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Focus: Insurance & Reinsurance Asia – December 2004

Corporate governance reforms and D&O cover in Hong Kong

In brief: In the latest edition of AAR's Focus: Insurance & Reinsurance Asia series, Partner Simon McConnell, (view CV) Senior Associate Mun Yeow and Lawyer Stephen Sander look at the current issues regarding Directors' & Officers' policies facing companies and non-executive directors in Hong Kong. 

HKSE Rules

On 30 January 2004, the Hong Kong Stock Exchange (HKSE) announced that it would introduce changes to its Main Board listing Rules. The changes announced came into effect on 31 March 2004, and included, among other things, a requirement that 'every board of directors of a listed issuer must include at least three independent non-executive directors' (Chapter 3, Rule 3.10(1)). The deadline for achieving this increase was 31 October 2004.

In its 31 March 2004 press release, the HKSE noted that independent non-executive directors (INEDs) 'play a pivotal role in the corporate governance of issuers. Given the increasingly important role of INEDs and to ensure that the views of INEDs carry significant weight in the board's decisions, the minimum number of INEDs required under the Listing Rules is increased from 2 to 3'.

Many listed companies failed to meet the 31 October 2004 deadline. The HKSE has adopted a cooperative approach in seeking to work with the listed entities and to encourage full compliance as soon as reasonably practicable.

It is notable that Rule 3.10(2) also requires that 'at least one of the independent non-executive directors must have appropriate professional qualifications or accounting or related financial management expertise'.

Rule 3.13 sets out a number of issues that will be considered by the HKSE in determining whether an INED is truly independent, such as:

  • the quantity of shares held by the INED in the relevant listed issuer;
  • whether the INED received an interest in any securities of the relevant listed issuer as a gift or by means of other financial assistance;
  • whether the INED, currently or within the previous one year of being appointed as an INED, provides, or has provided, services to the relevant listed issuer, or is an employee of a service provider who is or has done so;
  • whether the INED has a material interest in any principal business activity of, or is involved in, any material business dealings with the relevant listed issuer;
  • whether the INED is on the board specifically to protect the interests of an entity whose interests are not the same as those of the shareholders as a whole;
  • whether the INED is, or was connected with, a director, the chief executive or a substantial shareholder of the listed issuer within two years immediately before the date of the proposed appointment;
  • whether the INED is, or has at any time during the two years immediately before the date of the proposed appointment, been an executive or director of the listed issuer, of its holding company or of any of their respective subsidiaries or of any connected persons of the listed issuer; and
  • whether the INED is financially dependent on the listed issuer, its holding company or any of their respective subsidiaries or connected persons of the listed issuer.

However, the HKSE is entitled to take into account other factors relevant to a particular case in assessing independence.

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Companies Ordinance

As part of the reforms taking place in Hong Kong, amendments have been enacted to the Companies Ordinance. The amendments to section 165 are of specific interest for the purposes of this Focus.

Before the amendments, s165 provided:

Subject as hereinafter provided, any provision, whether contained in the articles of a company or in any contract with a company or otherwise, for exempting any officer of the company, or any person employed by the company as auditor from, or indemnifying him against, any liability which by virtue of any rule of law would otherwise attach to him in respect of any negligence, default, breach of duty or breach of trust of which he may be guilty in relation to the company shall be void: Provided that –

(a) ...

(b) nothing in this section shall operate to deprive any person of any exemption or right to be indemnified in respect of anything done or omitted to be done by him while any such provision was in force; and

(c) notwithstanding anything in this section, a company may, in pursuance of any such provision as aforesaid, indemnify any such officer or auditor against any liability incurred by him in defending any proceedings, whether civil or criminal, in which judgment is given in his favour or in which he is acquitted or in connection with any application under section 358 in which relief is granted to him by the court.

Section 358(1) of the Companies Ordinance states:

If in any proceeding for negligence, default, breach of duty, or breach of trust against a person to whom this section applies it appears to the court hearing the case that that person is or may be liable in respect of the negligence, default, breach of duty or breach of trust, but that he has acted honestly and reasonably, and that, having regard to all the circumstances of the case, including those connected with his appointment, he ought fairly to be excused for the negligence, default, breach of duty or breach of trust, that court may relieve him, either wholly or partly, from his liability on such terms as the court may think fit.

Table A of Schedule 1 of the Companies Ordinance sets out the 'Regulations for Management of a Company Limited by Shares, not Being a Private Company' (the Regulations). Article 137 of the Regulations provides for an indemnity drafted on terms compatible with the pre-amendment s165:

Every director, managing director, agent, auditor, secretary and other officer for the time being of the company shall be indemnified out of the assets of the company against any liability incurred by him in relation to the company in defending any proceedings, whether civil or criminal, in which judgment is given in his favour or in which he is acquitted or in connection with any application under section 358 of the Ordinance in which relief is granted to him by the court.

Clause 66 of the Companies (Amendment) Ordinance 2003, which came into force on 13 February 2004, amended s165 to read as follows:

(1) Any provision, whether contained in the articles of a company or in any contract with a company or otherwise, for exempting any officer of the company or any person employed by the company as auditor from, or indemnifying him against, any liability to the company or a related company that by virtue of any rule of law would otherwise attach to him in respect of any negligence, default, breach of duty or breach of trust of which he may be guilty in relation to the company or related company shall, subject to subsections (2) to (4), be void.

(2) A company may indemnify any officer of the company, or any person employed by the company as auditor, against any liability incurred by him-

(a) in defending any proceedings, whether civil or criminal, in which judgment is given in his favour or in which he is acquitted; or

(b) in connection with any application under section 358 in which relief is granted to him by the court.

(3) A company may purchase and maintain for any officer of the company, or any person employed by the company as auditor-

(a) insurance against any liability to the company, a related company or any other party in respect of any negligence, default, breach of duty or breach of trust (save for fraud) of which he may be guilty in relation to the company or a related company; and

(b) insurance against any liability incurred by him in defending any proceedings, whether civil or criminal, taken against him for any negligence, default, breach of duty or breach of trust (including fraud) of which he may be guilty in relation to the company or a related company.

(4) Nothing in this section shall operate to deprive any person of any exemption or right to be indemnified in respect of anything done or omitted to be done by him while any such provision as is mentioned in subsection (1) was in force.

(5) ...

Perhaps the most significant aspect of the amendment was the reduction in the scope of the prohibition to indemnities for liabilities 'to the company or a related company'. This removed the restriction for indemnities relating to liabilities to third parties and companies can now provide an indemnity for liabilities incurred by directors to third parties in the performance of their duties. In this respect, s165(3) now allows companies to effectively purchase and maintain D & O policies for the officers of the company.

The amendments were designed to enable Hong Kong companies to provide protection to directors by way of indemnities and D & O policies. This has special significance in light of the changes to the HKSE Rules discussed above. Given that Hong Kong companies are now required to have three INEDs, the amendments to s165 of the Companies Ordinance were a welcome relief to companies who can now offer a level of protection to their officers that was not previously available in Hong Kong.

It is notable that while subsection 165(3)(a) excludes fraud from insurable liabilities for liability to the company and a related company, the fraud exclusion does not apply for liability to third parties.

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What the changes may mean for the insurance business in Hong Kong

Similar amendments were introduced in Australia in the early 1990s and in the UK in the late 1990s. The changes have resulted in a significant increase in D & O cover taken out, such that today it would be unusual for a listed entity not to have such cover in place.

Nevertheless, the demand for D & O cover in Hong Kong is also being bolstered by a more stringent corporate governance regime that is being implemented. As the regulatory regime becomes more complex and more demanding in Hong Kong, companies are likely to embrace D & O cover in increasing numbers.

Risk factors have also increased as a result of other legislative developments; for example, the creation of a right in shareholders to commence statutory derivative actions.

The experience in other jurisdictions indicates that going forward there is a strong likelihood of Hong Kong directors entering into deeds with the relevant company obliging the company to provide the broadest indemnity possible under the law and take out an appropriate D & O policy.

Of course, while demand for D & O cover may be increasing as a result of the legislative reforms, their availability may be reduced by the increased risk profile created by those very same legislative reforms, leading to a reluctant market to underwrite those risks.

Accordingly, it may take some time for the D & O policy market to reach an equilibrium between the demand and the price insureds are willing to pay for such a cover on one hand and supply and the pricing of the risks by insurers on the other. 

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