In a revamp of our loophole series, we are going to document them one at a time, in the hope that regulators may do something about them . We start with the Trust Loophole in the Listing Rules, through which HKEx itself has passed. Three years after we first reported this software bug, it has still not been fixed.

The Trust Loophole
13 August 2003


Loophole number: 1
Use of loophole: For a director or substantial shareholder of a listed company to benefit from transactions with that company without disclosure
Location of loophole: Main board and GEM Listing Rules 1.01(a)
Status update This loophole was closed by amendment to the Listing Rules on 31-Mar-2004


Normally, under Chapter 14 of the Listing Rules, a director, chief executive or substantial (10%) shareholder of a listed company is a "connected person" of that company and any material transaction, with certain exceptions, is subject to disclosure and, if it is large enough, the approval of independent shareholders.

The definition of connected persons includes an "associate" of a director, chief executive  or substantial shareholder. The definition of "associate" includes any company which that person controls, defined to be capable of exercising 35% of the voting rights (or such lower threshold as may be specified in the Takeover Code). Since the Takeover threshold was reduced to 30%, that means the Listing Rule also kicks in at that level.

What this means in practice is that if you are a director or substantial shareholder or controller of a listed company and own 30% or more of another company (whether it is listed or not) then any deals between that other company and the listed company are connected transactions. The purpose of this rule is to prevent you from benefiting from abusing the listed company by over-priced sales to or under-priced purchases from the listed company, including asset injections or disposals.

The definition of "associate" of a director, chief executive or substantial shareholder (being an individual) also includes in Rule 1.01(a)(ii):

"the trustees, acting in their capacity as such trustees, of any trust of which he or any of his family interests is a beneficiary or, in the case of a discretionary trust, is a discretionary object"

The clear intention of that rule is to include, within the "connected persons" net, trusts which are often established by controlling shareholders or directors of listed companies to hold their personal assets. The person who establishes the trust, known as the "settlor", transfers legal title to the assets to a trustee, typically a subsidiary of a bank such as HSBC, Bank of Bermuda or Citibank. Although there is no formal obligation for the trustee to follow the instructions of the settlor when managing the assets if the trust, in practice they do, otherwise they wouldn't survive in the trust business. These instructions are euphemistically known as "wishes". In any case, the trust typically holds assets via a holding company, and there is nothing that prevents the settlor or his relatives being a director of the holding company.

The reasons for such trusts can include the legal avoidance of future inheritance tax or estate duty, or shielding assets from creditors or litigants. The beneficiaries of the trusts often include the spouse and children and sometimes (depending on whether this would compromise the tax planning) the settlor himself. The existence of such trusts is one reason why Hong Kong Estate Duty should be scrapped, because it is an entirely voluntary tax that is paid only by people who do not set up trusts and die rich.

The Loophole

The loophole is quite simple. The Listing Rules include trustees of trusts in the definition of connected persons, but they do not explicitly include any company controlled by the trustee. You might think that it was implicit, and that the rule would be useless if a trustee could avoid it simply by establishing a wholly-owned company to conduct business instead of the trustee. You would be right, but that is exactly the interpretation that the Stock Exchange has taken.

So if you are a controlling shareholder of a listed company, all you have to do to avoid the connected transaction rules is follow three simple steps:

  1. Visit your bank or lawyer and set up a trust, of which you or your family can be the sole beneficiaries.
  2. Set up a company and issue or transfer all its shares to the trustee.
  3. The company is now NOT a connected person of the listed company, and can now conduct transactions with the listed company which you control.

Note: if you also want to avoid the accounting standard on disclosure of "related party transactions", which are broader in scope than the Listing Rules, then don't be the director of the company owned by the trustee. Instead, ask your trustee to provide a director for you. You see, accountants have recognised that if you work for both parties to a "material" transaction as a member of "key management" then you have a conflict of interest and the transaction should be disclosed. Unfortunately, the standards do not define "key management", nor do they define what is "material".

The Solution

To close the Listing Rule loophole, change the definition of "associate" to include companies controlled (30% or more) by the trustees of any trust of which the director, substantial shareholder or his family is a beneficiary.

A further detail that needs amending is that, since beneficiaries of trusts can also be non-individuals, the rule should apply to all substantial shareholders (including companies and other entities), not just those who are human beings.


For an example of this loophole in action, look no further than Hong Kong Exchanges and Clearing Limited (HKEx, 0388), of which your editor is an elected director. It owns the Stock Exchange of Hong Kong Ltd (SEHK), which makes the Listing Rules.

Another director of HKEx, Dr Lo Ka-shui (Dr Lo), is a beneficiary of a trust which has majority control of Great Eagle Holdings Limited (GEH, 0041), a property and hotel investment company. A subsidiary of GEH leases property in Citibank Plaza to a subsidiary of HKEx, and GEH, as a listed company, pays listing fees to SEHK.

Although the trustee is an "associate" of Dr Lo and hence a connected person, the company the trustee controls, GEH, is not a connected person. So GEH is free to deal with HKEx and the transactions are not deemed to be connected transactions. GEH could, for example, buy a property from HKEx, and that would not be a connected transaction. The only reason we know about this is that Dr Lo is also the Managing Director of GEH, so the tenancy agreement is disclosed in the accounts as a "related party transaction", but that is due to the accounting standards, not the Listing Rules.

"Software" patches are urgent

When people find security loopholes in Microsoft's operating systems, the firm publishes software "patches" in a matter of days or weeks, in a race against time with hackers who can and will write viruses that will exploit the weakness. The Listing Rules are the "software" of the market, and SEHK should act with the same speed, to avoid exploitation of loopholes by listed companies, who may hack away at shareholder wealth.

But we first brought this loophole to public attention 3 whole years ago, in an article on 11-Aug-00 titled The Independent Panda. Nothing has changed in the Listing Rules since then, and no doubt numerous companies have  exploited the loophole before and after we reported it. The same situation prevails in most of the other loopholes we have reported. The software bugs go unpatched.

That story 3 years ago was about a company then called Panda-Recruit Ltd (8073) of which, by coincidence, Dr Lo was then Chairman. Now, in the greatest of ironies, we find HKEx passing through the same loophole, which its subsidiary SEHK has not closed, by not treating the transactions with GEH as connected transactions. We are not alleging any impropriety involving GEH or Dr Lo, simply showing you how the loophole works.

This is yet another reason why a listed company should not make the Listing Rules. As a special case, the SFC does administer the Listing Rules as applied to HKEx, but the SFC can only approve or reject changes to those rules proposed by SEHK. If SEHK and its Listing Committees do not feel like closing the loophole, then the SFC cannot do anything about it, unless it exercises the "nuclear option" in the law which allows it to override the SEHK and impose its own rules. It has never done so, and if it did, you would hear howls of protest from the same people at HKEx who are now objecting to the Expert Group recommendation that the regulatory function be transferred to the SFC.

What you don't know

Of course, the biggest abuses facilitated by loopholes like this are the ones we don't know about. By using this loophole, any controlling shareholder of a listed company could, at this very moment, be benefiting from "unconnected" transactions between companies owned by a trust he established and the listed company, and you, as an outside shareholder, wouldn't know anything about it even as your money is being slowly drained away. Sends a chill down your spine, doesn't it?

©, 2003

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