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21 March, 2018
What you need to know
A recent decision of the Hong Kong court relating to section 213 of the Securities and Futures Ordinance ("SFO") has potentially far reaching consequences for IPO sponsors, auditors and other advisors of listed companies in terms of extending their potential liability to investors arising out of regulatory breaches. The decision may also encourage the Securities and Futures Commission ("SFC") to be more aggressive in its use of section 213 in circumstances where the legislature has not provided for a class action regime that would enable investors to seek redress in their own right.
The court held, for the first time, that orders under section 213 to restore investors affected by regulatory breaches can be made not only against persons who were counterparties to transactions with the investors, but also against others "knowingly concerned" in the regulatory breaches.
Background
Qunxing Paper Holdings Co. Ltd ("Qunxing"), the first defendant, was listed on the Main Board of the Hong Kong Stock Exchange. Its underlying business of manufacturing, selling and printing paper products in Mainland China was operated through a wholly owned subsidiary, Shandong Qunxing Paper Ltd ("Shandong Qunxing"), which was held via the second defendant, another Qunxing subsidiary, Best Known Group Ltd ("Best Known"). The third and fourth defendants were the former Chairman and former Vice-Chairman of Qunxing, who were also father and son.
In 2007, Qunxing issued a prospectus for an international placing and Hong Kong public offering of its shares, raising HK$1.846 billion. At the time of its listing the former Chairman and Vice-Chairman held or controlled 67% of Qunxing's issued shares. In December 2010 and January 2011, Qunxing raised further funds from an open offer of new shares and placement.
In March 2011, trading in Qunxing's shares was suspended after its auditors issued a disclaimer of opinion. Shortly afterwards the SFC commenced an investigation into Qunxing and identified irregularities in its financial results.
These irregularities included a material overstatement of sales by Shandong Qunxing in Qunxing's prospectus, annual results and results announcements between 2007 and 2011. Certain documents provided by Qunxing to its auditors concerning the alleged sales were also found to be fictitious, and that persons who had been held out to the auditors as employees of a customer of the business were not in fact employed by the customer. Qunxing's annual reports and results announcements issued between 2009 and 2012 also failed to disclose the bank borrowings of the group, which were between four and 14 times the stated liabilities of the group at the end of the relevant periods.
In late 2013 the SFC commenced proceedings against the defendants under section 213 of the SFO, seeking declarations that: (a) Qunxing had committed the civil and criminal offence of disclosing false or misleading information inducing transactions, the civil offence of providing misleading information and breached section 342F of the Companies (Winding Up and Miscellaneous Provisions) Ordinance ("CWUMPO"), which imposes criminal liability for misstatements in a prospectus; and (b) the remaining defendants had been involved in, or party to, those contraventions. The SFC also sought remedial orders requiring all defendants to make payments to Qunxing's shareholders, with a view to restoring them to the positions they were in before their subscription or purchase of Qunxing's shares, or alternatively, damages.
In 2014, during the course of the proceedings, the SFC became aware that the third and fourth defendants had submitted an application to restructure Shandong Qunxing to a Mainland Chinese court on the basis of Shandong Qunxing's inability to repay its debts, a fact which had not been publicly disclosed in Hong Kong. On receiving enquiries from the SFC, all of Qunxing's directors, including the third and fourth defendants, resigned. The SFC subsequently obtained a court order appointing interim receivers and managers to Qunxing in March 2014. Qunxing was delisted in November 2017.
The SFC's application for orders under section 213 was heard in the Court of First Instance in May and August 2017. The receivers of Qunxing and Best Known were excused from attendance at the hearing, and no appearance was made by either the third or fourth defendants. Accordingly, the court made its decision with only the benefit of submissions advanced on behalf of the SFC, and without any counter-arguments being advanced by any of the defendants as to the appropriateness or scope of the orders sought.
Decision
The court handed down its decision on 6 February 2018.1 Unsurprisingly, it found that Qunxing had contravened each of the provisions of the SFO and CWUMPO identified by the SFC. The court therefore held that declarations under section 213 of the SFO could be made against all of the defendants for their involvement in those contraventions.
Although only Qunxing had been a party to the transactions with affected investors, the SFC had sought restorative orders against Best Known and the two former directors of Qunxing. The court noted that although there was no precedent for restorative orders under section 213 to be made against persons not a party to the relevant transactions with investors (in this case Qunxing as the issuer of shares purchased by investors), section 213 constitutes a substantive cause of action which is complementary to other provisions by which investors who have sustained loss can be made good.
The court held, in reliance on a similarly worded UK statute (since repealed) and case law related to it, that restorative orders could be made against persons who, although not a party to the transactions causing loss, were "knowingly concerned" in a contravention. As the two former directors were knowingly involved in the dissemination of the false and misleading information and that there was a high degree of culpability on their part for the contraventions, it was not unfair to make the orders against them.
The court also held that even though in a common law action for misrepresentation or deceit plaintiffs would be required to prove certain legal elements including reliance and inducement, it was not necessary for the SFC to do so in order for the court to make an order under section 213. It held that the purpose of section 213 was to protect the investing public and that to insist on investigating the circumstances of every individual investor and investment could destroy the efficacy of the statutory scheme.
Comment
Clear cases of disseminating false or misleading information to the market require redress for
investors, and section 213 is a useful tool that can be deployed by the SFC to achieve this aim. The decision reaffirms the flexible nature of the cause of action under section 213, and in a case where clear misrepresentations were made to investors and the market, it is not surprising that the court was willing to make orders against two former directors who were the controlling minds behind the misrepresentations, notwithstanding that they were not directly a party to the transactions with affected investors.
However, the decision raises a number of important issues that will require clarification in future cases, particularly in light of the uncontested nature of the SFC's application.
First, it is not clear what the legal threshold is before a person will be "knowingly concerned" in regulatory contraventions. Given extreme facts of the case, and in particular that the two former directors were the controlling force behind the regulatory contraventions, it was not necessary for the court to consider this issue in any detail. It is possible that the SFC will seek to rely on the decision in future to argue that a broader class of people are knowingly concerned in contraventions, such as IPO sponsors and auditors. However, it is not clear why the court adopted the concept of a person being "knowingly concerned" in a contravention, as sections 213(a)(ii) and (iii) expressly refer to those who have aided and abetted or otherwise assisted, counselled or procured a contravention, or were otherwise directly or indirectly involved in or a party to a contravention. Relying on that express language of section 213 would have been preferable to introducing the concept of being "knowingly concerned", which is not a well-defined legal concept.
Second, while the court held that the elements of a private action in tort do not need to be established by the SFC when bringing proceedings under section 213, it remains questionable as to whether this will be followed in subsequent cases. The proceedings were not contested and therefore the court did not have the benefit of counter-arguments to this interpretation of the provision. If upheld in future, this would appear to grant the SFC a substantial advantage in proving its case under section 213 as compared with an individual bringing a private action at common law in respect of losses incurred due to market misconduct. It may also encourage the SFC to be more aggressive in its use of section 213 in circumstances where the legislature has not provided for a class action regime that would enable investors to seek redress in their own right.
It is no secret that the SFC has made sponsor liability a key enforcement priority. The decision is therefore likely to be relied upon in future cases, including against sponsors, auditors and other advisors of listed companies. There is room for further clarification of the scope of section 213 following the decision in Qunxing Paper, which will need to be determined by the courts in future cases.
In the meantime, those involved in sponsoring or advising on IPOs or share issuances should take steps to ensure that they have adequate systems and controls in place. Inadequate due diligence is a focus of the SFC, so this should be carried out in a robust manner to verify the accuracy of the assertions made by the listed company. Due diligence should also be well-documented so that it can be readily demonstrated to the regulator the steps that the business took to discharge its obligations and the thoroughness of the work carried out.
1 Securities and Futures Commission v Qunxing Paper Holdings Co. Ltd and Ors [2018] HKCFI 271
For further information, please contact:
James Comber, Partner, Ashurst
james.comber@ashurst.com
