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Focus: HK Companies Ordinance Rewrite – impact on directors and shareholders

30 July 2010

In brief: The proposed draft Companies Bill will reform the Hong Kong Companies Ordinance in a number of significant ways. Partners Simon McConnell and Mun Yeow and Lawyer Kieran Humphrey look at the impact of the changes on both the directors and shareholders of Hong Kong companies.

• Background
• The key proposals
• Director's duty of care
• Indemnification of directors
• Shareholder's remedies – derivative actions

Background

In mid-2006, the Hong Kong Government launched a comprehensive review of the CO. This was intended to modernise the CO by implementing new reforms and simplifying some of the existing provisions. The first consultation phase concluded in March 2010 and the second phase concludes in early August 2010. The draft Companies Bill is scheduled to be tabled in the Legislative Council by the end of 2010.

The key proposals

While there are many proposed reforms to the CO, this article will focus on those that affect the directors and shareholders of Hong Kong companies. In this regard, there are three key reforms of interest:

• the codification of a director's duty of care;
• the indemnification of a director against third party claims; and
• the shareholder derivative action rules.

A short summary of each reform is set out as follows.

Director's duty of care

At present, the duties of a director are not codified and arise from common law and the articles of association of the relevant company. In general, a director's duties can be classified into two broad categories, namely fiduciary duties and the duties of care, diligence and skill. In some common law jurisdictions such as the UK, Australia and Singapore, a director's duty of care, as well as some fiduciary duties, have already been codified.

In order to bring Hong Kong in line with international standards, the proposed Companies Bill will codify a director's duty of care, skill and diligence, while leaving the fiduciary duties of a director to be governed by existing common law rules. The proposed amendments will be based on s174 of the UK Companies Act 2006 and the standard of care will be judged by the following two-limbed objective/subjective test:

• a director of a company must exercise the reasonable care, skill and diligence that would be exercised by a reasonably diligent person with the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same function as the relevant director (the objective limb of the test); and
• a director of a company must exercise the reasonable care, skill and diligence that would be exercised by a reasonably diligent person with the general knowledge, skill and experience that the director has (the subjective limb of the test).

That is, the test requires a director to maintain the minimum objective standard of care expected of all reasonable directors carrying out the same function. The minimum standard can be adjusted upward, taking into consideration the subjective personal attributes of a particular director. However, the minimum standard cannot be adjusted downwards to accommodate a particular director who is incapable of attaining the basic minimum standard expected of a reasonable director.

Indemnification of directors

Currently, the rules governing the indemnification of directors are set out in s165 of the CO. Under s165(1), a company is prohibited from indemnifying its directors for any liability owed to that company or a related company. However, there is no statutory prohibition against indemnity provided by a related company or provided for the director of a related company. The proposed Companies Bill will close this loophole by prohibiting any indemnity provided by a related company or to the director of a related company.

In addition, the rules governing the indemnification of directors against a third party will also be amended. At present, there is no statutory provision prohibiting or allowing a company to indemnify its director against a liability owed to a third party. Such indemnity is governed by common law rules. To provide greater certainty in this area,  it is proposed that the CO should expressly permit the indemnification of a director against third party liability. Moreover, indemnification of the following liabilities will continue to be prohibited:

• a criminal fine or penalty;
• a liability incurred in defending criminal proceedings in which the director is convicted;
• a liability incurred in defending civil proceedings brought by the company or a related company in which judgment is made against the director; and
• a liability incurred in connection with an application for relief in which the Court of First Instance refuses to grant the director relief.

Shareholder's remedies – derivative actions

As a general rule, shareholders are not allowed to bring a lawsuit against a third party for a wrong done to the company unless any such lawsuit is brought on behalf of the company by way of a derivative action. In Hong Kong, a shareholder's right to bring a derivative action is provided under both the CO and at common law.

Under s168BA – s168BI of the CO, shareholders of a specified corporation (ie – a Hong Kong company or a foreign company with an established place of business in Hong Kong) have a statutory right to bring proceedings on behalf of the specified company. Under s168BC(4), the common law right of a shareholder to bring a derivative action in appropriate circumstances is also preserved. The key differences between statutory and common law derivative actions include the following:

• 'multiple' derivative actions can only be brought under common law, as the current CO only provides for a simple derivative action.¹  A multiple derivative action is an action brought by shareholders of a parent company on behalf of its subsidiary in respect of a wrong committed against the subsidiary. In contrast, a simple derivative action is where a shareholder of a specified company brings proceedings on behalf of that company.
• court leave is required for both a statutory and common law derivative action. However, leave for a statutory derivative action is conditional on the court being satisfied that there is 'a serious question to be tried'.²  Leave for a common law derivative action will only be granted when the intended plaintiff can demonstrate a 'prima facie case'.³
• a shareholder can bring a statutory derivative action for 'misfeasance' committed against the company. Misfeasance is defined in the CO as fraud, negligence, default in complying with any statutory provision or rule of law or breach of duty.⁴ For a common law derivative action, a shareholder can bring an action only when the alleged wrong falls within the meaning of a 'fraud on the minority' – which involves its own complex legal test.

The co-existence of both statutory and common law derivative actions, and their different rules, were criticised by the Court of Final Appeal in Waddington Limited v Chan Chun Hoc (2008) 11 HKCFAR 370 for causing confusion and unnecessary complication.⁵ In light of this criticism, the proposed Companies Bill will abolish the common law derivative action and extend the statutory derivative action to include multiple derivative actions.

While these reforms will simplify Hong Kong's derivative action regime, it is unclear whether they will make it easier for shareholders to bring such actions. Importantly, the Hong Kong courts will continue to apply the same test for a statutory derivative action as they have under the existing CO. Accordingly, the reforms may not lead to an increase in the number of derivative actions initiated but should provide greater certainty to those considering such actions in future.

Footnotes

1. A multiple derivative action was recognised at common law by the Court of Final Appeal in Waddington Limited v Chan Chun Hoc (2008) 11 HKCFAR 370.
2. s168BC(3)(b) of the CO.
3. Waddington Limited v Chan Chun Hoc (2008) 11 HKCFAR  370.
4. s168BB(2) of the CO.
5. Draft Companies Bill, First Phase Consultation p. 61-63.