Section 214 Proceedings: High Court clears directors of misfeasance and misconduct allegations by the SFC, marking the first win against the regulator in over a decade

In the recent decision of Securities and Futures Commission v Zhou Ling and Dai Haidong [2024] HKCFI 2484, the High Court of Hong Kong ruled, for the first time in more than a decade, that the Securities and Futures Commission (SFC) had failed to prove at trial its case against directors of a listed company in director disqualification proceedings commenced under section 214 of the Securities and Futures Ordinance (SFO). DLA Piper represented the directors in this case.

Background

The SFC frequently initiates proceedings under section 214 of the SFO (Section 214 Proceedings) to seek disqualification, compensation and other orders for breaches of duty by current and former directors of listed corporations as part of its "front-loaded regulatory approach." Typically, directors facing such proceedings settle with the SFC under the Carecraft procedure, which we have covered in an earlier article (Carecraft procedure – things to look out). However, the Zhou Ling case demonstrates that it is possible to fully defend against such claims, and directors should not feel compelled to admit to misconduct they did not commit.

The Zhou Ling case involved Section 214 Proceedings against two former executive directors of a Hong Kong-listed pharmaceutical company (the "Company") for alleged misfeasance or other misconduct towards the Company's members. The allegation included (1) a director devising a series of artificial drug distributorship transactions to provide liquid capital to the counterparty (the "Artificial Transactions" allegation), and (2) in the Company's subsequent transaction to acquire a minority interest in a pharmaceutical company, that director had received a secret profit from the seller (the "Secret Profit" allegation).

Key Legal Principles

Whilst each case turns on its own facts, this case serves as an important reminder of the general evidentiary principles applied in serious allegations of corporate misconduct and highlights how procedural law will have an impact on preventing a party from challenging the authenticity of documents or to run unpleaded points.

Assessment of Evidence: The court held that the standard of proof for serious allegations such as secret profit remains that of a balance of probabilities, assessed against the inherent probability of the respective version of events put forward by each party, but that "the more serious the allegation, the less likely that it occurred and the stronger should be the evidence before the allegation is established". This contrasts with the SFC’s contention that the burden of proof lies with the directors to prove their version of events.

On the balance of probabilities, the court rejected the SFC's case as being inconsistent with the evidence provided by the respondents.

• For the Artificial Transactions allegation, the respondents proved that the transactions were genuine commercial transactions with documented market research reports. They justified the "sincerity money" arrangements under the contracts as being in line with industry practice. The SFC did not provide any evidence to challenge the industry practice, or to establish how the economic value of the counterparty was inflated, or in any event how this would establish misconduct on the part of the directors.
  
  
• For the Secret Profit allegation, the respondents proved that the alleged secret profit was in fact a loan between the parties that was made after completion of the Company's acquisition, so there was no basis for the SFC to contend there was a breach of duty by the director in failing to avoid any conflict of interests or to declare his interests at the time the board considered and approved the Acquisition. The SFC's case was based solely on the improbability of the loan occurring simultaneously with other financial transactions of the directors.

Notice of Non-admission and Proper Pleadings: The court has repeatedly emphasised the importance of filing a notice of non-admission to challenge the authenticity of documents and putting a party's case in its pleadings. This is not a mere procedural requirement but has a significant impact on a party's case. According to Order 27 of the Rules of the High Court (Cap. 4A), a party is generally deemed to have admitted the authenticity of a document produced during discovery unless it serves notice (a Notice of Non-Admission) in time requiring the document to be proved at trial.

In this case, the SFC made bare challenges against the authenticity of the respondent's documentary evidence during the trial, such as the market research reports for the drug distributorship transactions, without filing any notice of non-admission or taking issue with their authenticity in the pleadings. The Court did not consider such objections. Additionally, the SFC raised several unpleaded matters at trial, such as the director’s awareness of shareholder changes of the counterparty or an agreement to provide liquid capital through the alleged scheme. These points were similarly not entertained.

Practical Takeaways

Director's Liberty to Make Commercial Decisions: The court's reasoning in the present case shows that issues of commercial judgment are generally not a matter for the court to review or interfere with. One of the SFC's main arguments was that the Artificial Transactions lacked commercial purpose and were not genuinely conducted for the commercial benefit of the Company, but a scheme to provide liquid capital to other companies. Putting aside the fact that the SFC did not allege the respondents had any knowledge of the liquid capital scheme, applying Re A Company (Liquidators: Cowley and Lui) [2020] 3 HKLRD 96, the court took a deferential approach to matters of commercial assessment. It refrained from determining the commercial prudence of the transaction, as it considered that the evidence before the court is generally far less than necessary to judge business decision-making.

In this regard, directors can rest assured that the court generally would not interfere with the making of commercial decisions, to the extent that they are properly made and not illegal transactions. It would also be beneficial if directors can provide evidence of market conditions and/or industry practice in support of their decisions. The court maintains an open approach towards allowing directors to exercise their powers in the manner that they believe is in the interests of the company.

Keeping Record of Contemporaneous Documents: Companies and their directors should ensure that all transactions and decisions are well-documented. Creating a (digital) paper trail is fundamental to safeguarding the position of a company and its directors. In case of any dispute, contemporaneous documents are crucial in establishing the credibility of evidence, as they reflect the commercial context under which transactions and decisions are made. Documents made at the time of events are likely to be more accurate and reliable than those made after much delay. Companies and their directors should ensure appropriate policies and procedures are in place to clearly and simultaneously document the company’s affairs.

Fiduciary Duties: Despite their extensive powers, directors must adhere to their fiduciary duty to avoid conflicts of interest and fully disclose any personal interests in company transactions. Failure to comply can lead to severe legal consequences, including disqualification from directorship. This aligns with the SFC’s strategic enforcement priorities, which aim to uphold the quality of internal controls within companies by addressing director misconduct and ultimately protecting investors. The SFC has consistently emphasized this message, most recently in a September 2024 speech by its CEO, who stated that directors of listed companies “should be held accountable for safeguarding the integrity of a company’s financial disclosures and for overseeing robust internal controls to detect and prevent corporate misconduct.”; see Sound Corporate Governance as Bedrock for Quality Listing Market (sfc.hk). In the present case, the directors received a disqualification order of 1 year, out of the statutory maximum of 15 years, for admitting liability for not disclosing personal interests in one of the Company's acquisitions. However, we note this is one of the shortest disqualification periods ordered by the court in recent Section 214 Proceedings cases.

Case Strategy: Directors facing such petitions should seek legal advice immediately to determine whether to contest the case in full or enter into settlement negotiations to reduce the potential penalty.

The DLA Piper team is experienced in defending directors against Section 214 Proceedings and the full spectrum of securities litigation and regulatory investigations. To learn more about our services, please contact any of the authors or your usual DLA Piper contact.