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Major Changes Affecting Directors

(I) Directors’ Duty of Care, Skill and Diligence and Rules on Indemnification

 
Q1.

Is there any provision in the new Companies Ordinance (“the new CO”) which clarifies the standard of directors’ duty of care, skill and diligence?

 
Q2.

Is there any provision in the new CO which clarifies the rules on indemnification of directors against liabilities to third parties?

 

(II) Conflicts of Interests and Prohibitions

 
Q3.

What new measures are introduced under the new CO to avoid conflicts of interests between a company and its directors?

 
Q4.

To what extent are the prohibitions on loans and other similar transactions in favour of directors or their connected entities expanded under the new CO?

 
Q5.

Why is it necessary to introduce the requirement of ratification of conduct of directors by disinterested members’ approval?

 
Q6.

What types of prohibited transactions are subject to the new requirement of disinterested members’ approval under the new CO?

 
Q7.

To what extent are the prohibitions on payments to directors for loss of office expanded under the new CO?

 
Q8.

What are the changes in the requirement for disclosure of material interests of a director under the new CO?

 
Q9.

Are there any new exceptions to the prohibitions on a company’s loans and similar transactions in favour of directors or their connected entities?

 

(lll) Long Term Service Contract

 
Q10.

What does “long term service contract” mean? What is the requirement under the new CO?

 
Q11.

What is the rationale for introducing the requirement for members’ approval for directors’ employment exceeding three years?

 
Q12.

Does “director’s employment” cover employment contract entered into by a director in other capacities?

 
Q13.

Will the new requirement cover a service contract without any remuneration to a director?

 
Q14.

Will the new requirement cover a service contract without a fixed period of employment?

 
Q15.

When will the new requirement apply to director’s service contracts?

 
Q16.

How should a director’s long-term service contract be approved?

 
Q17.

What are the consequences if members’ approval for a long-term service contract is not obtained?

 
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(I) Directors’ Duty of Care, Skill and Diligence and Rules on Indemnification

 
Q1.

Is there any provision in the new Companies Ordinance (“the new CO”) which clarifies the standard of directors’ duty of care, skill and diligence?

 
Answer:

Yes. With a view to providing clear guidance to directors, the standard of directors’ duty of care, skill and diligence is clarified in section 465(2) of the new CO. Section 465(2) sets out a mixed objective and subjective test for the standard of a director’s duty to exercise reasonable care, skill and diligence under section 465(1) of the new CO. The section provides that “Reasonable care, skill and diligence” mean the care, skill and diligence that would be exercised by a reasonably diligent person with –

 
(a)

the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company (objective test in section 465(2)(a)); and

(b)

the general knowledge, skill and experience that the director has (subjective test in section 465(2)(b)).

 
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Q2.

Is there any provision in the new CO which clarifies the rules on indemnification of directors against liabilities to third parties?

 
Answer:

Yes. To remove the uncertainty over the right of directors to be indemnified against liabilities to third parties, the rules on such type of indemnification of directors are clarified in the new CO.


Section 469 of the new CO permits a company to indemnify a director against liability incurred by the director to a third party if the specified conditions are met. Certain liabilities and costs must not be covered by the indemnity, such as criminal fines, penalties imposed by regulatory bodies, the defence costs of criminal proceedings where the director is found guilty and the defence costs of civil proceedings brought against the director by or on behalf of the company or an associated company in which judgment is given against the director.

 
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(II) Conflicts of Interests and Prohibitions

 
Q3.

What new measures are introduced under the new CO to avoid conflicts of interests between a company and its directors?

 
Answer:

The following new measures are introduced under the new CO to avoid directors’ conflicts of interests –

 
(a)

expanding the prohibitions on loans and similar transactions to cover a wider category of persons connected with a director (see answer to Q4 below);

(b)

requiring ratification of conduct of directors by disinterested members’ approval (see answer to Q5 below);

(c)

requiring disinterested members’ approval for various prohibited transactions (see answer to Q6 below);

(d)

expanding the prohibitions on payments to directors for loss of office (see answer to Q7 below);

(e)

widening the ambit of disclosure required under section 162 of the old Companies Ordinance (Cap. 32) (“ the old Ordinance”) (see answer to Q8 below); and

(f)

requiring members’ approval for directors’ employment exceeding 3 years (see Q10 to Q17 below).

 
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Q4.

To what extent are the prohibitions on loans and other similar transactions in favour of directors or their connected entities expanded under the new CO?

 
Answer:

The prohibitions are expanded to cover a wider category of persons connected with a director. Sections 502 and 503 of the new CO prohibit a specified company (defined in section 491(1) of the new CO) from making a loan or quasi-loan to, or enter into credit transaction as creditor for an entity connected with a director without prescribed approval of members. Sections 486 to 488 of the new CO provide for the coverage of an entity connected with a director. It covers, on top of those in the old Ordinance (including, for example, the director’s spouse, a minor child of the director), the following –

 
(a)

an adult child, adult step-child, adult illegitimate child or adopted child of any age;

(b)

a parent;

(c)

a cohabitee;

(d)

a minor child, minor step-child, minor illegitimate child or minor adopted child of the cohabitee who lives with the director;

(e)

an associated body corporate as defined in section 488 of the new CO;

(f)

a trustee of a trust which includes the director’s minor adopted child; and

(g)

a business partner of the director’s minor adopted child.

 

“Specified company” as defined in section 491(1) means –

(a)

a public company; or

(b)

a private company or company limited by guarantee that is a subsidiary of a public company.

 
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Q5.

Why is it necessary to introduce the requirement of ratification of conduct of directors by disinterested members’ approval?

 
Answer:

The new CO requires the conduct of directors to be ratified by disinterested members’ approval to prevent conflicts of interest and possible abuse of power by interested parties (especially majority shareholders) in ratifying the unauthorised conduct of directors.


Section 473 of the new CO provides that any ratification by a company of conduct by a director amounting to negligence, default, breach of duty or breach of trust in relation to the company must be approved by resolution of the members of the company disregarding the votes in favour of the resolution by the director, any entity connected with the director and any person holding shares of the company in trust for the director or for the connected entity.

 
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Q6.

What types of prohibited transactions are subject to the new requirement of disinterested members’ approval under the new CO?

 
Answer:

Under the new CO, the new requirement of disinterested members’ approval applies as follows –

 
(a)

applicable to public companies in respect of the three types of prohibited transactions covered by Part 11 (i.e. loans, quasi-loans and credit transactions; payments for loss of office; and directors’ long-term employment); and

(b)

for loans, quasi-loans and credit transactions, the disinterested members’approval requirement is extended to a private company or company limited by guarantee that is a subsidiary of a public company.

 

If a company is subject to the disinterested members’ approval requirement, the resolution at a general meeting of such a company is passed only if every vote in favour of the resolution by the interested members is disregarded (sections 496(2)(b)(ii) and (5), 515(1)(b)(ii) and (4), 518(2)(b)(ii), (4) and (5) and 532(2)(b)(ii) and (4)).

 
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Q7.

To what extent are the prohibitions on payments to directors for loss of office expanded under the new CO?

 
Answer:

To plug any potential loophole that loss of office payments to directors may be made indirectly via other parties, the loss of office payment provisions are extended by section 516(3) to include –

 
(a)

payment to an entity connected with the director; and

(b)

payment to a person made at the direction of, or for the benefit of the director or an entity connected with the director.

 

Further, section 521(2) extends the prohibition to include payment by a company to a director or former director of its holding company. Section 522(2) extends the provisions to include the payment made in connection with a transfer of the undertaking or property of the company’s subsidiary.

 

By virtue of section 516(1) (definition of “takeover offer”) and section 523(1), the prohibitions in connection with a share transfer are extended to include all transfers of shares in the company or in its subsidiary resulting from a takeover offer.

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Q8.

What are the changes in the requirement for disclosure of material interests of a director under the new CO?

 
Answer:

The major changes under the new CO are –

 
(a)

the ambit of disclosure is widened to cover “transactions” and “arrangements” instead of just “contracts” (section 536(1) and (2));

(b)

for a public company, the ambit of disclosure is widened to include disclosure by a director of any material interest of entities connected with him, except that a director is not required to declare an interest if he is not aware of the interest or the transaction in question (section 536(2) and (4)(a));

(c)

a director is required to disclose the “nature and extent” of the interest instead of just disclosing the “nature” of the interest (section 536(1) and (2)); and

(d)

the disclosure requirements are extended to shadow directors (section 540).

 
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Q9.

Are there any new exceptions to the prohibitions on a company’s loans and similar transactions in favour of directors or their connected entities?

 
Answer:

Yes. Two new exceptions to the prohibitions on loans and similar transactions have been introduced –

 
(a)

exception for loan, quasi-loan and credit transaction of value not exceeding 5% of net assets or called-up share capital (section 505); and

(b)

exception for funds to meet expenditure, incurred or to be incurred by a director, on defending proceedings or in connection with an investigation or regulatory action (sections 507 and 508).

 

Under the old Ordinance, the approval of members on the granting of loans can only be relied on by a private company which is not a member of a group which includes a listed company. To facilitate business operations, sections 500 to 504 of the new CO provide for the prescribed approval of members as an exception to the general prohibition on loans, quasi-loans, credit transactions etc. which applies to all companies.


The requirements for obtaining prescribed approval of members for the purposes of sections 500 to 504 are set out in section 496 of the new CO.

 
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(lll) Long Term Service Contract

 
Q10.

What does “long term service contract” mean? What is the requirement under the new CO?

 
Answer:

"Long term service contract" means service contract under which the guaranteed term of the employment of a director with a company exceeds or may exceed 3 years. Under section 534(1) of the new CO, a company must not agree to such type of contract without the prescribed approval of its members.

 
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Q11.

What is the rationale for introducing the requirement for members’ approval for directors’ employment exceeding three years?

 
Answer:

In the absence of provisions requiring members’ approval for long-term employment of a director, there is a risk that a director may arrange for himself long-term employment with his company which entrenches him in office or makes it too expensive for the company to remove him from office before his contract expires (as the director might be entitled to damages for the company’s breach of contract arising from the early termination).


Section 534 of the new CO requires the approval of the members of a company for any contracts under which the guaranteed term of employment of a director with the company exceeds or may exceed 3 years.

 
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Q12.

Does “director’s employment” cover employment contract entered into by a director in other capacities?

 
Answer:

For the purposes of section 534, "employment" means any employment under a director's service contract. Section 531 defines "a service contract of a director of a company". In section 531, there are references to performance of services "as director or otherwise" and "performance of services outside the scope of director's ordinary duties as director". Therefore, the provisions cover a contract to perform services outside the scope of a director's ordinary duties.

 
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Q13.

Will the new requirement cover a service contract without any remuneration to a director?

 
Answer:

The provisions in the new CO do not exclude a service contract with no remuneration to a director. If the proposed contract with the director in question falls within the definition of "a service contract of a director of a company" in section 531, and with reference to the provisions of section 534, the guaranteed term of the employment of the director under the director's service contract exceeds or may exceed 3 years, the prescribed approval of the company's members must be obtained pursuant to section 534(1).


Companies should consider the terms and conditions of the proposed service contract and the provisions in section 531. If in doubt, they should seek independent legal advice.

 
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Q14.

Will the new requirement cover a service contract without a fixed period of employment?

 
Answer:

The prescribed approval of a company's members is required if the guaranteed term of the employment of a director of the company with the company exceeds or may exceed 3 years (section 534(1)).


The meaning of a reference to a guaranteed term of a director's employment is given in sections 534(2) to (5). The provisions provide, e.g., that a reference to the guaranteed term is a reference to the period during which the employment is to continue, or may be continued, otherwise than at the instance of the company; and cannot be terminated by the company by notice, or can be so terminated only in specified circumstances.


Companies should consider the terms and conditions of the proposed service contract and the provisions in section 534. If in doubt, they should seek independent legal advice.

 
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Q15.

When will the new requirement apply to director’s service contracts?

 
Answer:

Generally speaking, the new requirement will apply to service contracts entered into on or after the commencement date of the new CO (i.e. 3 March 2014).

 
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Q16.

How should a director’s long-term service contract be approved?

 
Answer:

The long-term service contract should be approved pursuant to section 532 of the new CO, either by resolution of members passed at a meeting or by written resolution.


In the case of resolution passed at a meeting, a memorandum setting out the proposed service contract should be sent to every member together with the notice convening the meeting. In the case of a written resolution, the memorandum should be sent to every member at or before the time at which the proposed resolution is sent to the member.


If the company is a public company, the resolution should be passed after disregarding the votes in favour of the resolution by the director with whom the service contract is proposed to be entered into and any member who holds any shares in the company in trust for that director.

 
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Q17.

What are the consequences if members’ approval for a long-term service contract is not obtained?

 
Answer:

If a company agrees to a director’s long-term employment without the prescribed approval of its members, the relevant provision in the service contract is void to the extent of the contravention. Further, the contract is to be regarded as containing a term entitling the company to terminate it at any time by giving reasonable notice (section 535).

 
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