Loans to directors and connected parties in Hong Kong – recent developments

The New Companies Ordinance (NCO) will come into effect on 3 March 2014. Among the amendments it contains are modifications to the prohibition on loans to directors and exemptions to the prohibitions. Now is an opportune time to review the new rules in Hong Kong in light of the changes in the NCO.

Background

While the NCO retains the general prohibition on a company entering into loans or other similar transactions with a director and persons or companies connected to the director, there are a number of significant and subtle changes to the rules and exemptions surrounding this prohibition that directors and officers need to review.

Wider category of persons and companies affected by the prohibition

There was a concern under the current Companies Ordinance (the Current CO - due to be repealed and replaced by the NCO) that boards and directors were circumventing the general prohibition on loans to directors by using persons outside the list of persons deemed connected to a director. The NCO, therefore, expands the number of persons and companies affected by the prohibition to include not only those persons previously deemed connected to the director but also:

• children who live with the director;
• adult children;
• a cohabitee;
• a parent;
• an associated body corporate (defined in section 488); and
• non Hong Kong companies controlled by the director.

An “associated body corporate” is defined in section 488 of the NCO to include a company in which the director controls 30% of the voting power of the company or a company in which the majority of directors act in accordance with instructions from the director or an entity connected with the director.

Extension of quasi-loans and credit transaction prohibitions

The Current CO prohibits a company from making loans to directors or providing security for loans to directors.

The Current CO also prohibits quasi-loans and credit transactions to directors by public or listed companies. The NCO extends this prohibition on quasi-loans and credit transactions to private companies that are subsidiaries of a public or listed company. These prohibitions are also extended to companies controlled and connected with such directors.

Quasi-loans and credit transactions are defined in sections 493 and 494 of the NCO to include:

• situations where directors agree to repay a liability or have an expenditure reimbursed other than pursuant to an agreement; and
• agreements to supply goods, agreements to lease goods or land to a director or agreeements to supply goods or services to a director on an understanding that payment is to be deferred.

New or amended exemptions to the prohibition on loans to directors

1. Member’s approval exemption extended to all companies

The NCO extends the members’ approval exemption to all companies but for public companies or its subsidiaries, the transaction must be approved by disinterested members in the manner prescribed under the NCO.

The prescribed procedure for receiving shareholder approval for these loans is set out in section 496 and involves the company sending its shareholders a memorandum containing information on the nature of the transaction, the amount of the loan, quasi-loan or credit transaction, the purpose of the transaction and the extent of the company’s liability.

1. Loans not exceeding 5% of net assets

A loan, quasi-loan and credit transaction of value not exceeding 5% of net assets or called-up share capital is an exception to the prohibition.

1. Funds for investigations or regulatory actions

The NCO introduces a new exception for funds to meet expenditure incurred by a director defending proceedings or in connection with an investigation or regulatory action.

The spending caps (often 5% of the company’s net assets) in relation to the following existing exceptions have been removed or relaxed:

• loans made to a director in relation to expenditure on company business or expenditures incurred in the ordinary course of business;
• home loans for a director’s primary residence; and
• loans in relation to leasing goods and land for directors.

Breach of loan prohibition no longer a criminal offence

The NCO abolishes criminal sanctions for a breach of the prohibition on loans. The drafters of the legislation considered civil sanctions were sufficient.

Conclusion

The NCO has widened the types of loans, quasi-loans and credit transactions that are prohibited and broadened the persons and entities deemed connected to directors in relation to these transactions. The NCO has also grown or modified the number of transactions exempt from these prohibitions. The rules, restrictions and exemptions, though, continue to be technical and complicated. To minimize risk, boards and directors should seek advice from Hong Kong and local counsel when contemplating these transactions.

Best Practice Tips

Questions to ask when contemplating a loan, quasi-loan or credit transaction to a director:

1. Is the loan, quasi-loan or credit transaction to a director or to a person or entity connected to the director?
2. Are the loans, quasi-loans or credit transactions by a public company or a subsidiary of a public company?
3. Do any of the exemptions to the prohibitions apply?
4. Has the prescribed member or disinterested member approval been provided for the loan, quasi-loan or credit transaction?