffective. The NEDs argued that the LAC failed to show it had considered the appropriateness of the sanction given their different individual knowledge and involvement. The CFI considered none of these issues would have affected the LAC’s conclusion and made the following remarks:

1.        the INEDs constituted the audit committee which was specifically responsible for, among other things, reviewing and monitoring the risk management and internal control principles, supervising the ICRM system, and reporting and making suggestions to the Board in relation to any material issues. The degree of care, skill and diligence reasonably to be expected of the INEDs to see that Kong Sun has established and maintained a proper ICRM system was at least as high as, if not higher than, that of the NEDs and executive directors;

2.        when the Board first learned of the unauthorised Pre-March Loans, any reasonable directors should immediately be concerned with: the (i) recovery of the loans, (ii) prevention of further unauthorized loans, and (iii) investigation of how the unauthorized loans came to be made and review of any deficiencies in the ICRM system; and

3.        although the NEDs were not members of the audit committee, their director’s duty must at least include a duty to see that proper ICRM systems were established and maintained. The LDC’s findings that Kong Sun did not have adequate ICRM systems, and that the Board failed to ensure that Kong Sun had established and maintained effective and appropriate ICRM systems are justified and cannot be faulted.

No error of law

The INEDs argued that the LAC erred in applying hindsight and failing to ask the right questions when assessing whether there is a breach of duty. The NEDs argued that the LAC erred in adopting a collective responsibility approach and imposing sanctions without considering individual circumstances of each director.

The CFI did not see that, the particular knowledge, skill, or experience of the INEDs/NEDs, required separate consideration. The Internal Control and Risk Management Failure and the Training Failure were systemic failures for which all the directors were individually responsible, and the Specific Breaches were consequences of those systemic failures. Regarding the Prevention Failure, all directors had the same relevant knowledge at the March Board Meeting. The measure taken by them to prevent the recurrence of further unauthorised loans was so obviously inadequate that no reasonable director could have considered that it was sufficient in the circumstances.

The CFI also considered the absence of written internal control procedures was itself a significant deficiency of Kong Sun’s ICRM systems. The public censure sanction, which serves to punish the wrongdoers, alert investors and communicates to the market the standards of conduct required by the SEHK, imposed on the NEDs cannot be considered as severe.

No procedural unfairness

It is argued that the INEDs and NEDs were never fairly and properly informed of the true allegations against them. The basis of the case against the INEDs and NEDs, as revealed in the Listing Department’s Report (“LD Report”), were different from the basis of the findings made by the LDC/LRC/LAC.

The CFI analysed the content of the LD Report and considered that there is no procedural unfairness as alleged. In any event, the INEDs and NEDs had full notice of the allegations made by the Listing Committee and they had challenged the same at the hearings before the LRC and LAC. Each tier involved a new hearing on the merits. Further, the patently inadequate measure adopted by the INEDs and NEDs would inevitably lead to the LDC/LRC/LAC’s conclusion that they had failed to take sufficient or effective action, or pro-active action with heightened awareness, to ensure there would be no further breaches.

Lessons for directors

While it is understandable that (independent) non-executive directors might be uncertain about their duties in a company, the Court had once again reminded them of their role to establish and maintain a proper system of internal control and risk management in the Company. As this case demonstrates, delegation of responsibility to senior management would not absolve the directors from their responsibilities. They should not be a passive or “rubber stamp” board but should take an active approach to oversee or rectify the Company’s internal compliance procedures and deficiencies.