Joint Collaboration Between Hong Kong’s Securities Regulators Targeting Dubious Financial Arrangements

April 2024 sees another instance of joint enforcement action by the Stock Exchange of Hong Kong Limited and the Securities and Futures Commission in targeting dubious financial arrangements perpetrated by the executive directors of a Hong Kong listed company. This case highlights the importance for the directors of listed issuers to comply with their directors’ duties to act in good faith and in the best interest of the company, particularly in the handling of financial arrangements concerning loan transactions.

Background

On March 15, 2024, we shared our Update on the joint collaboration of The Stock Exchange of Hong Kong Limited (Exchange) and the Securities and Futures Commission (SFC) in their enforcement efforts in combating IPO-related misconduct. Now a month later, there is another instance of joint enforcement action by the regulators.

On April 25, 2024, the Exchange issued a Statement of Disciplinary Action (Statement) against China Ecotourism Group Limited (stock code: 1371) (Company) and seven of its serving and former directors concerning misconduct in the Company’s transactions. The Exchange criticized the Company, and a “Prejudice to Investors’ Interests Statement” was issued against an executive director (ED) (namely Wu Jing Wei (Wu)) and two former EDs (namely, Chan Tan Na Donna (Chan) and Lau Ting (Lau)); meanwhile, a public censure was made against them as well as another former ED and other serving and former independent non-executive directors found to be involved in the transactions (collectively, Directors).

Upon reviewing the Company’s annual results for the year ended December 31, 2019, the Exchange was alerted to the Company’s substantial impairments related to (i) various loans (Loans), which its group companies had advanced to borrowers between 2014 and 2018 purportedly for developing its business in China and the Philippines, and (ii) its subsidiary’s HK$35 million subscription (Acquisition) of 37.5% shares in a company (Acquired Company) in 2018 purportedly for facilitation of the Company’s future business plan. 

The Exchange referred these observations to the SFC, whose investigation identified (among other findings) the following failures on the part of the Company and the Directors.

The Loans

1. The Company had failed to perform proper due diligence, properly analyze the underlying credit risks, and assess whether the intended business projects would likely lead to a meaningful outcome. The Company also failed to monitor that the loan proceeds were applied to the original intended purpose.
2. Shortly after the drawdown, certain proceeds were transferred to parties connected with Chan’s husband and with Lau and her ex-husband. Some transfers constituted connected transactions under the Listing Rules. However, the Company failed to comply with the applicable disclosure requirements.
3. All borrowers eventually defaulted on repayments, but the board of directors still nevertheless informed the auditors that the Loans were fully recoverable and suggested that no impairment was required during each financial year from 2014 to 2017. In the financial years ended in 2018 and 2019, the Company finally recognized the impairment loss on the Loan receivables and attributed it to adverse changes in government policy and the coronavirus outbreak.

The Acquisition

1. Upon completion, the subscription price for the shares in the Acquired Company was not paid to its parent company but to a third party, which then transferred the sum in part to Chan’s husband. Meanwhile, although the subscription agreement provided that upon half payment of the total consideration the Acquired Company had to issue and allot shares to the Company’s subsidiary and procure the appointment of Chan as its director, these actions did not take place, rendering the Acquisition a failure.
2. While the Company included a full impairment provision for the Acquisition in its 2019 financial statements, it did not announce the details until August 31, 2020.

Breaches

The Exchange concluded that the Company and the Directors had committed the following breaches:

1. Inadequate internal controls — The Company did not have adequate and effective internal controls to protect its assets and ensure compliance with the Listing Rules (including disclosure requirements for notifiable and connected transactions). The Company’s investment policy for potential business opportunities also lacked guidelines on record keeping and due diligence requirements.
2. Breach of the Listing Rules by the Company — The Company had failed to seek independent shareholders’ approval, publish announcements and circulars, and disclose relevant information in annual reports, in respect of the transfers in question.
3. Breach of Directors’ Duties and the Listing Rules — The Directors had breached their (i) directors’ duties under Rule 3.08 and (ii) directors’ undertakings to comply with the Listing Rules to the best of their ability and to use their best endeavors to procure the Company’s compliance with the Listing Rules. In particular, they had failed to:

1. arrange for sufficient due diligence, risk analysis, or credit assessment and conduct ongoing monitoring of the Loans and the Acquisition;
2. discharge their responsibility (in compliance with their undertakings) to ensure the Company’s compliance with the Listing Rules, including on public disclosure;
3. properly make impairment provisions for bad debts and allowed misrepresentations to be made to the auditors in respect of the recoverability of the Loans;
4. ensure that the former EDs were in compliance with their fiduciary duties toward the Company, including the duty to avoid conflicts of interest;
5. exercise independent judgment and due skill, care, and diligence in scrutinizing and approving the Company’s financial statements when confirming that no impairment was required; and
6. discharge their collective and individual duty to maintain adequate and effective internal controls and a risk management system.

While the Exchange has imposed sanctions against the relevant parties, the SFC’s investigation remains ongoing, and the SFC may take further enforcement action.

Implications and Takeaways

This case is another noteworthy example of the increasingly close regulatory collaboration among Hong Kong’s securities regulators as they look to uncover and combat financial misconduct perpetrated by senior managers and directors of Hong Kong listed companies through strategic coordination. It is particularly interesting to note the following:

1. In this case, the initial discoveries were made by the Exchange in the course of considering the Company’s annual results, which spurred a referral to the SFC for further investigation. Highly relevant fund tracing information and other evidence were uncovered during the SFC’s investigation, which were then shared with the Exchange.
2. This case once again demonstrates that the Exchange and the SFC are becoming much more synchronized in deploying their respective investigation powers to more effectively secure actionable evidence for enforcement action.
3. More generally, the process plays well into each regulator’s particular agenda and strengths:
   1. The Exchange has oversight of the annual financial reporting process of Hong Kong listed companies, and any audit issues, suspicious transactions, or unusual activities can be referred to the SFC for further investigation.
   2. The SFC can deploy its considerably wide statutory powers to compel the production of documents and evidence from the targets of the investigation, including materials that may not be readily available to the Exchange.
   3. The close sharing of such evidence between the SFC and the Exchange then facilitates the respective regulatory investigations.

Under this backdrop of greater strategic coordination in the investigative approach adopted by the securities regulators, it is even more paramount for Hong Kong listed companies and their directors to maintain high corporate governance standards and ensure that there are reliable internal controls and systems in place to detect and deter misconduct and misappropriation of company assets.

Furthermore, the following are worth noting:

1. The regulators drew specific attention to the Joint Statement issued by the SFC and the Accounting and Financial Reporting Council on July 13, 2023, which addressed the issue of targeting misconduct in relation to loans, advances, prepayments, and similar arrangements made by Hong Kong listed companies, as well as the Exchange’s ongoing thematic reviews. The present enforcement case therefore falls squarely within the regulators’ enforcement priorities, and it is expected that they will continue to scrutinize such matters in the future to identify and penalize similar misconduct.
2. Listed issuers are required to have adequate internal control systems to ensure that loan transactions are subject to effective vetting, risk assessment, due diligence, and approval process. There should also be effective measures in place for monitoring repayments and assessing impairments with proper disclosure in financial statements.
3. Directors of the listed issuers have a duty to safeguard the company’s interests and assets. They should exercise independent judgment and stay vigilant in monitoring the financial affairs of the listed issuer to ensure compliance with the Listing Rules.
4. This case serves as a reminder that all directors, including the independent non-executive directors who sit on audit committees, are held to their individual and collective responsibility to ensure (a) the issuer’s compliance with the Listing Rules (including disclosure obligations) and (b) the directors’ compliance with their fiduciary duties and duties of skill and care. Directors, particularly the audit committee, should ensure that accurate management representations are provided to the auditors. They should exercise independent judgment and closely scrutinize the information provided to the auditors. The Exchange has demonstrated that they will have low tolerance for directors who fail to meet the requisite standards and would not hesitate to impose severe sanctions upon discovery of breaches and misconduct.