Briefing on the new Hong Kong Companies Ordinance and its Impact on Directors’ duties and liabilities

by Publications Officer

Peter Gregoire
General Counsel, AIG Insurance Hong Kong Limited

The new Hong Kong Companies Ordinance (CAP. 622) (“New Ordinance”) which came into force on 3rd March 2014, seeks to provide a modernized legal framework for Hong Kong companies. The objectives of the New Ordinance are to enhance corporate governance, ensure better regulation, facilitate business and modernize the corporate legal framework.

The New Ordinance impacts and clarifies:
• the duties of care which company directors owe at law;
• the extent to which directors can be indemnified by their company for their liabilities; and
• the ability of a company to buy insurance covering directors against these liabilities.

As a result, Hong Kong companies should review the indemnity provisions in their articles of association and their Directors and Officers (“D&O”) insurance requirements in light of the New Ordinance (a practice which, it is recommended, should be completed on a regular basis in any event). This briefing is written with such review in mind.

A. DIRECTORS’ LEGAL OBLIGATIONS AND PERSONAL EXPOSURE TO LIABILITY

Why do company directors need protection by way of company indemnities and insurance?

The simple answer is that being appointed as a director of a company is a significant responsibility. As a director, you serve as a custodian, placed in a position of trust by the shareholders to run and look after the company. Out of that trust emerge the legal duties you owe: to the company, to shareholders, to potential investors, to third parties and to regulators watching over the company’s business. And from these legal duties springs a director’s personal exposure to liability which (as we shall see in Section C.) the director cannot be shielded from, or be indemnified for by the company.

The duties and legal obligations which give rise to a director’s personal liability emerge from various legal sources:

i) The new statutory duty of reasonable care skill and diligence

The New Ordinance (CAP. 622) introduces a new statutory duty, requiring a director to exercise reasonable care skill and diligence in his/her role as a director.

In exercising this duty, the director is to be tested against both the standard of a reasonable hypothetical diligent director (the “Objective Test”) and a subjective standard which takes account of the director’s own actual general knowledge, skill and experience (the “Subjective Test).  Essentially, the Objective Test sets a minimum standard which all directors must meet. The Subjective Test raises that standard for the particular director based on his/her actual professional experience and qualifications. For example, a director who is a qualified accountant may be held to a higher standard when a matter of the company’s accounting practices comes before the board, when compared with a director without such accounting qualifications.

The director owes this new statutory duty to the company and the principal remedy if a director breaches this duty is compensation by damages.

This new codified duty of care is not entirely new. It replaces the duty of “reasonable skill and care” which a director used to owe at common law. However, the codification of the duty in the New Ordinance clarifies the standard of care (by reference to the mixed Objective/Subjective test) which a director must meet.

As a matter of good practice, therefore, directors should give thought to the higher standard to which they will be held by reason of their specific expertise, qualification and experience and ensure their focus and contribution in and outside board meetings on issues in which they have such expertise, reflects this higher standard.

ii) Common law and equitable duties

Directors also owe legal duties at common law and in equity (essentially the precedents set by judges in the judgments on cases that go to court). These duties include:

• a duty to act in good faith and for the benefit of the company;
• a duty to avoid conflicts between the director’s personal interests and the interests of the company;
• a duty not to make “secret profit” (i.e. using his position as a director to obtain a benefit for himself from a third party, without the company knowing);and
• a duty to exercise his powers as a director for the benefit of the company and to comply with the company’s articles of association and resolutions.

If a director breaches any of these duties he/she may be sued for damages by the company.

In addition, a director may be liable for negligent misstatement at common law, effectively by making a false representation to a third party in which the director indicates that he assumes personal responsibility for the representation and the third party relies on such representation to his detriment. In these circumstances, the director may be sued for damages by the third party.

iii) Other statutory duties

Legislation in Hong Kong with which all companies must comply, contains provisions penalizing directors if the company fails to comply with requirements in the legislation. This is due to the notion that imposing civil or criminal liability on a director personally, is the principal means by which legislation can ensure a company complies with the law. It is for this reason alone, that exposure of directors to both civil and criminal liability (and criminal fines and imprisonment) is constantly increasing.

One can see this notion in section 101E of the Criminal Procedure Ordinance (Cap 221) (“CPO”) which provides that where an offence under any Ordinance is committed by a company and it is proved that the offence was committed with the consent or connivance of a director or other officer concerned in the management of the company, the director or other officer is guilty of the like offence.

Common examples of such penalties which could be imposed on directors in legislation which applies to all companies are set out in the table on the following page.

Common Examples of Directors’ exposure to personal liability in Hong Kong legislation

Legislation Directors’ potential exposure to personal liability
   
Companies Ordinance  In addition the statutory duty of reasonable skill care and diligence, the New Ordinance also imposes personal liability on directors to take all reasonable steps to ensure the company keeps proper accounting records. Further a director can be liable for fraudulent trading under section 275 of the Companies (Winding Up and Miscellaneous Provisions) Ordinance for allowing the company to incur further credit knowing there is no reasonable prospect of avoiding insolvency.
   
Employment Ordinance  Directors can be personally liable for a fine if they employ someone or fail to terminate someone where they know the person’s wages cannot be paid (sections 31 and 63A). Further, failure to pay wages to an employee in breach of the wage provisions under this Ordinance can attract a fine or imprisonment.
   
Mandatory Provident Fund Scheme Ordinance  Directors can be personally prosecuted for various offences, such as failing to enroll employees in an MPF scheme, failing to pay mandatory contributions etc.
   
Occupational Safety and Health Ordinance  This Ordinance requires every employer, so far as reasonably practicable, to ensure the safety and health at work of all employees in the company. Failure to do so attracts fines and imprisonment and the Ordinance provides for directors being personally liable.
   
Factories and Industrial Undertaking Ordinance  This Ordinance applies minimum health and safety requirements to companies in the industrial sector and breaches attract fines and imprisonment. Again the Ordinance makes provisions for directors to be guilty if the offence is committed with their consent, connivance or attributable to their neglect.
   
Bribery Ordinance  If a director (as agent of the company) accepts an “advantage” from a third party in connection with doing something in relation to the company’s affairs, he will be subject to ICAC investigation and potentially guilty of an offence and liable to fines and imprisonment.
   
Discrimination Legislation  Hong Kong has anti-discrimination legislation against discrimination on grounds of disability, sex, family status and race discrimination. If a director commits any unlawful discriminating act himself, he can be personally made liable to pay damages to the victim and be prosecuted.
   
Securities and Futures Ordinance (Listed Companies only) Directors of listed companies are also exposed to various liabilities under the Securities and Futures Ordinance in relation to the issue and dealings in their company’s securities and in providing information in relation to this. In particular, directors could be liable for market misconduct, failing to disclose inside information, providing false or misleading representations or information to regulators issuing false or misleading public communications or failing to disclose a director’s interests in shares or debentures of the company.
   

B. WHY DO COMPANIES NEED TO PROTECT DIRECTORS AGAINST THEIR EXPOSURE TOPERSONAL LIABILITY?

Old-school thinking had it that protecting directors’ exposure to personal liability might be against a company’s interests, as it may reduce their incentive to act with care. However, as corporate governance standards and theories have advanced, so has the realization that protecting the company’s directors benefits all the key stakeholders in a company:

Directors – Directors are the first obvious beneficiaries of being protected. Faced with personal exposure to liability, directors are under pressure to ensure their companies adopt and maintain robust corporate governance, compliance and risk management processes throughout its business practices. However, even the best governance frameworks cannot eliminate altogether a director’s exposure to investigation, civil suit or prosecute on.  Only ceasing to do any business at all can achieve elimination of exposure altogether! Protecting directors is therefore a vital part of enabling the directors to run the company as a business.

Human resources – The most accomplished directors have a full appreciation of their responsibilities and personal exposures and will make it a condition of their appointment that they are given protection by the company (by way of indemnity and D&O insurance).  Accordingly, human resources departments tasked with finding directors to serve, can only ensure suitably accomplished individuals are found, if the company offers suitable protection to directors.

Existing shareholders and investors – Shareholders and investors also benefit from having suitably accomplished directors to run the company into which they have invested their capital. As stated, offering suitable protection to candidates for directorships is often a condition of getting the best candidates for directorships to serve. Further, directors who face unlimited personal liability exposure may be incentivized to adopt excessively low-risk business strategies which would essentially lower the returns afforded to shareholders and investors. Shareholders and investors, therefore, directly benefit from directors being protected by way of indemnities and D&O insurance.

“as corporate governance standards and theories have advanced, so has the realization that protecting the company’s directors benefits all the key stakeholders in a company:“

Potential Shareholders and Investors – The fact that a company purchases D&O insurance, may also be an important consideration for potential shareholders and investors. As offering D&O insurance is usually pre-requisite to attracting suitably qualified directors to serve on a company’s board, so the presence of D&O insurance is symbolic that the company is run a suitably accomplished board able to put in place to the proper risk management and compliance procedures (and this is a reason why the Main Board Listing Rules require listed companies to disclose in the accounts if they have not purchased D&O insurance).

For all of the above reasons, properly protecting directors through the proper indemnities and the purchase of D&O insurance has come to symbolize corporate governance best practice.

C. HOW DO COMPANIES PROTECT THEIR DIRECTORS’ EXPOSURE TO PERSONAL LIABILITY?

There are two ways in which a company can provide their directors with a reasonable level of protection. The first is by way of the company providing the directors with an indemnity (i.e. a promise to indemnify the director for liabilities out of company assets). The second is by purchasing D&O insurance to cover the directors’ liabilities.

However, it should be emphasized that these two mechanisms are not alternatives. They are complementary and therefore both mechanisims are necessary. One of the key reasons for this is that the extent to which a company can provide a director with an indemnity is very limited, thereby making the purchase of D&O insurance an essential consideration for any company in addition to an indemnity from the company.

i) Limits placed on indemnification of directors by companies under the New Ordinance

The New Ordinance clarifies the limits placed on the ability of a company to indemnify a director for his/her liabilities out of company assets, as follows:

No indemnity permitted for a director’s liability to the company – Section 468(3) of the New Ordinance provides a complete prohibition on a company indemnifying a director (or a director of an associated company) for any liability owed by the director to the company (or associated company). So, for example, a company cannot indemnify a director for breach of the new statutory duty of reasonable skill care and diligence which is owed to the company.
Limited indemnity permitted for a director’s liability to third parties – Section 469 of the New Ordinance allows a company to provide a limited indemnity to a director (a “Permitted Indemnity”) for any liability owed by the director to third parties, if two conditions are met:

Primarily, the Permitted Indemnity must not cover a director’s liability for:

a) criminal fines or regulatory penalties,
b) defence costs incurred by the director in defending criminal proceedings in which the director is convicted, or
c) defence costs incurred by the director in defending civil proceedings brought by or on behalf of the company (or associated company) in which judgment is given against the director.

Secondly, the Permitted Indemnity must be disclosed in the Directors’ Report (of the companies report and accounts) and be made available for inspection by any shareholder on request.

ii) Directors & Officers Insurance and the New Ordinance 

Section 468(4) of the New Ordinance provides that the prohibitions on a company’s ability to indemnify its directors for liability to the company, do not prevent a company from purchasing and maintaining for a director of the company (or of an associated company) D&O insurance which covers a director’s liabilities.  Such insurance may cover:

a) a director’s liability for damages in negligence, default, breach of duty or breach of trust in relation to the company or associated company (except for fraud); and
b) a director’s liability for defence costs incurred by the director in defending any proceedings (whether civil or criminal) taken against the director for any negligence, default, breach of duty or breach of trust (including fraud) in relation to the company (or associated company).

Further, section 468(4) in relation to D&O insurance does not contain any of the restrictions which apply to the Permitted Indemnity.

This means that there is no restriction under the New Ordinance on a company’s power to purchase D&O for its directors. It also means that D&O insurance can cover directors for liability which the company cannot cover by way of indemnity. For example, D&O insurance can cover a director’s liability (including liability for defence costs) for breaches of duty owed to the company (even where the director is indeed found liable – save in the case of fraud).

The only limitations provided on the liabilities which D&O insurance can cover, are those set by common law restrictions based on public policy grounds (which would prevent coverage for liability resulting from any morally culpable behavior by the director, such as dishonesty and fraud).

Further, whilst a Permitted Indemnity provided by the company would need to be disclosed by the company in its Directors’ Report, the same would not be the case as regards D&O insurance purchased by the company.

iii) The New Model Articles of Association under the New Companies Ordinance and D&O Insurance

A company’s ability to purchase D&O insurance is now formally expressly recorded in the new Model Articles of Association for companies, which have been issued under the New Ordinance. These new Model Articles serve as the standard default Articles of Association for a company if the company does not adopt its own. The fact that this provision has been expressly included in the New Model Articles, provides implicit encouragement to all companies (public/ private; listed/ unlisted) to consider purchasing such insurance as corporate governance best practice.

The inclusion of this express power to purchase D&O insurance in the new Model Articles of Association would also appear to complement the Code Provision in the Hong Kong Stock Exchange’s Main board listing rules which requires a listed company to arrange appropriate insurance cover in respect of legal actions against its directors, or to explain why it has not done so in its annual/interim reports. Again this “comply or explain” requirement is indicative of the notion that purchasing D&O insurance represents corporate governance best practice.

D. INTERACTION BETWEEN PERMITTED INDEMNITY AND D&O INSURANCE

A typical D&O insurance policy coverage covers a director for liability which cannot be indemnified by the company (called Side A cover) as well as coverage for the company for its liability to the director in respect of any Permitted Indemnity provided to the director by the company (called Side B cover) (also known as “Company Reimbursement Cover”). D&O insurance often also provides Side C or “Entity Cover”, being coverage provided to the company itself for, say, securities claims or employment practices liability. In addition, as directors’ exposures have grown so has the scope of D&O insurance coverage been extended (by way of “Extensions”) to include coverage for a director’s legal costs in responding to regulatory investigations (being a crucial aspect of D&O coverage in Hong Kong, given the investigatory powers of regulators) or a breach of health and safety legislation. D&O insurance also includes risk management add-ons which assist the company in mitigating risks (such as covering the costs of a public relations consultant to “head-off” potential exposure and assisting directors of listed companies meet their training requirements).

“The fact that this provision has been expressly included in the New Model Articles, provides implicit encouragement to all companies (public/ private; listed/ unlisted) to consider purchasing such insurance as corporate governance best practice.”

A director looking to protect his/her liability would usually require coverage under both the Permitted Indemnity from the company and D&O insurance as the two are not alternatives, but complementary. In particular:

• As we have seen, D&O insurance provides coverage which cannot be covered under a Permitted Indemnity (for example coverage for directors liabilities owed to the company);
• D&O insurance also provides more extensive coverage which is not usually covered by the scope of indemnities (such as legal costs incurred in responding to investigations);
• D&O insurance may contain certain exclusions or deductibles which would otherwise be covered within the scope of Permitted Indemnity (hence a director would still want a Permitted Indemnity);
• D&O insurance protects the director against the risk of the company going insolvent rendering the Permitted Indemnity essentially worthless;
• D&O insurance also includes add-ons or extensions which assist the directors in managing and mitigating risk to the company. For example coverage can be provided for the costs of hiring public relations consultants to mitigate potential liability. In addition, panel law firms of the insurer are also often available to assist the directors of listed companies in meeting their training requirements.

For these reasons, in light of the New Ordinance, all companies should go through the process of evaluating their indemnity provisions and D&O insurance requirements.

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