The insurability of regulatory fines under Hong Kong law: a case study courtesy of Evergrande

This marks the first time that auditors of a defunct company will compensate its public shareholders. In particular, the level of regulatory sanction imposed on PwC in relation to the Evergrande audits has raised a recurring question for professionals and their insurers: to what extent are regulatory fines and penalties insurable under Hong Kong law?

Background

PwC acted as the reporting accountant for Evergrande’s listing in 2009 and subsequently served as Evergrande’s group auditor from its listing until resigning from that post in early 2023.

Following investigation, the SFC found that Evergrande’s financial reports for 2019 and 2020 contained materially false or misleading information, particularly regarding revenue recognition. Evergrande had manipulated its annual revenue and profits by prematurely recognising revenue from property sales before completion and delivery of those properties to buyers, with intent to substantially overstate its annual revenue and profits.

In parallel, the AFRC conducted its own investigation into PwC’s conduct as Evergrande’s auditor, focusing on compliance with auditing standards and the quality of audit work performed in respect of the 2019 and 2020 audits.

Decisions announced by SFC and AFRC

Whilst not admitted by PwC, the SFC considered that PwC, in its role as auditor of Evergrande, failed to maintain auditor independence during the audits of China Evergrande’s 2019 and 2020 financial statements and failed to exercise sufficient professional scepticism.

Consequently, with the ultimate objective of securing compensation for shareholders, the SFC has determined that the interests of Evergrande’s independent minority shareholders would be best served by reaching an agreement for PwC to pay them HK$1 billion in compensation.

Separately, the AFRC imposed a HK$300 million fine on PwC, together with a six‑month practice limitation, and fines totalling HK$10 million on two former registered responsible persons, in respect of failures identified in the Evergrande audits. The AFRC described the misconduct as serious and egregious, reflecting serious departures from professional auditing standards.

The SFC and AFRC press releases can be accessed here:

• SFC reaches agreement with PricewaterhouseCoopers for shareholder compensation of HK$1 billion regarding false financial statements of China Evergrande Group for 2019 and 2020
  
• AFRC imposes HK$300 million fine and six-month practice limitation on PricewaterhouseCoopers and HK$10 million in fines on its two former registered responsible persons over the Evergrande Audits

The insurability of fines in Hong Kong

On the one hand, PwC entered into an agreement with the SFC to provide compensation to affected shareholders. On the other, a significant regulatory fine has been imposed on it by the AFRC. The contrast between these two outcomes is useful to illustrate the question of their respective insurability under Hong Kong law.

Hong Kong law does not expressly prohibit regulatory fines from being insurable as a matter of law. The insurability of fines and penalties is therefore determined by common‑law principles, in particular the doctrine of illegality and broader considerations of public policy. As a common‑law jurisdiction, Hong Kong has consistently drawn on English authority in this area, including the UK Supreme Court’s decision in Patel v Mirza [2017] AC 467, which has been treated as persuasive and is routinely cited by Hong Kong courts in illegality cases.

The illegality doctrine and competing approaches

Historically, the common law applied what has become known as the “reliance approach”, derived from Tinsley v Milligan [1994] 1 AC 340, under which a person should not be granted a remedy where he has to rely directly on unlawful conduct to succeed. That approach has been criticised for its mechanical focus on reliance, which risks producing results that do not reflect a principled assessment of public policy and proportionality[1].

In Patel v Mirza, the UK Supreme Court reframed the illegality doctrine and held that a court should determine whether it would be harmful to the integrity of the legal system to allow a claim involving an illegal act by considering the following factors:

• the underlying purpose of the prohibition which has been transgressed;
• conversely any other relevant public policies which may be rendered ineffective or less effective by denial of the claim; and
• the possibility of overkill unless the law is applied with a due sense of proportionality.

The Hong Kong position: the Monat decision

The position in Hong Kong has been considered in detail by the Court of Appeal in Monat Investment Ltd v Lau Chi Kan Kenneth [2023] HKCA 479. In that case, the court undertook an extensive review of the development of the illegality doctrine and expressly considered both the "reliance approach" in Tinsley v Milligan and the "range of factors approach" articulated in Patel v Mirza. The Court of Appeal recognised that, prior to Patel, Hong Kong courts had followed Tinsley largely as a matter of stare decisis. However, it concluded that Patel v Mirza now represents the modern common law approach to illegality and "would be logical that Patel is followed in the absence of any local circumstances that render it inappropriate".

While Monat concerned adverse possession, its reasoning has broader application and has been cited and applied in various types of cases, including Kwan Hung Shing v Fong Kwok Shan Christine [2023] HKCA 1020 which confirms that domestic illegality can serve as a defence to unjust enrichment claims.

Relevance to regulatory and disciplinary fines

In the absence of direct Hong Kong authority addressing the insurability of regulatory fines, the courts are likely to adopt the proportional analysis applied in Patel v Mirza. Under that framework, the essential rationale of the illegality doctrine is that it would be contrary to the public interest to enforce a claim if to do so would be harmful to the integrity of the legal system, having regard to the purpose of the prohibition, competing public policies and the need for a proportionate outcome.

It should also be noted that, unlike criminal penalties, professional disciplinary regimes frequently serve mixed purposes, combining punishment and deterrence with the protection of the public and the maintenance of professional standards. As emphasised by Lord Sumption in Les Laboratoires Servier v Apotex Inc [2015] 1 All ER 671, the application of the illegality doctrine turns on the legal character and purpose of the statutory rule said to have been breached, and not every breach of statute constitutes "turpitude" for the purposes of the defence of illegality.

Insurability of the SFC settlement and AFRC fine under Hong Kong law

SFC settlement

The HK$1 billion payment agreed with the SFC is, strictly speaking, not a fine or penalty, but a compensation arrangement intended to provide redress to affected shareholders somewhat akin to a settlement to resolve civil proceedings. It is therefore best characterised as compensatory rather than punitive. Under Hong Kong law, there is no general public policy objection to insuring liabilities that are compensatory in nature, even where they arise from regulatory investigations or alleged misconduct. Applying the Patel v Mirza framework as endorsed in Monat, indemnification of such a payment would not ordinarily undermine the integrity of the legal system, as it does not negate the purpose of the underlying regulatory prohibitions but instead facilitates redress to affected third parties. In practical terms, questions of cover are therefore more likely to turn on policy construction (including the scope of “loss” and any admissions or conduct exclusions), rather than on illegality or public policy grounds.

AFRC fine

Different considerations arise in relation to the HK$300 million AFRC fine, which constitutes a lawfully imposed regulatory sanction. Unlike compensatory payments, a regulatory fine is inherently punitive and intended to be a deterrent. Indemnification by insurers may risk blunting the intended regulatory impact. While Hong Kong law does not impose a categorical bar on insuring fines, a court applying Patel v Mirza is likely to scrutinise closely whether indemnity would frustrate the purpose of the AFRC’s disciplinary regime. Given that the fine was imposed for serious and egregious audit failures, it is arguable that allowing insurance recovery may be contrary to public policy by diluting deterrence and accountability. As such, putting aside typical policy exclusions for fines or penalties, there is a material risk that indemnification of the AFRC fine would be regarded as uninsurable as a matter of common law illegality or public policy. However, the question of the insurability of fines such as those imposed by the AFRC has yet to be settled in either England or Hong Kong.

Last but not least, questions of insurability cannot be considered in the abstract. Coverage must first be included in relevant policies, the wording of which must be carefully scrutinised, including any exclusions for fines or penalties to ensure a full understanding of the scope of coverage. That said, in the absence of clarity, under existing Hong Kong law, the compensatory payment to shareholders appears to be more likely to be insurable (subject to policy terms), whereas the AFRC fine may face a higher hurdle on public policy grounds.

Conclusion

The insurability of regulatory fines in Hong Kong remains a developing area, and recent cases in Hong Kong and in England expressly provide that regulatory sanctions or fines are not automatically uninsurable particularly where they were imposed in the absence of findings of dishonesty. Whether a fine can be insured will depend on the nature of the conduct, the purpose of the regulatory regime and the application of the illegality doctrine to the particular facts. Companies should therefore pay close attention to the scope of their insurance arrangements and the terms on which cover is provided, as well as future legal developments.

[1] As discussed by the Hong Kong Court of Appeal in Monat Investment Ltd v Lau Chi Kan Kenneth [2023] HKCA 479.