Semester : March 2007

Week :

Subject : Hong Kong Corporate Law

Topic : Financial Services Legislations

Readings1. Hong Kong Business Law, Anne Carver, Longman

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Lecture

Lecture Outlines

1.Introduction

1. The financial services sector covers those companies and their employees involved in stock dealings e.g. the sale and purchase of company shares and debentures, banking, insurance and money lending.

2. The establishment of the Securities and Futures Commission (SFC) was in 1989.

3. The Securities and Futures Ordinance (Cap 571) was passed and gazetted in March 2002, and came into operation on 1 April 2003.

2.The Securities and Futures Commission

1. The Securities and Futures Commission (SFC) was established in 1989 to regulate the securities and futures markets in Hong Kong.

2. The Securities Ordinance established the office of the Commissioner of Securities, and provides a regulatory framework within which the stock exchange operates. It protects investors in securities by requiring registration of dealers, investment advisers and representatives and by regulating trading practices. It also empowers the Securities Commissioner to investigate malpractices. At the same time, the Stock Exchanges Compensation Fund was created to compensate clients of defaulting stockbrokers.

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3. The Protection of Investors Ordinance attempts to protect investors by prohibiting fraudulent and reckless advertisements and requiring the vetting of advertisements inviting members of the public to invest in securities.

2.1 The Commission of SFC

1. The Securities and Futures Commission Ordinance, was enacted in accordance with the Committee’s recommendations, and the SFC was established on 1 May, 1989.

2. Under the SFC Ordinance, the SFC is established as a corporation with a considerable degree of autonomy from the Government.

2.2 Functions of SFC

1. The SFC’s basic function is to administer the laws relating to the trading of ‘securities’ and ‘futures contracts’ in Hong Kong.

2. The SFC now has power under section 38D of the Companies Ordinance to approve and register prospectuses and power under section 38A to exempt prospectuses from certain requirements that otherwise would apply.

3. Section 47 of the SFC Ordinance empowers the SFC to make ‘transfer orders’ whereby it can transfer its powers, so far as they relate to companies listed on the SEHK to the SEHK. Pursuant to that section, the SFC has partially transferred to the SEHK its powers in relation to prospectuses where a prospectus is in relation to a company listed on the SEHK. The SFC has retained the power to review prospectuses for other companies.

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2.3 Powers of SFC

1. To enable the SFC to carry out these functions, the SFC is given statutory powers under its own ordinance — the Securities and Futures Commission Ordinance. It is also given the powers previously provided to the Com-missioner of Securities under the Securities Ordinance, and the Protection of Investors Ordinance.

2. The SFC also has power under section 51 of its Ordinance to make an order suspending the functions of the directors or chief executives of the SEHK and HKFE. It may do this only after consulting the Financial Secretary, and if it is satisfied that: it is in the interest of the investing public or in the public interest

to do so; or it is appropriate to do so for the protection of investors or for the

proper regulation of the SEHK or the HKFE.

3. Suspension orders have a maximum duration of six months.

4. The SFC, as described in the unit, is a statutory organization empowered to enforce securities market regulations and oversee the market operation of the Stock Ex-change of Hong Kong Limited (SEHK), the Hong Kong Futures Exchange Limited (HKFE) and the Hong Kong Securities Clearing Company Limited (HKSCC), which were integrated under a single umbrella com-pany, the Hong Kong Exchanges and Clearing Limited (HKEx), in 2000. Currently, the SEHK, the HKFE, and the HKSCC are subsidiaries of the HKEx, which itself is a public listed company.

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3.Regulations of financial services companies

The purpose is to ensure that investors, depositors, insurance policy holders and borrowers have confidence in the people and organisations participating in the financial services sector.

3.1 Regulations of securities

Securities and Futures Ordinance dealing with the following matters:

1. Registration of dealers

1.1 The Securities and Futures Ordinance provides for the registration of dealers, investment advisers and repre-sentatives to ensure that only fit and proper persons are involved in the sale of securities and investment schemes.

A ‘dealer’ is any person who carries on a business of dealing in ‘securities’ (which was defined in the previous section) or any direc-tor or manager of a company that deals in securities.

An ‘investment adviser’ is any person who, for remuneration, carries on a business of advising others on securities, issuing analyses or reports on securities or undertakes to manage a portfolio of securities.

A ‘representative’ is the employee or agent of a dealer or investment adviser who is engaged to carry out any of the functions of a dealer or investment adviser.

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1.2 Dealers, investment advisers and representatives must be registered before they may carry on their businesses. The power to register is granted to the SFC. In general terms, in order to gain registration, an applicant must prove that he or she is a fit and proper person and has sufficient financial resources. The SFC may take into account any matter which it considers to be relevant in determining whether an applicant is fit and proper. The SFC must, however, also consider the applicant’s:

financial status educational or other qualifications or experience ‘having regard to

the functions which, if the application is allowed, he will perform’ ability to perform such functions ‘efficiently, honestly, and fairly’ reputation, character, financial integrity and reliability.

2. On-going requirements

2.1 These include requirements to keep proper accounts and records, to meet the capital requirement and to keep a register of the securities in which they have an interest. All registered persons are also required to provide annual reports to the SFC detailing their activities during the preceding year and their continuing compliance with the legislation.

2.2 To enforce these and other requirements, the SFC has powers to enter a registered person’s place of business and to inspect records. The SFC can also require registered persons to disclose details of securities transactions.

2.3 Where a registered person fails to comply with the relevant legislation or is guilty of misconduct, the SFC may move to de-register the person. In order to ascertain whether any breach or misconduct has occurred, the SFC is also empowered to conduct investigations.

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3. Trading in securities

3.1 These principally include requirements that:

a dealer may only transact dealings in securities at or through the SEHK

dealers may not tout for business or hawk securities door-to-door every contract entered into by a dealer for the purchase or sale of

securities must be evidenced in a contract note that must be delivered to the client for whom the transaction was entered into

dealers may not engage in ‘option’ or ‘forward trading’ or in ‘short selling’.

Option trading refers to transactions whereby a dealer confers on a client the right to purchase from or sell to the dealer any securities of a listed company. Forward trading occurs when a dealer enters into a contract to buy or sell securities on a future date. Short selling is the highly dangerous practice of selling securities that are not presently owned by a dealer or his client.

3.2 Dealers are prohibited from using their clients’ shares as security for loans without the permission in writing of the relevant client.

4. Compensation Fund

The Fund may be used to pay claims arising against stockbrokers where the broker has failed to produce money or securities entrusted to him or purchased by him on behalf of a client.

5. Investigations.

5.1 The SFC is provided with wide powers under Part XI of the Ordinance to appoint an inspector to investigate:

any alleged breach of trust, defalcation, fraud or misfeasance any matter concerning dealing in securities or the giving of

investment advice.

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5.2 On completion of an investigation, an inspector reports his findings to the SFC and delivers a copy to the Department of Justice, which may institute criminal proceedings.

3.2 Protection of investors1. The Securities and Futures Ordinance attempts to provide some

measure of protection to persons investing in ‘securities’, property other than securities, and ‘investment arrangements’ in property other than securities. In this context, ‘investment arrangements’ means arrangements which have the purpose of enabling investors to derive income from or participate in the profits from non-securities property.

2. These protections are provided in two main ways:

Firstly, the Securities and Futures Ordinance bolsters existing common law remedies. A person who induces another to enter into a contract by making a fraudulent misrepresentation may be liable to damages in tort. The Securities and Futures Ordinance bolsters the common law remedy of damages by also making it a criminal offence for a person to make fraudulent or reckless misrepresentations to induce another to buy or sell securities. In tort, the circumstances in which a plaintiff may receive damages for negligent misrepresentations causing pecuniary loss are limited. The Securities and Futures Ordinance seeks to alleviate this by, in effect, deleting the need to prove a special relationship where it is alleged that a negligent misrepresentation induced an investor to buy or sell securities or enter into an investment arrangement.

Secondly, the Securities and Futures Ordinance makes it an offence to issue, or to be in possession of for the purpose of issuing, an advertisement which is or which contains an invitation to the public to buy or sell securities or enter into an investment arrangement.

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3.3 Banking Ordinance1. The new Banking Ordinance (Cap 155) came into effect on 1

September 1986 as an amalgamation of the previous Banking Ordinance and of the Deposit-taking Companies Ordinance. According to its long title, the purpose of the Ordinance is “To regulate banking business and the business of taking deposits and to make provision for the supervision of authorized institutions so as to provide a measure of protection to depositors and to promote the general stability and effective working of the banking system . . . .”

2. In 1993, the Hong Kong Monetary Authority (HKMA) was set up taking over the functions of the Office of the Banking Commissioner as well as the Office of the Exchange Fund.

3. The Banking Ordinance attempts to achieve these objectives in five ways:

3.1 HKMA.

HKMA has the primary function of promoting the general stability and effective working of the monetary and banking system. HKMA is also given responsibility for a wide range of functions, includ-ing the suppression of illegal, improper or dishonourable practices, and the promotion of proper standards of conduct and sound and prudent practices by authorised institutions.

3.2 Prohibitions.

Firstly, the Ordinance places restrictions upon persons carrying on ‘banking business’ and ‘the business of taking deposits’. The meaning and effect of these prohibitions will be explored further in the next topic. In general terms, only authorised institutions are permitted to carry on the businesses of borrowing money or operating cheque ac-counts in Hong Kong.

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3.3 Authorisation.

1. Secondly, the Ordinance provides for the licensing and registration of ‘authorized institutions’. This authority is mainly vested in HKMA. Authorized institutions mean:

banks restricted licence banks (previously, licensed deposit-taking

companies) deposit-taking companies (previously, registered deposit-taking

companies).

2. The difference between the three types of authorised institutions is that only banks can carry on ‘banking business’. This means the business of receiving from the general public money on current or savings account that is repayable on demand or on less than three months’ notice. Also, only banks can operate cheque accounts. A restricted licence bank can take deposits of any amount over $500,000 for any term. A deposit-taking company can take deposits of over $100,000 for terms of more than three months. The purpose of these restrictions is to ensure that only banks deal directly with the general public, while restricted licence banks and deposit-taking companies are effectively confined to non-consumer depositors.

3. To be granted a banking licence, a company must have a minimum paid-up share capital of at least $300 million. HKMA is empowered to grant licences to companies wishing to become restricted licence banks if they have paid-up capital of $100 million. It is given power to register deposit-taking companies if they have paid-up capital of $25 million.

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3.4 On-going requirements

1. The Banking Ordinance therefore requires all authorised institutions to comply with on-going prudential requirements intended to ensure that it remains sound and financially viable. Authorised institutions must maintain minimum levels of reserves and capital before they are permit-ted to pay dividends. They must provide ‘adequate’ provisions for bad and doubtful debts, and maintain the minimum level of paid-up capital.

2. A second principle of banking regulation is to ensure that authorised institutions operate prudent lending practices. This means, essentially, that they should lend to persons and companies that are good credit risks and should not lend too much to any single borrower. Section 81 provides, in part, as follows:

“(1) The financial exposure of an authorized institution to (any single borrower or group of related borrowers) shall not exceed an amount equivalent to 25% of the paid-up capital and reserves of the institution.

(2) The financial exposure of an authorized institution to any (singleborrower or group of related borrowers) shall, for the purposes of this section, be taken to be the aggregate of-

(a) all advances, loans and credit facilities (including letters of credit) given to;

(b) the value of the institution’s holdings of shares and debentures and other debt securities issued by . . . .”

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4. The Ordinance also tries to ensure that authorised institutions do not over-extend their lending and other financial commitments. They do so by maintaining a ‘capital adequacy ratio’ of at least 8%.

Capital base Share capital + reserves

Capital adequacy ratio

= _____________ = _____________ > 8%

Risk weighted index

Loans + other sundry debtors

In other words, an authorised institution may not lend any more than 12.5 times its capital.

4. Finally, all authorised institutions are required to maintain their assets in such a manner that they can be liquidated into cash to repay deposits in an emergency. All authorised institutions must maintain a ‘liquidity ratio’ of at least 25%.

4.1 On-going scrutiny

1. Much of the Ordinance is concerned with the requirements for authorised institutions to provide on-going information to HKMA to ensure continued compliance with the Ordinance and continued financial health.

2. The Ordinance imposes is the requirement that all institutions keep HKMA informed, in advance, of any change of their ‘controllers’. HKMA has a power to object to the appointment of a controller; in this way, HKMA can ensure that unfit persons, such as persons who have convictions for dishonesty, do not control authorised institutions.

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3.4 Insurance Companies Ordinance1. Insurance Authority: The Ordinance firstly establishes the office of

the ‘Insurance Authority’ who is a civil servant.

2. Prohibition: The Ordinance then prohibits anyone other than an authorised insurer from carrying on ‘insurance business’ in Hong Kong.

3. Authorisation: Thirdly, the Ordinance empowers the Insurance Authority to authorise insurers if all the persons who are directors, the chief executive, managing directors or are in control of one third of the voting power of the company are ‘fit and proper’.

4. Section 8 of the Ordinance provides that the nature of those criteria depends on whether the applicant company is intending to carry on ‘general’ or ‘long-term’ business.

5. In general terms, general insurance includes all of those types of insurance for which annually renewable policies are issued. This includes automobile accident, fire, theft, medical and property contents insurance. Long-term insurance is insurance, usually in the form of an investment, that is entered into in the expectation that a claim, if any, will not be made for a considerable time into the future. Therefore, long-term insurers must keep considerable reserves to ensure that they can pay claims or investment returns in the future, whereas general insurers can operate and determine their profits on a year-by-year basis. Insurers can be authorised only to carry on long- or short-term classes of insurance.

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6. On-going requirements: Each insurer must appoint an account-ant as the company’s auditor. Also, if the company carries on long-term business, it must also appoint a qualified person as its actuary. An actuary is a professional who solves monetary problems involving interest and probability calculations. In relation to a long-term insurer, the appointed actuary’s most important responsibility will be to calculate the company’s liabilities. These include its contingent liabilities to pay death and other claims in the future. Based on the actuary’s calculations, an insurer (and the Insurance Authority) will be able to ascertain whether the insurer has sufficient assets to meet those claims. Insurers carrying on long-term business are required to conduct an investigation of their financial condition every year. The investigation must include a valuation by the appointed actuary.

7. In addition, all insurers are required to keep and preserve ‘proper books of account’ for at least seven years. Each year they must submit to the Insurance Authority the report of the investigation referred to in the previous paragraph, as well as their annual accounts.

8. All such insurers are required to keep a ‘long-term business fund’ which is a fund consisting of assets acquired using receipts from its long-term business.

9. Separate accounts must be kept for the long-term business fund which show the assets representing the fund and the liabilities attributable to that business. At all times the insurer must ensure that the value of the assets exceed the liabilities by at least $2 million. By section 23, the long-term business fund may only be used for the purposes of that business, and cannot be applied generally by the insurer. Equally, section 23 (4) states that any mortgage or charge of the long-term business fund shall be void unless it is made for the purposes of the long-term business. Furthermore, the long-term business of one insurer can be transferred to another insurer only with the permission of the court.

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10. On-going scrutiny: Each authorised insurer is required annually to provide accounts and a financial report to the Insurance Authority. Additionally, the Insurance Authority is empowered by Part V to require further information accounts and actuarial reports from insurers.

11. In an extreme case the Insurance Authority may de-authorise an insurer, or apply to the court for the winding-up of the insurer on grounds that:

the insurer is insolvent; the insurer has failed to comply with the requirements of the

Ordinance; the insurer has failed to keep and maintain proper books of account;

or it is otherwise just and expedient to do so in the circumstances.

12. Under section 46, where a long-term insurer is wound up, the liquidator is required to continue carrying on the long-term business with a view to transferring that business to another insurer.

3.5 Money Lenders Ordinance1. The purpose of this short Ordinance is to regulate money lending

transac-tions and to ensure that persons involved in the business of money lending are reputable and comply with minimum standards. Firstly, the Ordinance provides for the licensing of ‘money lenders’, who it defines as: “. . . every person whose business (whether or not he carries on any other business) is that of making loans . . . but does not include- “[authorized insurers, banks or subsidiaries of banks and deposit taking companies, nor does it include loans made to companies under a registered debentures, for the export or import of goods or services, by a company’s holding company, or if the borrowing company has paid-up share capital of $1 million or more or is listed on the SEHK.]”

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2. The Ordinance states that all moneylenders must be licensed. Under

section 11, on receiving an application in an approved form, the licensing court may grant a licence only if the Commissioner of Police or the Registrar of Money Lenders has made no objection to the application, and the applicant and all others involved in the management of the proposed money lending business are fit and proper. All licences are renewable annually.

3. Secondly, the Ordinance prescribes that a loan by a money lender will not be enforceable unless, within seven days of the loan, the lender provides to the borrower a note stating:

the names and addresses of the lender, the borrower and the guarantor, if any

the amount in figures and words of the loan the date of the loan the terms of repayment the form of security, if any the rate of interest expressed as a percentage per annum the place that the loan was made.

On demand, the money lender is required to provide a copy of the loan agreement to the borrower.

4. Thirdly, the Ordinance prohibits certain types of loans by money lenders. Section 22 (1) states: “ Any agreement for the loan of money by a money lender shall be illegal if it provides directly or indirectly for-

the payment of compound interest; prohibiting the repayment of the loan by instalments; the rate or amount of interest being increased by reason of any

default in the payment of sums due under the agreement . . . .”

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5. Next, section 23 of the Ordinance provides that a loan by a money lender may not be recovered in court proceedings unless the lender proves to the court that when the loan was contracted he was licensed. Section 33 also provides that where in court proceedings it is alleged that a lender is unlicensed the burden of proof shall be upon him to prove that he is licensed or is not a money lender. Consequently, borrowers attempting to defend court proceedings brought by lenders often claim that the lender is, in fact, an unlicensed money lender.

6. Fifthly, and most importantly for everyday commercial life, sections 24 and 25 of the Ordinance contain provisions that apply to all loans, not just to loans by money lenders. Section 24 states that no loan at a rate of interest exceeding 60% per annum, nor any security on such loan shall be enforceable. Section 25 says that where proceedings are before any court for the enforcement of any loan or security and the court regards the transaction to be ‘extortionate’ the court may: “reopen the transaction so as to do justice between the parties having regard to the circumstances . . . and give such directions in respect of the terms of the transaction or the rights of the parties thereunder as the court thinks fit.”

7. By section 25, the courts treat as extortionate loans at rates of interest exceeding 48% per annum; a loan could also be regarded as extortionate if its terms were grossly unfair to the borrower. For instance, a loan on terms that required the borrower to pay an excessive ‘consultant’s fee’ or ‘establishment fee’ to the lender might be regarded as extortionate.

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4. Restrictions on companies

4.1 Banking business and deposit-takingThe main prohibitions imposed by the Banking Ordinance are as follows:

1. Section 11 — ‘No banking business shall be carried on in Hong Kong except by a bank’

2. Section 12 — ‘No business of taking deposits shall be carried on in Hong Kong except by an authorized institution’

3. Section 97 — this section makes it an offence for any person other than a licensed bank to use the word ‘bank’ or ‘ngan hong’ in its title or to represent that it is a bank.

The term ‘deposit’ is defined in the Ordinance as follows:

“deposit”-

(a) means a loan of money-(i) at interest, at no interest, or at negative interest; or (ii) repayable at a premium or repayable with any consideration in money or money’s worth; but (b) does not include a loan of money-(i) upon terms involving the issue. by any company, of debentures or other securities in respect of which a prospectus has been registered under the Companies Ordinance (Cap. 32); (ii) upon terms referable to the provision of property or services; or (iii) by one company to another (neither company being an authorized institution) at a time when one is a subsidiary of the other or both are subsidiaries of another company, and references in this Ordinance to the

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taking or the making of a deposit shall be construed accordingly.

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4.2 Insurance business1. Section 6 (1) of the Insurance Companies Ordinance provides that

“No person shall carry on any class of insurance business in or from Hong Kong except . . . a company authorized under [this Ordinance] to carry on that class of insurance business . . . .

2. Any person who carried on a business of entering into insurance contracts would violate section 6.

3. An insurance contract, in the widest sense of the term, is any contract whereby one party, the insurer, undertakes, in return for the agreed consideration (called the premium), to pay to another person (called the insured) a sum of money, if in the future a specified but uncertain event happens. The term ‘insurance business’ would also be sufficiently broad to catch transactions associated with the servicing of insurance contracts such as accepting claims, paying benefits and taking premiums in Hong Kong.

4. Section 2 (3) states that “For the purposes of this Ordinance, a person shall be deemed to carry on a class of insurance business in or from Hong Kong if-(a) he opens or maintains an office or agency in Hong Kong for the

purpose of carrying on that class of insurance business in or from Hong Kong; or

(b) he holds himself out as carrying on that class of insurance business in or from Hong Kong.”

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4.3 Money lending1. Section 7 provides that “No person shall carry on business as a

money lender . . . without a licence.”

2. The term ‘loan’ is defined as including advances, forbearance to require payment of money owing on any account, money paid for another person and every agreement that is in substance a loan.

3. In Kirkwood v Gadd [1910] AC 422 the House of Lords considered the meaning of those words as used in the English Moneylenders Act 1900. Lord Loreburn L C, after noting that it would always depend on the facts of each case, said: “ What is carrying on business? It imports a series or repetition of acts.” Lord Atkinson, Lord James and Lord Shaw refused to formulate any principle to explain the phrase noted that a single transaction could amount to carrying on business if it was evident that it was intended to be the first of many similar transactions.

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Tutorial

Question 1You are a director of Mo Chuen Mo Laan Limited, a Hong Kong company that operates a chain of fashion boutiques throughout Hong Kong. Sales have recently been down, so the sales manager proposes a scheme to attract new business. Under the scheme customers will be able to:

1 ‘Lay by’ items of clothing by depositing 10% of the purchase price with the boutique. The boutique will then hold the clothing for the customer for one week. At the end of the week, if the customer does not buy the goods, the money will be refunded.

2 Purchase clothes with a credit card issued by Mo Chuen Mo Laan Limited. The terms of the credit card will be that half of the balance owing must be repaid each month.

3 Obtain a full refund of the purchase price if any clothes bought from Mo Chuen Mo Laan Limited are stolen or de-stroyed by fire within a month after purchase.

Advise, giving a short statement of your reasons, whether these arrangements might breach the Banking Ordinance, the Insurance Companies Ordinance or the Money Lenders Ordinance.

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Tutorial AnswersThis is a skeleton answer, only main points are covered. Students are expected to have a more detailed answer or different approach when facing the same or similar question in the examination. If you believe this is a model answer and copy it directly to your answer book you will score no marks or even fails.

Question 11 The Banking Ordinance prohibits persons from carrying on the busi-

ness of taking ‘deposits’, that is loans of money. It is possibly that the lay-by system proposed by Mo Chuen Mo Laan could constitute a business of taking loans. However, the term does not apply to loans upon terms referable to the provision of property. The lay-by system is referable to the sale of clothing and therefore seems not to be deposit taking.

2 The Money Lenders Ordinance prohibits any unlicensed person from carrying on the business of a money lender, that is the business of making ‘loans’. The proposed credit card system appears to constitute a business of making loans as it involves making advances to customers to purchase clothes and also constitutes a forbearance to require payment of money owing by customers. Unless Mo Chuen Mo Laan Limited becomes a licensed money lender, the credit card system will be illegal.

3 The system of providing refunds could also constitute a breach of the Insurance Companies Ordinance. That Ordinance prohibits any person other than an authorised insurer from carrying on insurance business in Hong Kong. Insurance business is the entering into of insurance contracts. It is arguable that the undertaking to be given by Mo Chuen Mo Laan — to refund the purchase price if a customer’s clothes are stolen or damaged by fire — is an insurance contract.

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