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International arbitration report
In this edition, we focused on the Shanghai International Economic and Trade Arbitration Commission’s (SHIAC) new arbitration rules, which take effect January 1, 2024.
Issuers’ lending activities under spotlight of HKEx: Red flags and investigation focus
Hong Kong SAR | Publication | May 2024
Over recent years, the Hong Kong Stock Exchange (HKEx) has noted a rise in misconduct associated with loans and lending activities among listed issuers, which often result in significant impairment losses being suffered. As emphasised by the HKEx, these cases will be taken very seriously because the funds of public investors are at risk.
In this article, we will explore some of the red flags that issuers should be aware of in handling loans, advances and lending arrangements (the Loans), HKEx’s investigation focus on breaches, as well as some practical tips on issuers’ and directors’ duties based on HKEx’s recent Enforcement Bulletin1 and other guidance.
Content
Suspicious Lending Behaviour
Whether issuers are already in the business of money lending or are expanding their commercial operations into Loans, regulators will always scrutinise suspicious cases. Understanding the key red flags that draw HKEx’s attention will help to identify areas that warrant issuers’ careful evaluation and robust risk management in lending activities.
A loan cycle can generally be categorised into the below stages, each of which presents various challenges and potential red flags:
| Loan stages | Unusual activities | Red flags |
| Pre-loan stage | Issuers as lenders will assess and evaluate the feasibility and suitability of the Loan before it is granted or drawn | Questionable commercial merits e.g. interest-free or at interest rates lower than issuers’ costs of financing |
| Unreasonably large lending to individuals or to connected borrowers |
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| Lack of business and risk management plan on the lending portfolio |
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| Lack of safeguarding measures e.g. lack of legal documentation, insufficient collateral/security |
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| Lack of records of due diligence and credit assessment |
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| Post-loan stage |
The Loan drawn by the borrower will be repaid according to agreed terms, which will be monitored by the issuers as lenders |
Repeated renewals, extensions or roll-overs of the Loans on same terms despite minimal or no repayment |
| Unauthorised Loans or prepayments which have bypassed usual pre-lending controls or assessments |
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| Lack of evidence of monitoring in light of changing risk factors and status of each Loan |
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| Recovery stage |
Issuers as lenders will take various actions to recover unpaid or defaulted Loans and to mitigate potential losses |
Minimal efforts to recover overdue payments |
| Minimal efforts to consider strategy in respect of potential bad debts |
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| Impairment of all or most of the Loans, sometimes shortly after the grant |
HKEx will take an interest in issuers’ Loans if any of these red flags are present, even if there is no breach of disclosure or shareholders’ approval requirements under HKEx’s Listing Rules (Listing Rules). Issuers should therefore exercise caution to avoid such red flags.
HKEx’s Investigation Focus and the Practical Tips Behind
While the HKEx is tightening its grip on issuers’ lending activities, their investigation focus is turning towards scrutinizing three areas: directors’ duties, internal controls and disclosure obligations on the Loans.
Not only do these focal points provide an insight into HKEx’s enforcement actions, they can also serve as useful guides on the practical actions issuers and directors can adopt to effectively manage the regulatory requirements and credit risks from the Loans.
|
Investigation Focus |
Loan Cycle |
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| Pre-loan Stage |
Post-loan Stage |
Recovery Stage |
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| Directors’ duties: To critically assess the commercial rationale of the Loans e.g. are they in the issuer’s and shareholders’ best interests? Are the terms fair and reasonable? Directors’ decision making process, and whether appropriate care has been taken in conducting the business will be closely examined |
Proper due diligence, credit check and credit assessment on borrower and the collateral/security |
Regular review and monitoring of the Loans portfolio and status of payments due |
Consider proactive and appropriate measures to minimise risks e.g. issuing demand letters, request for additional securities, if appropriate, take legal actions |
| Assess enforceability of the collateral such as pledges |
Adopt procedures for escalation for further consideration and management in case of any issue |
Retain evidence of carefully considered options and strategies for recovery of the Loans with sound reasons for the decisions e.g. board minutes that document the discussions made |
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| Business and risk assessments e.g. analysis of risk appetites against potential returns and risks of defaults etc |
Risk assessments (e.g. update background and credit checks) before any renewal or extension of Loans |
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| Develop assessment on recoverability of Loans, and support impairment assessment under applicable account standards |
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| Effective lending- related internal control: To assess and manage issuers’ credit risk exposures, identify impairments and make timely internal and external reporting e.g. announcements and financial statements |
There must be adequate checks and balance with segregation of duties and monitoring system to avoid unfettered decision-power on individuals over grants of Loans |
Same considerations as pre-loan stage for renewal or extension, as well as subsequent monitors of the Loans |
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| Keep proper records of various actions and considerations taken e.g. commercial assessment and approval process; due diligence and risk assessment and management actions |
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| Put in place appropriate internal control mechanisms to assess enforceability of pledges offered |
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| Ensure sufficient reporting mechanisms to the issuer’s board for Loans granted by subsidiaries |
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| Disclosure obligations |
Obligations under Listing Rules Chapters 14 and 14A must be observed (including timely disclosures and/or shareholders’ approval) if the Loans are of material nature and/or being made to connected parties If the Loans involve financial assistance, obligations under Chapter 13 will have to be considered |
Same considerations as pre-loan stage for any renewal or extension of Loans, which are regarded as new transactions under Listing Rules |
When assessing recoverability and impairment of Loans, any disclosures in financial statements and announcements shall be accurate, complete in all material respects, and shall not be misleading or deceptive |
Case Studies and Consequences of Breach
1. HKEx’s Sanctions and Disciplinary Actions
In the recent enforcement cases, HKEx’s found that issuers involved in ill-considered Loans may often have directors and senior management failing to take active steps to safeguard issuer’s assets.
In this regard, HKEx has taken reputational sanctions against the directors, such as public censures, directors unsuitability statements and prejudice to investors interests statements2. HKEx may also pass orders against issuers for remedial or rectification actions (e.g. conduct independent internal control review).
In the case of Hong Kong Resources Holdings Company Limited, HKEx imposed disciplinary actions against the issuer and relevant directors for, among other things, failure to disclose accurate and complete information in an interim report regarding auditors’ concerns over problematic loans, and inadequate internal controls for a lending businesses.
In China Saite Group Company Limited, the issuer and relevant directors did not provide timely and accurate information to HKEx during the investigation on the questionable loans. In particular, the INEDs had failed to apply independent judgment on the concerns leading to audit issues. The issuer and relevant directors, including a former chairman, faced public censure from HKEx. The issuer was subsequently delisted.
2. Other Legal or Regulatory Implications
The outflow of funds through Loans gives rise to risks of misappropriation of funds, or false or misleading financial statements. The HKEx has made it clear that it will refer its findings and cooperate with other regulators and law enforcement agencies when necessary, including SFC, the Accounting and Financial Reporting Council and the Hong Kong Police.
An example of the cooperation HKEx sought during one investigation is the case of China Ecotourism Group Limited, where the SFC assisted in obtaining evidence regarding some problematic fund flows.
Conclusion: Stay vigilant and be proactive
Material lending transactions and material asset impairments have formed part of the HKEx’s thematic reviews of issuers’ annual reports in recent years. Hence, even in absence of any breaches of the Listing Rules, questionable Loans are constantly on the regulator’s radar.
HKEx has vowed to take issuers’ problematic lending activities very seriously. Proper directors’ oversight and effective internal controls over lending businesses are considered by the HKEx as essential to safeguard shareholders’ interests. Accordingly, issuers and their directors must always stay vigilant and have a questioning mindset when handling Loans.
Footnotes
1
HKEx’s Enforcement Bulletin (April 2024 edition)
2
Under these sanctions, HKEx are empowered to impose a range of follow-on actions, including denying issuers to facilities of the market (e.g. by withholding HKEx’s approvals, or prohibiting dealers and financial advisers from acting for issuers) pursuant to Main Board Listing Rules (MBLR) 2A.10
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