Hong Kong Court of Final Appeal clarifies “innocent purpose” defence to insider dealing

The Hong Kong Court of Final Appeal (CFA) has recently allowed the Securities and Futures Commission’s (SFC) appeal against the Market Misconduct Tribunal’s (MMT) findings that two former executives of a listed company (ATML), Mr Charles Yiu Hoi Ying and Ms Marian Wong Nam, had not engaged in insider dealing in ATML shares.

The appeal focused on the defence to insider dealing under section 271(3) of the Securities and Futures Ordinance (SFO), which is sometimes referred to as the “innocent purpose” defence. In brief, it provides that a person shall not be regarded as having engaged in market misconduct by reason of an insider dealing taking place through his/her dealing in listed securities, if he/she establishes that the purpose(s) for dealing in the securities were not or did not include the purpose of securing or increasing a profit (or avoiding or reducing a loss) by using inside information.

Overturning the rulings by the MMT and the Court of Appeal on the applicability of the defence, the CFA held that Mr Yiu and Ms Wong could not rely on the defence as they sold their ATML shares taking advantage of their knowledge that the prices were significantly higher than they ought to have been and which would not be achievable if the inside information were available to the market.

The CFA’s clarification of the applicability of the innocent purpose defence means that it would be difficult for persons who are connected to listed companies for the purpose of insider dealing provisions to rely on the defence, unless in exceptional circumstances where they can demonstrate that the purpose of their dealings is unconnected with the market price of the shares.

Background

At the relevant time, Mr Yiu was ATML’s director of finance and executive director, and Ms Wong was ATML’s company secretary. ATML was insolvent and was no more than a listed shell. In June 2007, Goodpine Limited (Goodpine) served a winding-up petition on ATML, alleging that ATML was indebted to and had failed to satisfy Goodpine of a debt of approximately HK$70.3 million including interest. Goodpine had commenced action to recover the debt after a previous ATML creditor assigned the debt to it in February 2007. In April 2007, prior to the serving of the winding-up petition, Goodpine served a statutory demand on ATML to seek payment of the debt.

The public was not informed about the assignment of the debt to Goodpine and the subsequent statutory demand at the time. Mr Yiu and Ms Wong sold their ATML shares before information about the winding-up petition was disclosed to the public and made a profit of over HK$10 million in total. After the winding-up petition was disclosed to the public, the share price fell substantially.

The MMT found that the elements of insider dealing were established against the individuals, holding that when they sold their ATML shares, they had information that they knew constituted inside information, which was price sensitive. The inside information comprised of the assignment of debt and the subsequent statutory demand.

The individuals were, however, not found to be culpable of insider dealing on the basis that they could rely on the innocent purpose defence. The MMT found that they had not used the price sensitive information to secure a profit as their sole motivation for selling the shares was to take advantage of an unexpected speculative boom in the ATML share price, and they believed that the debt owed by ATML to Goodpine would be resolved behind closed doors and would never be known by the market.

The MMT’s decision was upheld by the Court of Appeal.

Insider dealing and innocent purpose defence

Insider dealing, as defined under section 270(1) of the SFO, involved five elements:

1. the corporation concerned must be publicly listed (in Hong Kong);
2. the person concerned must be “connected with the corporation”(connected person);
3. he/she must have information which constitutes “relevant information” (now referred to as “inside information” under the SFO);
4. he/she must know that such information is inside information; and
5. he/she deals in the corporation’s listed securities with such knowledge.

All five elements above must be shown to exist at the time the person deals in the listed securities.

The CFA agreed with the MMT and the Court of Appeal that the above elements were established against Mr Yiu and Ms Wong. The primary question in the appeal was whether they were entitled to rely on the innocent purpose defence. Aspects of the defence were noted in the judgment:

• It is a defence which only comes into play where a prima facie case of market misconduct has been established.
• The burden of establishing the defence is on the person seeking to rely on it, discharged on a balance of probabilities.
• That person must establish that the purpose for which he/she dealt with the securities was not (or if there was more than one purpose, did not include) the prohibited purpose of securing or increasing a profit by using inside information.

To discharge that burden, the person might often be expected to give direct evidence of his/her subjective purpose to show that he/she was acting for what might be called an “innocent purpose”. If such direct evidence is not given, that person must nevertheless be able to point to evidence which demonstrates that he/she acted for a purpose (or purposes) which entirely excluded the above mentioned prohibited purpose when dealing with the securities.

CFA decision

The CFA, in a majority decision of four to one, held that the MMT made an error in law and that Mr Yiu and Ms Wong could not rely on the innocent purpose defence:

• It was clear that they were looking to secure unexpectedly high profits when they sold the ATML shares. Hence, the question was whether it was also part of their purpose to use inside information to secure such profits.
• Using inside information means making a decision to buy or sell the listed securities because of the quoted market price, knowing that the price is either artificially high or low because the inside information is not generally known to those accustomed or likely to deal in the securities.
• In selling their ATML shares, Mr Yiu and Ms Wong did use the inside information as they took advantage of their knowledge that the prices they were securing would not have been achievable if the inside information were disclosed to the market. They knew that the prices at which they sold the shares were artificially high.
• Their belief as to what might happen in the future (that the indebtedness owed by ATML to Goodpine would eventually be resolved behind the scenes and would never enter the public domain) was legally irrelevant in establishing the innocent purpose defence. As mentioned above, the relevant time at which to examine the questions of whether the elements of insider dealing are satisfied and whether the defence is applicable is the time of dealing in the securities.

The dissenting judge, Mr Justice Tang PJ, was of the view that section 271(3) of the SFO should be interpreted to provide a defence for a defendant who can show that he/she would have done what he/she did even if he/she had not had the information. The MMT was entitled (based on factors such as the timing of the sale) to hold that Mr Yiu and Ms Wong had sold the shares because of the speculative bubble in the shares and that the inside information was not a factor influencing the sale.

As a result of the majority decision, the CFA set aside the orders made by the Court of Appeal and the MMT and remitted the matter back to the MMT to decide on the appropriate sanctions.

Comment

The clarification of the innocent purpose defence renders the defence more difficult to establish, essentially requiring proof that the purpose of a dealing is unconnected with the market price of the shares. The CFA noted that this may well put the connected persons at a disadvantage compared to others who may deal in the same shares, but it is the consequence of being connected persons who come into possession of price sensitive information. A restriction on such connected persons from dealing is the reasonable price of achieving a fair and level playing field in the market, akin to restrictions placed on trustees and other fiduciaries.

Market participants who are connected persons in possession of inside information should avoid dealing in listed securities until the information is made public, unless in exceptional situations such as dealings pursuant to prior contractual obligations or in compliance with court orders, under which the innocent purpose defence might arise.