Transactions under negotiations – at what stage should directors disclose inside information?

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Introduction

On 18 March 2020, the Market Misconduct Tribunal (“MMT”) found that Magic Holdings International Limited (“Magic”), a listed company in Hong Kong, and five of its directors failed to disclose inside information as soon as reasonably practicable on L’Oréal S.A.’s (“L’Oréal”) proposed acquisition of Magic in 2013 (the “Proposal”), as required by section 307B of the Securities and Futures Ordinance (Cap. 571) (“SFO”), which provides that a listed corporation must, as soon as reasonably practicable after any inside information has come to its knowledge, disclose the information to the public.


What is inside information?

Pursuant to section 307A of the SFO, the concept of inside information comprises three key elements:

(1)   the information about a particular corporation must be specific;

(2)   the information must not be generally known to that segment of the market which deals or which would likely deal in the corporation’s securities; and

(3)   the information would, if so known be likely to have a material effect on the price of the corporation’s securities.

 

In layman’s term, it has to be a piece of specific information, which is not known to the public and is price sensitive.


Safe harbours

Section 307D of the SFO sets out the “safe harbour” provisions which permit a corporation to withhold disclosure of inside information under specified circumstances. In respect of information of an incomplete proposal or negotiation, a corporation may withhold disclosure if the corporation takes reasonable precautions for preserving the confidentiality of the information and the confidentiality of the information is preserved.

The corporation needs to ensure that knowledge of information is restricted to those who need to have access to it and that recipients of the information are aware that the information is confidential and recognise their obligations to maintain the information confidential. Where the information has not been kept confidential or there has been a leak, whether intentionally or inadvertently, these conditions will not be fulfilled and any “safe harbour” will no longer apply.


Did the inside information come to the knowledge of Magic?

Whilst the MMT accepted that Magic and L’Oréal had several rounds of discussion relating to the Proposal since early March 2013, it found that there was no substantial commercial reality to such negotiations prior to 27 April 2013 which were mere exploratory testing of the waters and which was not at a concrete stage where the parties intend to negotiate with a realistic view to achieving an identifiable goal. Inside information however emerged in the meeting among the three founders of Magic, L’Oréal and its financial adviser on 27 April 2013 (the “27 April Meeting”) where L’Oréal proposed the preliminary offer price per share, and incurred and prepared to commit significant resources in negotiation and due diligence.

The MMT rejected the argument that the founders attended the 27 April Meeting for their personal interests as shareholders, and drew inference from the circumstantial evidence that the founders had confirmed to L’Oréal at the 27 April Meeting that they would meet the institutional investors to inform them of the Proposal. Accordingly, the MMT was satisfied that the founders made arrangements for and then conducted meetings with the institutional investors as officers of Magic. However, the Proposal was not announced to the public until 15 August 2013, when L’Oréal and Magic issued a joint announcement.


Was Magic permitted to withhold disclosure?

The MMT found that the confidentiality of the inside information was not preserved and that the Proposal had likely been leaked to the public, as suggested by (i) enquiries made by some investment analysts as to the Proposal in mid-April 2013; and (ii) the significant but unexplained rise in Magic’s share price from its close of HK$4.00 on 26 April 2013 to HK$4.85 on 8 May 2013.

When questioned about the measures taken to monitor confidentiality, Magic claimed that it had collated information of the price and volume of trading in Magic’s shares and there would be discussions among the board of directors upon noticing share price fluctuation. However, the sample collated materials provided by Magic merely identified the shareholdings held by each shareholder at the relevant times and did not contain any indication of the trading price of Magic shares. Executive directors would not be able to rely on the materials to monitor Magic’s share price movements or the overall movement of turnover in Magic shares during the stipulated period.

Further, although Mr Chris Cheng (“Mr Cheng”), an executive director, and Mr Stephen Tang (“Mr Tang”), one of the founders and executive directors, noticed the share price of Magic had an upward trend and an increased volume after 15 April 2013, they did not escalate the information to other founders or executive directors. As such, given the significant rise in price of trading in Magic shares on and between 26 April and 8 May 2013, the MMT concluded that Magic had not taken reasonable measures to monitor the confidentiality of the inside information and was not made aware of any information which indicated that confidentiality had not been preserved.

Thus, the MMT concluded that Magic failed to disclose inside information to the public as soon as reasonable practicable after being aware that confidentiality of the information had not been preserved.


Liability of the directors

Whether the directors were negligent which led to Magic’s breach?

The MMT was of the view that Mr Cheng and Mr Tang failed to disclose to other directors and their legal adviser as to the information relevant to the movement in price and volume of trading in Magic shares, which included enquiries from investment analysts made to Magic in mid-April 2013. Further, the MMT considered that the notice of the upcoming board meeting to be held on 24 May 2013 was deficient and significantly incomplete as it did not cover any discussion of disclosure obligations. As such, Mr Cheng and Mr Tang failed to exercise the skill and diligence required of them in carrying out their functions as directors and chairman and company secretary of Magic respectively, contrary to section 307G(2)(a) of the SFO.


Reasonable measures taken by directors to prevent breach of disclosure

Concerning the issue whether the board of directors of Magic had ensured proper safeguards existed to prevent the breach of Magic’s disclosure requirements, the MMT took into account the different roles of executive and non-executive directors (“NEDs”). Given the above findings, the MMT considered that Magic’s breach of its disclosure requirement was caused by the fact that the directors were not informed timeously of all information in relation to the disclosure of information to the public. Apart from the capability of Mr Cheng and Mr Tang as discussed above, other executive directors had failed to take reasonable measures by simply abdicating the responsibility for regulatory compliance to Mr Cheng and Mr Tang.

The MMT considered Mr Dar Chen and Mr Thomas Yan, a NED and independent non-executive director (“INED”) of Magic respectively, had taken necessary and sufficient steps as they proactively raised the concern to the board of directors as to whether there are sufficient systems and procedures to prevent a breach of Magic’s disclosure requirements and made relevant recommendations to address the concerns.

The MMT considered that since Professor Yang Rude and Professor Dong, who were INEDs, were appointed to bring their skill and knowledge as academic research scientists to Magic, they were entitled to place trust in and reliance on the experience and professionally qualified executive directors in relation to matters of regulation and compliance, therefore MMT concluded that they were not liable under the SFO.

Contrastingly, Mr Sun Yan, a NED of Magic, was a highly experienced businessman who had been the managing director and chairman in companies in the Mainland for many years. The MMT considered that he should have taken measures to ensure Magic has proper safeguards to prevent the breach of disclosure requirement and he should not have solely relied on the executive directors to address issues of compliance with Part XIVA of the SFO.


Conclusion

The consequential orders of the MMT’s findings are scheduled to be decided on a subsequent hearing. In light of the MMT’s report, directors should ensure adequate and transparent internal control system is in place to safeguard compliance with disclosure obligations under Part XIVA of the SFO, and review such system regularly. Very often, it is only a lapse of weeks or even days that can lead to a breach of the disclosure requirements. In the event that directors are in hold of inside information or are aware of circumstances suggesting inside information may be leaked, they should consult legal advisers immediately as to the necessary courses of actions to be taken.

 

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Important: The law and procedure on this subject are very specialised and complicated. This article is just a very general outline for reference and cannot be relied upon as legal advice in any individual case. If any advice or assistance is needed, please contact our solicitors.
Published by ONC Lawyers © 2020