Regulatory Newsletter 
Issue 1 of 2012: February

SUMMARY OF CONTENTS

Landmark ruling on insurance broker commissions
by Robert Clark (robert.clark@deacons.com.hk)

Hobbins v Royal Skandia Life Assurance Ltd (Skandia) & Anor HCCL 15/2010 (6 January 2012), is the first case in Hong Kong regarding the legality of insurance brokers receiving commissions. In this landmark ruling, the court ruled that commissions paid by an insurer to an insurance broker are not illegal secret profits, unless they are in excess of what is normally paid in the insurance market. Robert Clark of Deacons acted for the successful insurer, Skandia.

Background

Clearwater (an insurance broker) acted as Mr Hobbins' agent to purchase Investment Linked Assurance Scheme (ILAS) products from Skandia. Clearwater (with Mr Hobbins' knowledge) made money from commissions and fees paid by insurers (such as Skandia) whose ILAS products were purchased by Mr Hobbins. Mr Hobbins sought to set aside the investment schemes (as they were not doing well) and to be restored to the position he was in immediately before entering into them. Mr Hobbins sought restitution on the basis that, although Clearwater had disclosed to him that it would be earning commission from insurers, it did not inform him precisely how much commission it would be earning and had therefore breached its fiduciary duty owed to him as his agent.

Further, it was alleged that the contracts whereby Mr Hobbins purchased ILAS products from Skandia were illegal under Section 9(2) of the Prevention of Bribery Ordinance (PBO) or tainted by an underlying fraudulent misrepresentation. Section 9(2) of the PBO prohibits a person, without lawful authority or reasonable excuse, offering any advantage to an agent as an inducement to or reward for doing any act in relation to his principal's affairs or business.

Issues considered and the Court's decision

1. Was Clearwater Skandia's agent?

No. There was an express term in the contract that Clearwater was not Skandia's agent. Clearwater had no express or implied authority to act as Skandia's agent and there was no suggestion that Clearwater had apparent authority to act as such. It is long established at common law that insurance brokers (such as Clearwater) are acting solely as agents for an insured. The mere fact that an insurer pays brokerage fees to a broker does not mean the broker is undertaking to perform any obligation on behalf of the underwriter.

2. Were Skandia's contracts with Hobbins illegal under the PBO?

No. There was no breach of the PBO. There was "lawful authority" (consisting of a long line of judicial pronouncements dating back to the 19th century to the present) for the commercial practice that an insurance broker acts as an agent of the insured and not the insurance company. As a result of those judicial pronouncements, it has long been settled at common law that commission paid to an insurance broker by an insurer does not constitute an illegal secret profit, unless it is in excess of what is normally paid within the insurance market. There was no evidence whatsoever that the commission or fees which Clearwater received from Skandia were otherwise than that normally paid in the insurance market.

3. Was Clearwater in breach of its fiduciary, common law or statutory duty to Hobbins?

No. There was no breach of Clearwater's obligation as Mr Hobbins' agent to make adequate disclosure of the fact that it would receive commission from Skandia. An agent is a fiduciary and obliged (by equity) to disclose commission/fees earned from third parties in connection with the agent's handling of the principal's business. It is accepted practice at common law for an insurance broker to receive commission from an insurer, provided those commissions do not exceed the usual market rate. Clearwater had disclosed the fact that it would be remunerated by way of commissions and fees from insurers (such as Skandia). That should be regarded as minimum good practice for insurance brokers. To go beyond that and say that Clearwater should have disclosed the quantum of commission it expected to receive would be to impose a standard which would be at odds with case law on prevailing commercial practice among insurance brokers.

4. Was Skandia liable as principal for Clearwater's breaches?

No. Skandia was not Clearwater's principal and Clearwater was not Skandia's agent. Further, Clearwater had not committed any breaches.

5. Were the ILAS contracts between Skandia and Hobbins void/unenforceable?

No. There was no misrepresentation by Clearwater and no illegality under the PBO.

6. Was there an obligation on Clearwater to make restitution?

No.

Practical implications

This ruling will ease insurance brokers' concerns about whether they can legally receive commissions. However, the judgment also demonstrates that brokers should obtain their clients' consent before receiving commissions and that the amount of commissions should not exceed the usual market rate. It is advisable for brokers to include clear terms in contracts with their clients stating that they will receive commission/fees from insurers and recording that the client consents to this.

Back to Top

Closer Economic Partnership Arrangement between Mainland China and Hong Kong
by Franki Cheung (franki.cheung@deacons.com.hk) and Christine Wong (christine.wong@deacons.com.hk)

What is CEPA?

The Closer Economic Partnership Arrangement (CEPA) is a free trade agreement between Mainland China and Hong Kong that offers Hong Kong products, companies and residents preferential access to the Mainland market. Many of the preferences go beyond China's WTO concessions. CEPA is not a closed agreement and both sides hold regular meetings on further concessions and the details for implementation. To date, eight supplementary agreements to CEPA containing further concessions have been agreed by the two sides.

CEPA mainly covers the following areas:

• the removal of tariffs and other barriers on trade in goods;

• the opening up of the Mainland market to Hong Kong service suppliers;

• measures for the promotion of trade and investment;

• mutual recognition of professional qualifications;

• strengthening of cooperation in the areas of finance, tourism and trade and investment facilitation between Mainland China and Hong Kong.

Trade in goods

Qualifying goods

All products of Hong Kong exported to Mainland China may enjoy tariff free treatment except for certain types of prohibited articles on condition that the products meet the prescribed rules of origin (ROO). For products falling under a large number of tariff codes, the ROO have already been determined. For products that to date have no agreed ROO, there exists a mechanism whereby interested enterprises may apply and request to include the products in subsequent phases of ROO discussions which will be held twice a year.

To qualify for duty free import, products must satisfy the ROO requirements. Under these requirements products are deemed to be of Hong Kong origin if they satisfy either of the following conditions: the products are obtained entirely in Hong Kong or the goods have undergone substantial transformation in Hong Kong.

There are five different criteria for determining whether products have undergone substantial transformation in Hong Kong:

1. Manufacturing or processing operations: manufacturing or processing operations carried out in Hong Kong have conferred essential characteristics to the products;

2. Change in tariff heading: the tariff heading of the product under the Product Description and Harmonised System Code has changed as a result of manufacturing or processing operations exclusively carried out in Hong Kong;

3. Value-added content: with effect from 1 April 2012, refers to the total value of raw materials and component parts originating in Hong Kong, combined with labour costs and product development costs incurred in Hong Kong, being greater than or equal to 30% of the FOB value of the exporting goods, and that the final manufacturing or processing operations should be completed in the area of Hong Kong. Where Hong Kong incorporates raw materials and components parts originating in Mainland China as part of the exporting goods, such raw materials and component parts should be regarded as originating in Hong Kong in the calculation of the valued-added content of the exporting goods; the value-added content of such exporting goods should be greater than or equal to 30%, and moreover, when the value of raw materials and component parts originating in Mainland China is not taken into account, the value-added content should be greater than or equal to 15%;

4. Other criteria: other criteria than the foregoing agreed by the two sides; and

5. Mixed criteria: use of two or more of the above criteria to determine origin.

The ROO requirements applicable to each type of product are set out in detailed tables.

The two sides have also agreed not to adopt any anti-dumping or countervailing measures against the other side's products. The Mainland has undertaken not to impose tariff rate quotas on products of Hong Kong origin.

Application procedure

A Hong Kong manufacturer must first apply to the Hong Kong Trade and Industry Department (TID) for Factory Registration. After having obtained Factory Registration, a manufacturer can lodge an electronic application for a Certificate of Hong Kong Origin - CEPA to the TID or any one of the five government-approved certification organisations. The Certificate must then be passed on to the Mainland importer who will produce the Certificate to the Mainland Customs in order to claim duty free treatment for the imports.

Overseas manufacturers

An overseas manufacturer is not required to establish itself a presence in Hong Kong to take advantage of CEPA. It can partner up with, or outsource production to, a Hong Kong manufacturer.

Trade in services

Service sectors

CEPA provides for liberalised market access in a wide range of service sectors ahead of China's liberalisation schedule pursuant to its WTO obligations and facilitates the recognition of Hong Kong professional and technical qualifications. Under the most recent supplement, as from
1 April 2012, three new service sectors as well as 13 existing service sectors will be further liberalised. The total number of service sectors covered by CEPA will be expanded to 47 as follows:

In some sectors the concessions surpass China's WTO commitments. Unless otherwise provided in CEPA, Hong Kong companies remain eligible to benefit from China's WTO commitments in the various service sectors.

Benefits

The CEPA benefits in services are situated mainly in four areas:

• earlier market access: Hong Kong service suppliers can enter the PRC between one to five years earlier than under the WTO timetable;

• higher equity share: Hong Kong service suppliers are permitted to hold a higher equity share (in certain service sectors even up to 100%) in PRC service companies;

• lower capital thresholds: capital requirements to set up in the PRC have been reduced substantially thus opening up the field to smaller players; and  

• recognition of Hong Kong qualifications: eligible Hong Kong residents are allowed to take qualification examinations for professionals and technicians in the Mainland in a wide range of specialisations and to obtain the relevant professional qualification certificates.

Qualifying criteria

Hong Kong service suppliers can be individuals or juridical persons. Where a Hong Kong individual is eligible for a benefit, the person must be a permanent resident of Hong Kong and in some cases also be a PRC national. A juridical person includes any form of organisation including corporation, trust, partnership, joint venture, sole proprietorship or association.

Except in the legal sector, a juridical person must satisfy the following criteria to qualify as a "Hong Kong service supplier":

• it is incorporated or established in Hong Kong;

• it has obtained any licence or permit for providing such services if required by law;

• the nature and scope of its business in Hong Kong encompasses the nature and scope of the services it intends to provide in the Mainland. With effect from 1 April 2012, apart from meeting the requirements in Annex 4 and Annex 5 of CEPA, any restrictive requirements applicable to the nature and scope of the business of foreign investment entities in PRC laws, regulations and administrative regulations shall also apply;

• it pays profits tax in Hong Kong;

• it has at least three to five years (depending on the sector) of substantive operations in Hong Kong (this requirement does not apply to real estate service suppliers);

• it owns or leases business premises in Hong Kong commensurate with the scope and the scale of its business; and

• 50% of its staff in Hong Kong are Hong Kong residents without limit of stay and persons from the Mainland staying in Hong Kong on a One Way Permit.

Certification procedure

To establish its status as a "Hong Kong service supplier", an enterprise must apply to the TID for a Certificate of Hong Kong Service Supplier. On the strength of this Certificate, the Hong Kong service supplier can then apply to the relevant PRC authorities for permission to set up a presence in the PRC to supply the relevant services in the Mainland under CEPA. Some of the documentation to be submitted to the TID and the relevant PRC authorities needs to be verified by a China-appointed attesting officer. There may also be additional requirements for market entry depending on the service sector.

Overseas service suppliers

An overseas service supplier can take advantage of CEPA through a merger with, or acquisition of, a Hong Kong service supplier. It must acquire at least 50% of the Hong Kong entity and is required to wait one year after the merger or acquisition before it will be eligible for any CEPA benefits.

Financial cooperation

Under CEPA VIII, the two sides agreed to strengthen cooperation in the area of finance, by supporting Mainland banks to develop their international businesses via Hong Kong's international financial platform, by supporting Hong Kong insurance companies to enter into Mainland insurance market via institutional set-up or capital injection, and by enhancing bilateral cooperation in the development of insurance products, business operation and operational management.

Cooperation in tourism

Under CEPA VIII, the two sides agreed to strengthen cooperation in the area of tourism as follows:

• to jointly improve the quality of tourism services and to establish a coordination mechanism for strengthening the regulatory regime for the tourism market in the Mainland and Hong Kong;

• to jointly promote overseas tourism and to build up closer cooperation between Mainland and Hong Kong in this respect;

• to encourage mutual entry of tourism enterprises and investments in Mainland and Hong Kong;

• to introduce measures on joint personnel training between Mainland and Hong Kong and to support Hong Kong to develop cruise tourism.

Trade and investment facilitation

The two sides agreed to further strengthen economic and trade cooperation through trade and investment facilitation in ten areas: trade and investment promotion; customs clearance facilitation; commodity inspection and quarantine, food safety, quality and standardisation; electronic business; transparency in laws and regulations; cooperation of small and medium enterprises; cooperation in industries; protection of intellectual property; cooperation on branding; and cooperation on education. Under CEPA VIII, the two sides agreed to further strengthen cooperation in commodity inspection and quarantine and food aspects. Further, the two sides agreed to strengthen collaboration in science and technology, and to support the establishment of a branch of the Chinese National Engineering Research Centre in Hong Kong as well as to set up a High-Tech Industrialization Base in Hong Kong.

How Deacons can help you with CEPA

Our China Practice Group has advised on investments, business activities and trade transactions in Mainland China for more than 25 years. A unique feature of our China Practice Group is that we are the first foreign law firm in Mainland China to have received official approval from the Ministry of Justice to establish three representative offices in the major economic cities of Beijing, Shanghai and Guangzhou. Deacons can assist with CEPA in various ways:

• qualifying as a Hong Kong service supplier: we can advise on the requirements for qualifying as a Hong Kong service supplier per business sector and on Mainland business strategy under CEPA;

• application to the TID for the Certificate of Hong Kong Service Supplier: our China-appointed attesting officers can assist with the preparation and attend to the verification of the required documents and the administration of oaths of the requisite declaration as well as attending to the application to the TID;

• overseas service suppliers: we can assist with the legal matters for forming a joint venture or acquiring or merging with a Hong Kong service supplier;

• establishing Mainland China service company: we can assist with the procedures and documentation for establishing a service company in Mainland China under CEPA.

Back to Top

The Pyramid Schemes Prohibition Ordinance Cap 617
by Joseph Kwan (joseph.kwan@deacons.com.hk)

The Pyramid Schemes Prohibition Ordinance (New Ordinance) came into effect on 1 January 2012. The purpose of the New Ordinance is to eradicate pyramid schemes. It repeals the 30 year old Pyramid Selling Prohibition Ordinance Cap 355 (Old Ordinance), which was no longer effective in combating various forms of pyramid selling.

What is a pyramid scheme?

Generally, a pyramid scheme is one whereby new participants are required to make a payment, at the time of joining, in return for the right to receive benefits when they recruit other people into the scheme. The scheme might be promoted as a club supported by fabricated testimonies about the financial returns to the participants. Although pyramid schemes might take different forms to disguise their true nature, they share a number of features. For example, no matter how a pyramid scheme is promoted, there is no genuine underlying business and the only way a profit can be generated is to use the investments contributed by new participants. Provided that a certain number of new participants are recruited within a specified period of time, the scheme can afford to pay profits to its participants with new money coming in. Hence, the promoter of the scheme makes money by recruiting more people, rather than by running a legitimate business. However, as the number of participants increases, so does the liability. Depending on the rate of increase of new participants, there will come a time when there are insufficient new participants to sustain the payouts. At that point, the scheme will collapse. Participants will lose their investments, as the money would have disappeared by then. Some people might incur substantial liability because they were lured into or forced to take out loans to fund their payment into the scheme. People most vulnerable to these types of schemes are those who are unsophisticated in making investment decisions. They are more likely to yield to aggressive sales tactics and be misled about financial returns in joining the scheme.

A pyramid scheme is very similar to a ponzi scheme. In both cases, there is no genuine underlying business and the payout is made to the earlier investors with money from new investors. The difference between the two schemes is that a ponzi scheme usually involves the promotion of an investment opportunity where the fraudster collects all the investments and then distributes dividends to investors. Under a pyramid scheme, each participant can directly benefit from the scheme, depending on how many new investors are introduced into the scheme.

As between a pyramid scheme and a legitimate multi-level marketing scheme, the rewards in the latter case are tied in with the sale of products and/or services rather than with the introduction of new participants. Also, the products and/or services sold are genuine with real market value rather than products and/or services that do not exist or are priced at an unrealistic level.

Loopholes under the Old Ordinance

Under the Old Ordinance, the "pyramid selling scheme" prohibited was one whereby:

Where an offence under the Old Ordinance had been committed by a body corporate, a director, secretary, principal officer or manager of that body corporate, or any person acting or purporting to act in any such capacity, also committed a like offence. It was a defence if that person could prove that the offence was committed without his or her consent or connivance, and that he or she exercised such diligence so as to prevent the commission of the offence as the person ought to have exercised, having regard to the nature of his or her functions and to all other circumstances.

In the decisions of HKSAR v Yau Mee Kwan [2004] 1 HKC 526 and HKSAR v Li Chi Yung [2004] HKCU 652, two loopholes in the Old Ordinance were identified, as follows:

In both cases, convictions were quashed on appeal, due to the loopholes. Accordingly, it was necessary to update the Old Ordinance because the definition of a "pyramid selling scheme" did not sufficiently cover the essence of a pyramid scheme.

Amendments Introduced by the New Ordinance

The objectives of the New Ordinance are to :-

The provisions of the New Ordinance, aimed at achieving the above objectives, are outlined below.

New definition of "pyramid scheme"

The definition of "pyramid scheme" has been revised to mean a scheme with all of the following characteristics:

Under the New Ordinance, a scheme may be a pyramid scheme regardless of:

Further, a scheme may be a pyramid scheme even if it has any or all of the following characteristics:

The New Ordinance provides that in deciding whether a scheme that involves the marketing of goods or services (or both) is a pyramid scheme, a court must have regard to the following matters in determining whether a participation payment under the scheme is entirely or substantially induced by the prospect held out to a new participant of entitlement to a recruitment payment:

The new definition of "pyramid scheme" is much wider under the New Ordinance and covers schemes irrespective of whether they involve any sale of goods or services. This should directly deal with the loopholes in the Old Ordinance. However, pyramid schemes are sometimes disguised as legitimate multi-level marketing schemes involving the sale of goods and/or services. The "participation fees" might take the form of "training fees" or "payment for products". In practice, it may not be easy to prove that the participation payment was induced entirely or substantially by the prospect held out to the participants that they will receive a benefit substantially relating to the introduction of new participants. The factors to be considered by the court to determine whether a scheme that involves the marketing of goods or services (or both) is a pyramid scheme, are intended to deal with this difficulty. If the goods and/or services paid for by a participant, when they join the scheme have little value or the value has been substantially exaggerated, the court may find that the true consideration for the participation fee is to confer a right to benefit from the introduction of new participants. Furthermore, if the emphasis on the return is focused on the recruitment of new members, rather than on the sale of the products and/or services, this will be a factor in support of the existence of a pyramid scheme.

There are of course risks to operators of genuine multi-level marketing schemes, who might find their schemes falling within the scope of the revised definition of "pyramid scheme". A genuine scheme should avoid a substantial link between the reward and the introduction of new participants. The link should be between the reward and the sale of genuine goods and/or services. After all, the law seeks to prohibit multi-level marketing schemes which do not involve a genuine underlying business. Such schemes are bound to fail and the participants will lose their investments.

Criminal liability for participants and those who induce others to join a pyramid scheme

To curb the proliferation and expansion of pyramid schemes, persons who induce other persons to join a pyramid scheme, with the knowledge that the benefits they may receive are entirely or substantially derived from the introduction of further new participants, are now caught by the provisions of the New Ordinance, in addition to those who knowingly establish, advertise or manage pyramid schemes or assist in such. Under the New Ordinance, the following persons will commit an offence:

The New Ordinance provides that where an offence has been committed by a body corporate (or member of a body unincorporate), and it is proved that the offence has been committed with the consent or connivance or is attributable to the neglect of a director, secretary, principal officer or manager of the body corporate (or partner, office holder or manager of a body unincorporate) or any person purporting to act in such capacity, such person also commits a like offence.

The rationale for revisions making participants in a pyramid scheme potentially liable (as well as promoters i.e. persons who establish, advertise and manage pyramid schemes or assist in such), is that a pyramid scheme cannot be sustained if not for the introduction of new participants by existing participants. One view is that if a participant knows that the benefit he or she obtains is derived from the introduction of new participants, he or she should not induce others to join. Otherwise, that person is similar to a promoter of the scheme and should be penalised. One of the key components of a pyramid scheme under the revised definition is the holding out to participants of the prospect that they will be entitled to receive a benefit entirely or substantially relating to the introduction of further new participants. As a result, those who have been recruited to the scheme would have been told that the benefit that will flow to them would relate to the introduction of new participants. If the participant then asked their friends to join the scheme, they are potentially liable to prosecution. The fact that money has been lost upon the collapse of the pyramid scheme would not in itself be a defence available to the participant. In practice, it is going to be difficult, in some cases, to distinguish between an innocent participant and one who has the requisite knowledge. Also, some schemes might have hundreds of participants and it will be challenging for the law enforcer to decide who should be prosecuted. Hong Kong has decided not to follow other jurisdictions, such as Mainland China and Singapore, which have a total ban on multi-level marketing schemes. Instead, Hong Kong is to rely on legislation that prohibits pyramid schemes. The fact that criminal liability is to be imposed on participants of pyramid schemes means that the public has the burden to assess whether a scheme is legitimate or not. In reality, due to the different tactics adopted by fraudsters, it will be hard for ordinary members of the public to tell whether what has been marketed to them is a pyramid scheme. As the principle behind a pyramid scheme is to exploit the naivety of the participants, it is likely that unsophisticated participants might find themselves losing their investments, as well as being prosecuted for knowingly inducing others to participate in a pyramid scheme.

Maximum penalties increased

To enhance the deterrent effect, the maximum penalty for an offence has been increased under the New Ordinance from a fine of HK$100,000 and imprisonment for three years, to a fine of HK$1,000,000 and imprisonment for seven years.

Power to award compensation

As under the Old Ordinance, the New Ordinance provides that if a person is convicted of an offence, the court may (in addition) to imposing the penalties referred to above, order the person to pay compensation to any person who has suffered financial loss resulting from that offence and such compensation is recoverable as a civil debt.

Conclusion

Only time will tell whether the New Ordinance will be effective in eradicating pyramid schemes. The fact is that the number of prosecutions against promoters of pyramid schemes is small. From 2007 to September 2010, there were 10 complaints of suspected pyramid schemes. Although 27 people were arrested as a result, none were prosecuted, due to insufficient evidence. Despite the New Ordinance, it will be challenging for law enforcers to obtain sufficient evidence to prove cases to the criminal standard of "beyond a reasonable doubt".

The new definition of "pyramid scheme" is much wider under the New Ordinance and will cover schemes irrespective of whether they involve any sale of goods or services. If you are conducting any business involving a multi-level marketing schemes, you should ensure that it does not violate the New Ordinance. As participants may also commit an offence under the Ordinance, individuals should approach multi-level marketing schemes with caution.

Back to Top

Please click here to view or download this publication.

Whilst every effort has been made to ensure the accuracy of this publication, it is for general guidance only and should not be treated as a substitute for specific advice.