Hong Kong Stock Exchange Unveils Red Flags in Questionable Loans and Lending Arrangements and Latest Enforcement Priorities

On April 30, 2024, the Hong Kong Stock Exchange (HKEX) published the April 2024 edition of its Enforcement Bulletin, which summarizes its latest key findings on listed issuers’ common misconduct in loans, advances, and other similar arrangements; provides practical tips to ensure compliance with the Hong Kong Listing Rules (Listing Rules); and highlights its key areas of focus when investigating lending activities.

Rising misconduct in relation to lending activities

The HKEX has in recent years increasingly investigated loans, advances, and other lending arrangements made by listed issuers, which were often brought to its attention due to significant impairments to the issuers’ assets or inquiries raised by the issuers’ auditors. Some common red flags include:

Recent disciplinary actions by the HKEX on lending activities–related misconduct

Practical tips for handling loan arrangements

The HKEX reiterates that (i) compliance with directors’ duties, (ii) internal controls, and (iii) compliance with disclosure obligations remain their key areas of focus when investigating loans, advances, and other similar arrangements. Listed issuers and their directors should proactively see to the following principles when granting, extending and renewing, and considering auditing and reporting issues of loans:

1. Legitimate commercial rationale — Directors are expected to critically evaluate the loan arrangements and to ensure that there is a legitimate commercial rationale, the terms are fair and reasonable, and it is in the best interest of the issuer.
2. Risk management — Before granting the loan, proper due diligence of both the borrower and its creditworthiness as well as assessment of the risk of default, overall recoverability, and enforceability of any underlying security have to be made. After granting the loans, it is essential to regularly review and monitor the loan portfolio, which includes the status of any payment due. In cases of default, proactive remedial measures (e.g., requesting for additional security, issuing demands, and commencing legal action) should be taken to minimize risks and maximize potential recovery.
3. Effective lending-related internal controls — Loans have to be properly vetted and approved. There should be adequate checks and balances, segregation of duties, and an effective monitoring system to prevent any individual from having unfettered decision-making authority over approval of loans or advances. If the loan is made by a subsidiary, the subsidiary has to properly report to the issuer to allow the issuer’s board of directors to properly monitor the loan.
4. Recordkeeping — There should be proper records documenting the commercial assessment, risk management and approval process for the HKEX’s vetting and scrutiny in the event of an investigation.
5. Listing Rules compliance —

1. Disclosure obligations — Issuers should see to their obligations under the Listing Rules, including making timely disclosures, renewing size test calculations, and obtaining shareholders’ approval where applicable, not least (i) when the amount is significant, (ii) when it may constitute a connected transaction, or (iii) when the loan may fall under the definition of an “advance” or “financial assistance” and trigger obligations under Chapter 13 of the Listing Rules. In particular, the HKEX emphasized that renewal/extension of a loan is seen as a new transaction, and issuers should comply with the applicable Listing Rules requirements.
2. Timely and accurate reporting — Issuers have to ensure that any disclosures in financial statements and announcements concerning its assessment of the recoverability and impairment of the loan receivables are accurate and complete in all material respects and are not misleading or deceptive.

Cooperation with other regulators

We drew attention to the latest joint enforcement efforts among Hong Kong’s securities regulators in our updates on March 15, 2024, and April 29, 2024. The HKEX have again emphasized that it will continue to collaborate with other regulators and law enforcement agencies, including the Securities and Futures Commission (SFC), the Accounting and Financial Reporting Council (AFRC), and the Commercial Crime Bureau of the Hong Kong Police, in conducting investigations into potential misconduct.

Other recent HKEX enforcement cases

As summarized in the Enforcement Bulletin, the HKEX concluded 14 disciplinary actions in the second half of 2023 in which director unsuitability statements were made against 12 directors, prejudice to investors’ interests statements were made against eight directors, and five cases involved settlements. These cases commonly involved, among others, failure by directors and senior management to actively safeguard the relevant listed issuer’s assets.

As highlighted in the HKEX’s publication “A Snapshot of INEDs’ Roles and Responsibilities” in November 2023, the HKEX stressed that INEDs have various responsibilities under the Listing Rules and the Corporate Governance Code as well as a crucial supervisory role in overseeing the listed issuer’s risk management and internal controls. This is consistent with the SFC’s recent enforcement efforts in obtaining a three-year disqualification order against a former INED of China Candy Holdings Limited in respect of the issuer’s financial arrangements and reporting issues (see our case commentary in December 2023). INEDs should therefore closely observe their ongoing directors’ duties, including to exercise independent judgment and proactively and diligently scrutinize, inquire, and verify the listed issuer’s financials.

Commentary

1. This Enforcement Bulletin serves as a firm reminder to listed issuers and their directors that the use of company assets, comprising public investors’ funds, remain under close scrutiny by regulators and any failure in safeguarding the listed issuer’s assets will likely result in enforcement action.
2. The HKEX emphasized that questionable lending arrangements remain one of its areas of focus for surveillance and enforcement efforts. Notably, the HKEX would investigate suspicious arrangements notwithstanding there being apparent compliance with the relevant disclosure and approval requirements under the Listing Rules. Significant overdue debts, material asset impairments, and questions raised by auditors concerning lending arrangements (e.g., lack of proper internal approvals, evidence of transfers) will continue to be key indicators that may trigger scrutiny from the HKEX, including as part of the HKEX’s thematic review of issuers’ annual reports.
3. Directors should be mindful of their duties and obligations under the Listing Rules and ensure that due consideration is given to the commercial rationale and the associated risks of a proposed transaction involving loans, advances, or other money-lending arrangements. Based on our experience, the HKEX particularly focuses on and looks closely at the directors’ decision-making process in assessing and approving the lending arrangements. The onus is on the directors to produce documentary evidence to demonstrate that proper steps have been taken and in accordance with established internal controls and processes, and in line with the disclosure and other requirements under the Listing Rules. Listed issuers should critically consider and review any existing or contemplated lending arrangements in light of the HKEX’s expectations and shore up any potential deficiencies in their existing practice.
   
4. Finally, listed issuers, directors, audit committees, and auditors should also be reminded that aside from the HKEX taking a close interest in the lending practices of issuers, the SFC and the AFRC are also monitoring their conduct and practices concurrently, as indicated in the Joint Statement of the SFC and AFRC in July 2023. Therefore, any non-compliance with the requisite requirements may result in parallel investigations followed by multiple disciplinary actions and sanctions in the prevailing regulatory environment.