On 12 December 2023, the Hong Kong Securities and Futures Commission (SFC) announced that it had obtained a three-year disqualification order from the Hong Kong Court against a former Independent Non-Executive Director (Former INED) of China Candy Holdings Limited (Company), for failing to discharge his monitoring and supervisory role as a member of the Company’s board and audit committee. The relevant judgment was rendered on 20 November 2023 in the case of SFC v Xu Jinpei and others  HKCFI 2908 (Judgment).
This case serves as a firm reminder to all Independent Non-Executive Directors (INEDs) of Hong Kong-listed companies that they bear a heavy burden to exercise independent judgment and proactively and diligently scrutinise, inquire and verify the financial position of their listed company as part of their ongoing director’s duties. In failing to identify and follow up on potential red flags arising in the listed company’s treasury, cash management and financial reporting functions, INEDs may be deemed negligent in exposing the listed company and its shareholders to risk of substantial loss and prejudice. The SFC takes a dim view of INEDs failing to properly discharge their duties and would regard their passivity and inaction as being misconduct almost on par with executive directors or senior managers who have direct involvement in publishing false or misleading information to the public, fabricating accounting records or engaging in other misconduct. The SFC has also once again demonstrated that they will take decisive enforcement action against directors’ misconduct by seeking disqualification orders under section 214 of the Securities and Futures Ordinance (SFO).
This case further reinforces the common theme from the regulators that directors bear both collective and individual responsibility over the conduct of the listed company, and it is not an answer for INEDs to place excessive reliance on other persons (including other directors, staff of the listed company or internal and external auditors) to identify and resolve compliance issues. It is a core duty that they must personally oversee and discharge.
The Company is an investment holding company that was listed on the Growth Enterprise Market board of the Hong Kong Stock Exchange between 11 November 2015 and 31 December 2019. The Company and its operating subsidiaries (collectively, Group) were principally engaged in the manufacturing of candy products in the PRC. The Company’s listing was cancelled on 31 December 2019, pursuant to a suspension of trading on 12 December 2017 and a subsequent failure to achieve resumption by 31 July 2019.
Following an investigation, the SFC concluded that the Company’s published 2016 interim report and 2016 annual report contained significant overstatements in the Company’s cash and bank balances by 87% and 97% as of 30 June 2016 and 31 December 2016 respectively, which grossly inflated the company’s financial position at those financial period cut-off points. The SFC found that the overstatements were the result of using creative accounting methods (i.e. offsets using non-existent deposits and withdrawals around the cut-off points), and supporting documents and records relating to the financial position of the Company/Group were also fabricated in an effort to conceal the overall scheme.
Based on these findings, the SFC presented a petition under section 214 of the SFO to the Hong Kong Court on 15 May 2022 to seek disqualification orders against eight individuals, namely the then seven members of the Company’s board, including the Former INED, and the Company’s former chief financial controller (s214 Proceedings). The SFC alleged that the business affairs of the Company were conducted in a manner (1) that involved defalcation, misfeasance or misconduct towards the Company or its members; (2) that resulted in its members not having all the information regarding the Company’s business affairs that they might have reasonably expected; and/or (3) that was unfairly prejudicial to its members. The SFC also alleged that, while the Company’s Chairman, CEO and chief financial controller were the instigators and perpetrators of the fraudulent scheme, the other directors were also negligent and/or in breach of their duties to the Company.
Seven of the eight respondents in the s214 Proceedings continue to dispute the SFC’s allegations, but the Former INED reached an agreement with the SFC in or around January 2023 to dispose of the proceedings against him by way of the Carecraft procedure. This is a mechanism where the SFC and a respondent could present the Hong Kong Court with a summary of agreed facts and proposed orders (Carecraft Schedule), which then serves as the basis of the Court’s order (although the Court is not bound to follow the agreed terms, it will commonly be guided by the SFC’s recommendation) and the summary disposition of the proceedings against the said respondent. The Hong Kong Court ultimately adopted the agreed terms in the Carecraft Schedule, whereby the Former INED was disqualified from being a director or being directly or indirectly involved in the management of any listed or unlisted company in Hong Kong for the agreed period of three years. The Former INED was also required to pay the costs of the SFC in the court proceedings.
- In the Judgment, the Court reiterated the key principles for imposing a disqualification order, including that there must be a sufficiently serious failure by the director to satisfy his duties such that a disqualification is justified and fair. Also, the period of disqualification must reflect the gravity of the offence and take into account any mitigating factors.
- There is no hard and fast rule on the duration of the disqualification period, and the discretion rests with the Court. However, as a benchmark, serious cases would commonly merit a disqualification of over 10 years, while relatively less serious cases would merit less than five years. Disqualification of six to 10 years may be imposed for cases in between.
- The Court indicated that it may take into account other relevant considerations such as “the age, state of health and character of the offender, the nature of the breaches, the honesty and competence of the offender, the length of time he has been in jeopardy, whether he appreciates and/or admits the breaches, his general conduct before and after the offence, the periods of disqualification of his co-directors that may have been ordered by other courts, and the interests of shareholders, creditors and employees”.
- In the Former INED’s case, the Court considered the following aggravating and mitigating factors:
- The Former INED’s admission of negligence placed the case in the relatively less serious category (meriting a disqualification of up to five years), but the misconduct was deemed to have caused substantial harm and prejudice to the Company’s members by denying their access to information regarding the true position of the Company’s assets and financial positions;
- Also, since the Former INED occupied a relatively senior position and was a member of the Audit Committee, he was expected to have knowledge of the Company’s finance, business and management. The SFC also indicated that there was a need to protect the public against the future conduct of the Former INED. A disqualification of at least three years was considered warranted;
- The Former INED was cooperative in relation to the s214 Proceedings and accepted liability. He also adopted the Carecraft procedure, which saved time and costs for the SFC and the Court, and he agreed to pay his share of the costs of the SFC in the s214 Proceedings; and
- The Former INED was not involved in the daily operations of the Company, and there was no suggestion that the Former INED was involved in any dishonesty or lack of integrity, nor that he had knowingly taken part in the scheme to inflate the financials or falsify documents.
Practical tips for INEDs in complying with their directors’ duties
Corporate governance remains a key area of focus for the regulators. In recent years, the Hong Kong Stock Exchange (HKEX) and the SFC have actively taken disciplinary and enforcement actions against directors for financial reporting and internal controls failures. In particular, there is a particular focus on INEDs’ responsibilities, and we have seen cases where serious sanctions were imposed on INEDs.
In November 2023, the HKEX published “A Snapshot of INEDs’ Roles and Responsibilities”, which reminded INEDs that they play a key role in the board’s oversight of the listed company’s risk management and internal controls, and they also have various responsibilities and obligations under the Listing Rules and the Corporate Governance Code. At a high level, it is expected that an INED would adopt the following approach, among other things, in discharging his/her duty to the listed company:
The recurring themes in such guidance underscores the ongoing focus of the regulators on ensuring that INEDs of listed companies are fully aware of their duties and obligations, and it is the regulators’ expectation that INEDs will proactively take steps to achieve compliance at both the individual and company levels. The list of enforcement actions taken by the SFC against directors of listed companies continues to grow over time, and section 214 of the SFO is increasingly becoming a favourite tool in the SFC’s toolkit to wield against non-performing directors.
- INEDs of listed companies should be aware that they bear onerous obligations and duties under the Listing Rules and SFO, and it is paramount that they take their roles and responsibilities for monitoring and supervision seriously, since regulators will not hesitate to hold them to the requisite standard.
- Given INEDs commonly form the audit committees of listed companies, they have a particularly important role in supervising the financial reporting and annual audit of the listed company. Any unusual patterns of transactions or significant movements of funds in the company’s financial accounts should put an INED on enquiry, and it is critical to raise questions and seek sufficient information so the INED can form an independent judgment on whether there are any potential compliance issues.
- INEDs also play a crucial role in ensuring that the listed company maintains robust and effective internal controls and risk management systems. Therefore, regular reviews and assessments should be proactively undertaken, and any deficiencies and gaps should be readily identified and resolved in a timely manner.
- INEDs are reminded to properly document and keep records of their contributions in overseeing and maintaining the listed company’s corporate governance and internal control functions, as well as the steps taken to discharge their duties. Having such records readily on hand will greatly assist the INEDs to prove, when called upon by regulators in a regulatory investigation, that they have dutifully performed their roles.
- INEDs are often caught in the crossfire since, while they rarely play any active role in instigating the substantive misconduct, any failure on their part to readily identify and follow up on red flags may be regarded as negligence. It is therefore important for INEDs to devote sufficient time to discharge their responsibilities effectively, and they should be fully engaged with and critically scrutinise the listed company’s business affairs, both inside and outside the boardroom, to properly discharge the duties of an INED in the face of a stringent and exacting regulatory landscape.
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