MELVIN WAXMAN v. LI FEI YU AND OTHERS

HCA 1973/2012

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

ACTION NO 1973 OF 2012

____________

_______________

D E C I S I O N

_______________

Introduction

1.  I have before me two summonses taken out by the 2^nd and 4^th to 8^th defendants (the “Corporate Defendants”).  By their first summons dated 7 December 2012 (“1^st Summons”), the Corporate Defendants apply to strike out the plaintiff’s (“Plaintiff’s”) writ of summons and statement of claim dated 6 November 2012 (“SOC”), which is an action brought on behalf of the 9^th defendant (the “Company”).  On 14 February 2013, the Plaintiff amended the SOC as he was entitled to under Order 20 rules 1(1) and 3(1) of the Rules of the High Court (“RHC”).  Then, by their second summons dated 23 May 2013 (“2^nd Summons”), the Corporate Defendants apply to strike out the Plaintiff’s amended writ of summons and amended statement of claim (“ASOC”).  In addition, the Corporate Defendants seek an alternative relief that there be a determination or trial of a preliminary issue as to the Plaintiff’s locus in bringing the action on behalf of the Company.

Dramatis Personae

2.  The Plaintiff is a United States national.  He had been in the plumbing business for over fifty years.  He is assisted by his son (“Larry”).

3.  The 1^st defendant (“Frank”) is a national of the People’s Republic of China (“the PRC”) residing in Xiamen.  He owns and controls the Corporate Defendants and the 3^rd defendant which was deregistered.  He is the controlling mind and corporate will of the Corporate Defendants.  He has not been served the SOC or ASOC and is not an applicant in either of the summonses.

4.  The 2^nd defendant (“Solut”) is a company incorporated in Hong Kong and wholly owned by Frank.

5.  The 9^th defendant (the “Company”) is a company incorporated in Hong Kong.  Since March 2003, its shares are held by Frank, the Plaintiff and Larry as to 60%, 30% and 10% respectively.  Frank, Larry, the Plaintiff and Keith Ngai (“Keith”) are its four directors.  Frank is its president.

6.  The Plaintiff, Frank and Solut are also the parties in High Court Action 1972 of 2012 (“HCA 1972/2012”).  The 3^rd defendant was deregistered.  The Corporate Defendants are represented by Skadden, Arps, Slate, Meagher & Flom (“Skadden”).  The Plaintiff is represented by Oldham, Li & Nie (“OLN”).

7.  “WDI Group” refers to WDI Plumbing and the five companies set up by Frank and the Plaintiff, including the Company, mentioned in paragraph 9, WDI Technology mentioned in paragraph 10 and Solut.  The Plaintiff’s allegation in HCA 1972/2012 is that these companies in WDI Group are beneficially held by Frank, his brother-in-law, the Plaintiff and Larry in certain agreed proportion.  That is disputed by Frank and Solut.  

8.  For the purpose of this decision, “WDI Camp” refers collectively to the companies in WDI Group with the exception of Solut.

9.  Bai Ping (“Bai”) is an in-house counsel of WDI Technology and personal assistant of Frank.  She filed two affirmations in support of the Corporate Defendants’ striking out applications.   

The background

10.  The Plaintiff came to know Frank at a conference in 1989.  Together they established a Sino-foreign joint venture in plumbing business in Xiamen (“WDI Plumbing”).  The business was successful.  Between 1995 and 2002, they formed five other companies including the Company to engage in other aspects of the plumbing business.  Since 1999 when the Plaintiff reached the age of 65, he began to leave the day‑to‑day management of their business to Frank.

11.  By July 2002, the manufacturing facilities of WDI Plumbing were about to reach full capacity.  Through Solut as his investment vehicle, Frank and WDI Plumbing set up another Sino‑foreign equity joint venture (“WDI Technology”) to take advantage of the more favourable land prices and tax incentives available to Sino-foreign joint ventures to acquire a piece of land in Xiamen for the purpose of building a new factory for WDI Group. 

12.  Since August 2012, dispute arose over the distribution of the shares in WDI Technology among the Plaintiff, Larry, Frank and his brother-in-law.  On 21 August 2012, the Plaintiff first sought inspection of the books of accounts of the Company.  He was denied access.  Prior to commencement of this action, OLN on behalf of the Plaintiff made a non-particularized allegation in a letter dated 13 September 2012 that Frank used the Company’s cash flow to finance certain activities of his companies. By a letter dated 26 September 2012, Skadden, acting on behalf of all the defendants, including Frank, replied that there had been transactions of the type referred to but such payments had been properly recorded as receivables in the Company’s management accounts and would be settled in due course.  The Plaintiff did not respond. 

13.  On 22 October 2012, the Plaintiff issued a writ of summons with a general indorsement in High Court Action No 1972 of 2012 claiming the shares in WDI Technology against Frank and Solut and a writ in this action on behalf of the Company against all the other defendants.  It was not until 26 October 2012 that the books of the Company were provided to the Plaintiff for inspection.  During the inspection, the Plaintiff discovered that for ten years from 31 July 2002 to 1 April 2012 Frank had, without prior disclosure to and authorisation from the board of directors or the shareholders, used the Company’s funds to settle various operating expenses for the Corporate Defendants which are not members of WDI Group.

14.  On 6 November 2012, the Plaintiff filed statements of claim in both actions.  In the original SOC in this action, the Plaintiff claimed loss and damage in the sum of $525,030.40, being the Company’s funds used to pay the operating expenses of the Corporate Defendants and in the sum of $342,000 for the Corporate Defendants’ use of the registered office of the Company as their registered offices.  The SOC did not contain a plea of wrongdoer’s control of the Company by Frank preventing the Company from suing.  The originating and other legal processes were duly served on the Corporate Defendants but not on the 1^st Defendant who is resident in Xiamen in the PRC.

15.  On 8 November 2012, the 5^th Defendant remitted a total sum of $1,112,234 into the account of the Company in settlement of the payments made by the Company on behalf of the Corporate Defendants.  On 13 November 2012, Skadden informed OLN of the payment and invited the Plaintiff to discontinue this action.

16.  Then on 7 December 2012, the Corporate Defendants took out the 1^st Summons seeking to strike out the SOC.  In the affirmation filed in support of the application, the Corporate Defendants pointed out the absence of a plea of wrongdoer’s control and a plea that the cause of action was pursued on behalf of the Company. 

17.  Then two months later, the Plaintiff filed the ASOC which included those pleas and abandoned the claim on the engagement of legal representation by the Company.  He substantially increased his claim for payment of operating expenses and use of the Company’s registered office against the Corporate Defendants to $1,102,322.40 and $4,666,548 respectively, while the total amount of claim against Frank was increased to over $7 million.

18.  On 23 May 2013, the Corporate Defendants took out the 2^nd Summons to strike out the ASOC.  Presumably, in view of the amendment, they abandoned the ground that no reasonable cause of action had been pleaded.  As the pleadings now stand, the Plaintiff is claiming against Frank for breach of fiduciary duties owed to the Company in (a) misapplying the Company’s assets for the purposes of himself and the Corporate Defendants; (b) causing the Company to pay $2,242,349 to himself purportedly as director remuneration; (c) denying the Plaintiff and Larry access to the Company’s documents; (d) producing false accounts and minutes of the Company; and (e) failing to convene meetings.  As against the Corporate Defendants, the Plaintiff claims $4,656,636.80 being the total amount of the Company’s funds of $1,102,322.40 paid on behalf of the Corporate Defendants plus a sum of $4,666,548.40, being 40% of the rental and administrative expenses of the Company between 2002 and 2012 for their use of the Company’s office as their registered offices less the sum of $1,112,234 repaid by Frank and the Corporate Defendants. 

19.  Frank is not a party to these applications.  He has not been served the originating processes.  The Corporate Defendants do not dispute the fact that the Company has been paying their operating expenses.  By repaying the Company the sum of $1,112,234 which is slightly more than the amount claimed by the Plaintiff, the Corporate Defendants are admitting the claim but saying that the payments were in accordance with an established back-to-back arrangement and now the amount has been duly repaid.  They admit the use of the Company’s office as their registered offices but deny that the Company suffered any loss as claimed.  The major grounds of their striking out application are essentially that the Plaintiff has failed to establish a prima facie case of the Company’s claim against the Corporate Defendants, whether as originally pleaded or as amended, or a prima facie case that the claims fall within an exception to the rule in Foss v Harbottle.  Their subsidiary grounds are that the action is frivolous, vexatious and otherwise an abuse of the process of court and that the action is premature and misconceived.

Legal principles applicable to a challenge on locus in a derivative action

20.  The legal principles applicable to a challenge on locus in a derivative action has been well settled by the Court of Final Appeal in Waddington Ltd v Chan Chun Hoo Thomas (2008) HKCFAR 63. The practice in common law in a case where the plaintiff’s standing to bring a derivative action is challenged is that he must establish a prima facie case of both (a) that the company, on behalf of whose shareholders he sues, would be likely to succeed if it brought the action itself and (b) that the case falls within an exception to the rule in Foss v Harbottle (1843) 2 Hare 461.  In Waddington Ltd, Ribeiro PJ firmly rejected the proposition that the plaintiff in a derivative action was not required to establish a prima facie case.  He said at paragraph 20:

“20. The common law rule is therefore that a plaintiff whose standing to bring a derivative action is challenged must establish a prima facie case that the company is entitled to the relief claimed and that the action falls within an applicable exception to the rule in Foss v Harbottle (usually the fraud on the minority exception).”

Although this dictum was obiter, it was endorsed by the other members of the court: Li CJ, Bokhary and Chan PJJ.  The dictum must be taken as the most authoritative statement of the law in this jurisdiction.

21.  Counsel are in dispute as to how this prima facie test operates in an application to strike out a common law derivative action.  Essentially, their dispute is about the burden and standard of proof. Mr Shieh, counsel for the Corporate Defendants, is of the view that the approach in such an application is not the usual one as in striking out on the basis that a statement of claim disclosed no reasonable cause of action or that a claim is scandalous, frivolous or vexatious.  The courts are not to proceed on the basis that the allegations in the plaintiff’s pleadings are facts as they would be on the trial of a preliminary point of law or determining a striking out application under Order 18.  Rather, the onus is on the plaintiff to actually provide sufficient evidence for the court to be satisfied that there is a prima facie case that the company would be likely to succeed and that the case falls within an exception to the rule in Foss v Harbottle. He relies on Tan Eng Guan v Southland Co Ltd & Ors [1996] 2 HKLR 117; Waddington Ltd and Company Law in Hong Kong at paragraph 8.027. 

22.  Ms Chan, counsel for the Plaintiff, disagrees. She submits that the prima facie test is met simply on the basis of the pleaded facts without the plaintiff having to actually prove them.  She refers to the dicta of Ribeiro PJ in Waddington  Ltd at paragraphs 6 and 7:

“6. His Lordship furthermore held that the threshold test for permitting such a derivative action to proceed requires the plaintiff to show, on a prima facie basis, both that the company having the cause of action would be likely to succeed if it brought the proceedings itself and that the case falls within an applicable exception to the rule in Foss v Harbottle. On the facts assumed, Barma J held that such a prima facie case had been established in relation to the transaction involving Profit Point. But he held that no prima facie case had been shown in relation either to Autoestate’s acquisition of Pretty Star Limited or to Autoestate’s acquisition of Bagnols Limited.

7. Since the Statement of Claim had formulated Waddington’s claim solely as a derivative action on behalf of Playmates (and not on behalf of either Profit Point or Autoestate, neither company having then been joined as a party), the entire pleading had to be struck out as falling foul of the reflective loss principle. However, since a derivative action on behalf of Profit Point was in principle available and was prima facie sustainable on the facts pleaded, he declined to dismiss the action but granted Waddington the opportunity to reconstitute its pleading to accord with the principles laid down. Whether the Autoestate transactions could be revived as part of Waddington’s claim would depend on whether an amendment capable of meeting the threshold requirement of a prima facie case could be formulated on the facts.” (Plaintiff’s emphasis underlined)

Relying on the dicta high-lighted above, Ms Chan argues that in quoting Barma J’s approach in the Court of First Instance, the Court of Final Appeal approved the approach that what a plaintiff has to show is a prima facie case on the facts as pleaded which are assumed to be true without the plaintiff having actually to prove them. 

23.  Ms Chan also draws support for her proposition from paragraph 21 of Waddington Ltd, where in approving the observation of Lord Bingham in Johnson v Gore Wood & Co [2002] 2 AC 1 at 36, Ribeiro PJ said that at the strike-out stage any reasonable doubt must be resolved in favour of the claimant.  For completeness, I quote hereunder the dicta of Ribeiro PJ in paragraphs 20 and 21:

“20. The common law rule is therefore that a plaintiff whose standing to bring a derivative action is challenged must establish a prima facie case that the company is entitled to the relief claimed and that the action falls within an applicable exception to the rule in Foss v Harbottle (usually the fraud on the minority exception). Where, as often occurs, the plaintiff seeks an order to be indemnified as to costs by the company which may benefit from the derivative action, the court’s approach is to consider whether and to what extent an honest, independent and prudent board might decide to authorise prosecution of the action, given the available evidence. (My emphasis underlined)

21.    One may also note in passing that the burden and threshold requirements are different where a defendant seeks to strike out a plaintiff’s action on the ground that the loss claimed is merely reflective loss.  In such cases, the plaintiff is asserting his own cause of action and the burden lies on the defendant to show that it is plain and obvious that the losses are indeed merely reflective and the action is unsustainable.  Thus, in Johnson v Gore Wood, Lord Bingham of Cornhill noted: “At the strike-out stage any reasonable doubt must be resolved in favour of the claimant.”

With respect to Ms Chan, I think she was misreading what was said by Ribeiro PJ.  From paragraph 20, it is clear that his Lordship was of the view that the burden of proving a prima facie case rests on the plaintiff whose locus to bring the derivative action is challenged.  When paragraph 21 is read together with paragraph 20, it is obvious that his Lordship was actually distinguishing between striking out an action in which the plaintiff is asserting his own cause of action as in a striking out under Order 18, and striking out a derivative action.  It was in the context of a striking out under Order 18 that his Lordship said that any reasonable doubt must be resolved in favour of the claimant.  Indeed, in Johnson v Gore Wood, Lord Bingham was considering the defendant’s application to strike out the plaintiff’s claim on the usual ground of abuse of process and not striking out in a locus challenge.  I agree with Mr Shieh that in a striking out application involving a locus challenge in a derivative action, the burden of proof is on the plaintiff to prove a prima facie case that the company is entitled to the relief claimed and that the action falls within an applicable exception to the rule in Foss v Harbottle.

24.  As for the standard of proof required, it is just the prima facie case standard.  This standard was considered by the English Court of Appeal in Prudential Assurance Co Ltd v Newman Industries Ltd (No2).  The relevant passages have been quoted by Ribeiro PJ in paragraphs 15 to 18 in Waddington Ltd and it would be convenient to quote these paragraphs from the judgment of the Court of Final Appeal:

“15. The Court of Appeal in Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204 at 219 addressed the need for a standard to determine whether a sufficient case has been shown by the plaintiff, identifying the potential dilemma posed by the choice of standard as follows:

“...what course is to be taken ... if ...  the court is confronted by a motion on the part of the delinquent or by the company, seeking to strike out the action?  For at the time of the application the existence of the fraud is unproved.  It is at this point that a dilemma emerges.  If, upon such an application, the plaintiff can require the court to assume as a fact every allegation in the statement of claim, as in a true demurrer, the plaintiff will frequently be able to outmanoeuvre the primary purpose of the rule in Foss v Harbottle by alleging fraud and ‘control’ by the fraudster.  If on the other hand the plaintiff has to prove fraud and ‘control’ before he can establish his title to prosecute his action, then the action may need to be fought to a conclusion before the court can decide whether or not the plaintiff should be permitted to prosecute it. In the latter case the purpose of the rule in Foss v Harbottle disappears.  Either the fraud has not been proved, so cadit quaestio; or the fraud has been proved and the delinquent is accountable unless there is a valid decision of the board or a valid decision of the company in general meeting, reached without impropriety or unfairness, to condone the fraud.”

16.    The Court concluded that the answer was for a prima facie case test to be adopted, coupled with the possibility of seeking the views of the company in general meeting where appropriate:

“In our view, whatever may be the properly defined boundaries of the exception to the rule, the plaintiff ought at least to be required before proceeding with his action to establish a prima facie case (i) that the company is entitled to the relief claimed, and (ii) that the action falls within the proper boundaries of the exception to the rule in Foss v Harbottle. On the latter issue it may well be right for the judge trying the preliminary issue to grant a sufficient adjournment to enable a meeting of shareholders to be convened by the board, so that he can reach a conclusion in the light of the conduct of, and proceedings at, that meeting.” Ibid at 221-222

17.    The foregoing passages from Prudential were applied by Knox J in Smith v Croft(No 2) [1988] Ch 114 at 129-130 and 131 at 221-222,where his Lordship held that O 18 r 19 or O 33 r 3 were equally acceptable vehicles for deciding whether a minority shareholder had the necessary standing, Ibid at 135 applying the prima facie case test whichever procedure is adopted:

“...my conclusion is that it is the question stated by the Court of Appeal as a preliminary matter that has to be decided, that it is a special form of procedure concerned with giving sensible operation to the rule in Foss v Harbottle, 2 Hare 461 and which was concerned with avoiding the Scylla and Charybdis, on the one hand of having a preliminary issue which effectively requires one to try the whole action where the rule serves no useful purpose, and on the other side of the strait, of assuming that everything that the plaintiffs allege is necessarily correct as a matter of fact, which is of course the technique the court adopts when it has what was called a strict demurrer. The Court of Appeal, it seems to me, has laid down a halfway house for this very special type of case, one in which the legal issues in this particular case are sufficiently well defined for the parties to be able to argue them.” Ibid at. 138-139.

This has continued to be the approach of the English courts (See, eg, Barrett v Duckett [1995] BCC 362 at 367; Halle v Trax [2000] BCC 1,020 at 1,023; and Airey v Cordell [2007] BCC 785 at 797, §55.)

18.    The prima facie case test has also been adopted in Hong Kong.  Thus, in Tan Eng Guan v Southland Company Ltd [1996] 2 HKLR 117, the Court of Appeal held that the Judge at first instance should not have entered summary judgment where the plaintiff’s locus standi to bring a derivative action was being challenged and, referring to the prima facie case test adopted in Prudential and Smith v Croft (No 2), held that the question of standing was best dealt with by the trial of a preliminary issue, as recognized in England and Wales.”

25.  In balancing between the very onerous burden of proof to the necessary legal standard and the purpose of the rule in Foss v Harbottle, the English Court of Appeal chose at this preliminary stage the prima facie case test, which Knox J described in Smith v Croft (No 2) [1988] Ch 114 at 129-130 and 131 as a halfway house for this very special type of case.  This phrase has been used day in and day out in the courts.  It is widely understood by the legal profession.  It means something less than proof beyond reasonable doubt or proof on a balance of probability.  This is because once those standards are reached, it would be actual proof on a criminal or civil standard.  The term prima facie case or prima facie evidence just means sufficient evidence to pass the judge so as to make the issue fit for determination by the tribunal of fact.  To achieve that standard, the party which bears the burden of proof has to adduce sufficient evidence to satisfy the court, sitting as the tribunal of law, that there are reasonable grounds for believing that his case or the issue in question is well founded so that the issue becomes one which is fit for the tribunal of fact to adjudicate on.  It should never be equated with proof beyond reasonable doubt or proof on a balance of probability.

26.  As to how this burden is discharged by the plaintiff in a locus challenge, Ms Chan adopts the approach in an Order 18 striking out application and argues that the burden is discharged once a party shows that an issue is hotly disputed.  Then, it is not a matter which could be determined summarily and should be left to trial.  With respect, I disagree.  Such an approach totally ignores the plaintiff’s burden of having to prove a prima facie case and equates the burden as nothing but raising a disputed issue of fact.  That cannot be right.  In my opinion, how this burden is discharged depends on the circumstances of the case.  If the issues in question are adequately pleaded and not contradicted by evidence filed by the parties, then the pleading alone would be sufficient proof of the prima facie case.  But even if contrary evidence has been filed by the defendant, the courts are not required to conduct a trial by affidavit nor in all cases necessarily required to call the makers of the affidavit for cross-examination.  The courts are capable of and well experienced in making provisional finding of facts on affidavit evidence in such interlocutory proceedings by testing the plaintiff’s case against documentary evidence, incontrovertible evidence, or evidence which is not in dispute.  The court can determine against the backdrop of such contrary evidence whether the plaintiff’s evidence has passed the judge so as to make the issue or the case fit for determination by the tribunal of fact.  In an appropriate case, the court may be satisfied on the basis of the pleaded case that the prima facie test is met, irrespective whether contrary evidence has been filed by the defendant.  This may well explain why Barma J held at first instance in Waddington Ltd that on the facts assumed a prima facie case had been established.  That was a decision on its facts which is far from laying down any principle of law that the plaintiff is relieved of its burden of having to prove a prima facie case in resisting a striking out application in a locus challenge.

27.  The present dispute between counsel arose out of their refusal to appreciate that a different burden of proof applies in a striking out application based on the ordinary frivolous and vexatious or no reasonable cause of action grounds under Order 18 from that in a striking out application based on a locus challenge in a derivative action.  If the striking out application is made on both basis, then the application has to be considered on each basis separately.  If an applicant, ie the defendant, proceeds on the former basis, he has to accept the facts pleaded by the plaintiff as proven.  But if he proceeds on the latter basis, he puts the plaintiff to the proof of a prima facie case.  In the majority of cases, where the plaintiff succeeds in proving a prima facie case in a locus challenge, it is difficult to see how the defendant can succeed in striking out the plaintiff’s action under the Order 18 grounds.

Prima facie case of the Company’s claim – payment of expenses

28.  The thrust of the Corporate Defendants’ argument that the Plaintiff has failed to establish a prima facie case of the Company’s claim is that the operating expenses, whether the lesser sum claimed in the original SOC or the increased sum under the ASOC were repaid on 8 November 2012 before the filling of the ASOC.  The cause of action was thereby extinguished.  The argument is very technical.  First, Mr Shieh relies on the Plaintiff’s failure to plead wrongdoer’s control in the SOC.  Second, he relies on the reimbursement on 8 November 2012 by the 5^th defendant on behalf of the Corporate Defendants of $1,112,234 to the Company, which is more than the total of the two sums pleaded in the SOC or the revised amount of operating expenses pleaded in the ASOC filed three months after the said payment.  Then, he argues that by the time the Plaintiff purported to cure the defect in the SOC on 14 February 2013 by pleading wrongdoer’s control, it was already too late since insofar as the Corporate Defendants are concerned the expenses were settled and there is no longer a live cause of action which may be pursued by the Plaintiff against them.

29.  With respect, such argument is disingenuous. The effect of amendment of a writ or pleading has been succinctly summarised in paragraph 20/8/2 in Hong Kong Civil Procedure 2013.  An amendment duly made, with or without leave, takes effect, not from the date when the amendment is made, but from the date of the original document which it amends.  This rule applies to every successive amendment of whatever nature and at whatever stage the amendment is made.  When an amendment is made to the writ, the amendment dates back to the date of the original issue of the writ and the action continues as though the amendment had been inserted from the beginning.  The writ as amended becomes the origin of the action, and the claim thereon indorsed is substituted for the claim originally indorsed (per Collins MR in Sneade v Wotherton, etc [1904] 1 KB 295 at 297).  Similarly, in the pleadings, once pleadings are amended, what stood before amendment is no longer material before the Court and no longer defines the issues to be tried (per Hodson LJ in Warner v Sampson [1959] 1 QB 297 at 321).  Therefore, the plea of wrongdoer’s control and the amount of claim are all related back to the date of issue of the SOC.  Despite the rather substantial increase in the sum claimed under the ASOC, the amendment does not create any new or different cause of action.  The effect of the amendment is to insert a plea of wrongdoer’s control ab initio and to increase the amount of operating expenses and damages claimed.  Simply put, the ASOC has the effect of relating the increased amount of claim back to the date of the SOC.   Therefore, the payment on 8 November 2012 did not have the effect of extinguishing the cause of action which had accrued before the payment was made.  Furthermore, the payment actually amounted to an admission that the operating expenses were owed to the Company and the Company had a good cause of action against the Corporate Defendants.  Besides, in addition to the claim for operating expenses, there is also an increased claim for damages for the use of the Company’s registered office, which is not covered by the payment.  The fact that the operating expenses have been fully repaid before the issue of the ASOC does not extinguish the cause of action, but may be relevant as to costs.

30.  The secondary arguments advanced by the Corporate Defendants in Bai’s affirmations are that (1) because the Corporate Defendants do not have bank accounts in Hong Kong, a long standing back-to-back arrangement was made under which the Company, which is a holding company with no income, was given unsecured and interest free loans by WDI Technology to pay the operating expenses of the Corporate Defendants; (2) it is factually incorrect that those operating expenses were not recorded and/or improperly written off; (3) it is misconceived for the Plaintiff to suggest that Frank gave no consideration for the transfer of the funds to pay the operating expenses since the funds were not advanced to Frank but to the Corporate Defendants and were duly recorded as receivables repayable by them; and (4) the claims are premature as they are not supported by any proper letter before action. 

31.  These arguments are premised on the existence of the back-to-back arrangement between the Company and the Corporate Defendants. In support of her assertion of the existence of this arrangement, Bai quoted in her affirmation the following passages from Skadden’s letter of 26 September 2012 in reply to OLN’s demand for inspection:

“There have also been transactions of the type referred to in your letter of 13 September 2012. Due to the fact that a number of companies related to Mr Frank Li do not have bank accounts, the Company has customarily settled miscellaneous invoices on behalf of these companies in respect of, mainly, the audit fee, the company secretarial fee and the business registration fee. We are instructed that such payments have been properly recorded as receivables in the current account within the Company’s management accounts. We are further instructed that such receivables as remain outstanding will be settled in due course.

In your letter of 13 September 2012 your client makes allegations against Mr Frank Li of misappropriation of the Company’s assets for personal gain relating to such transactions.  Such allegations are without any basis.  First, the transactions were transparently recorded as receivables in the Company’s management accounts.  Second, if the transactions indeed constituted acts of misappropriation for personal gain (which is denied) as you have sought to mischaracterize them, one would expect that there would have been evidence of concealment; but there is none.  Third, the Company’s management accounts have been provided to the auditors for auditing in accordance with the applicable accounting standards and the audited accounts of the Company have duly been approved by Mr Frank Li and Mr Melvin Waxman.”

(Emphasis by the Corporate Defendants underlined. My emphasis high-lighted in bold print.)

32.  Despite Skadden’s very assuring letter, it can be readily seen that the existence of the alleged long standing back-to-back arrangement is illusory.  The obvious flaws in Bai’s argument are that she treated the Company and the Corporate Defendants as Frank’s own companies and there is also nothing to support the existence of this long standing arrangement.  While it is true that the Company is related to Frank who is a common and majority shareholder of the Company and the Corporate Defendants, the Company and the Corporate Defendants belong to two different camps.  The Company is a member of the WDI Camp held by Frank, the Plaintiff and Larry.  The Corporate Defendants are companies held by Frank solely, or at least not jointly with the Plaintiff and Larry, and carrying on his personal business, which is unrelated to WDI Camp.  If Frank should look for an entity to make the payments, he should and would turn to one within his own camp and not one within the WDI Camp.  When the Company paid the operating expenses of the Corporate Defendants using funds from WDI Technology, it was used as a conduit for siphoning funds from one camp to the other.  Simply put, Frank was using funds from WDI Camp to settle the liabilities of his own companies, ie the Corporate Defendants. This is really the basis of the Plaintiff’s complaint. I appreciate, of course, that Bai’s argument is that the Company would be and was reimbursed under the long standing back-to-back arrangement.  But, is this assertion credible?

33.  Some of the Corporate Defendants are substantial investment and trading companies.  Solut holds 60% of the shareholding in WDI Technology, which itself is a substantial company and the income generating arm of WDI Group.  The 6^th defendant, Swell International Trading Co Limited (“Swell International”), had an annual turnover of between US$1,434 million and US$3,499 million.  It is inconceivable that these two companies, at least, do not have bank accounts and operating offices in Hong Kong of their own, which could be used as registered offices for the Corporate Defendants.  Hong Kong is an international business and banking centre where natural persons and companies can freely open bank accounts.   It is incredible that for over ten years these Hong Kong companies do not need a bank account in Hong Kong for their business activities and took no steps to open one.  No explanation was given for this bald assertion.

34.  Except for Bai’s oral assertion, there is simply no evidence of this arrangement.  The arrangement is not corroborated by any document showing that it has been previously disclosed or considered by the board of directors or the shareholders of the Company at general meetings.  Most significantly, there is no evidence of any previous payment and reimbursement to support the long standing or back-to-back nature of this alleged arrangement.  For the past ten years, the Company had only paid but had never been reimbursed.  It was not until 8 November 2012 and only after the request for inspection of the Company’s books that Skadden informed OLN on Frank’s instruction that the receivables “will be settled in due course”.  It is also significant to note that settlement “in due course” meant the only reimbursement in ten years.  The assertion of long standing arrangement of payment and reimbursement is just a bald assertion unsupported by any evidence.  As the Plaintiff put it, the reimbursement is no difference from restitution by a thief after having been caught.  I seriously question the existence of this alleged long standing back-to-back arrangement.

35.  Except for the fact that the payments were entered in the books of the Company, there is no support for Bai’s assertions. Based on the entries, Bai argued that the Plaintiff knew that the operating expenses were properly recorded in the accounts of the Company and not written off.  The basis of her assertion is that the Plaintiff had access to the source documents as a result of the inspection of the Company’s books and was able to plead in the SOC and ASOC the source and particulars of payments from the “Expense List”, “Payment Voucher”, “Invoice” and/or “Petty Cash” as appropriate.  In particular, she said that the amounts due from the Corporate Defendants as a result of the payments were recorded in the current accounts between the Company and the Corporate Defendants; in the Detail Trial Balance/General Ledger of the Company and were recorded as part of the assets of the Company in the annual Balance Sheet in the Management Accounts of the Company.  She reiterated that the payments were not written off or treated as gifts.  Obviously, the SOC and ASOC were drafted based on the books of the Company which were eventually disclosed to the Plaintiff.  However, I think these entries in the books should be viewed with suspect in view of the delay in their production for inspection.  The books were not readily available for inspection or available within a reasonable time upon request.  OLN first requested for the books on 21 August 2012, Keith indicated that the Company would need 14 days to produce the books.  On 27 August 2012, Sally Lo of the Company refused to disclose any documents saying that they were locked up by a staff who was then on maternity leave for three months.  Later, she said that the headquarters in Xiamen had instructed the Company and its corporate secretary not to produce any document to the Plaintiff.  Despite arrangements made with Skadden, the internal accounting documents for the financial years of 2007 to 2009 only were produced.  The Company refused to produce the books of accounts for the remaining financial years under the excuse that they were stored in the warehouse.  The Plaintiff only had access to the full set of books until 67 days after OLN’s first letter requesting for inspection and four days after commencement of the action.  If the entries had been entered contemporaneously in the books, there is no good reason why the books could not have been produced timeously.  Such inordinate delay and the non-reimbursement in ten years cast serious doubts on the authenticity of the entries and suggest that the entries were concoctions which would not have been made but for the Plaintiff’s demand for inspection.

36.  Bai also relied on the Plaintiff’s approval of the audited accounts of the Company as his knowledge and approval of the payment of the Corporate Defendants’ operating expenses. However, nowhere in the audited accounts was the existence of the payments made by the Company for the Corporate Defendants disclosed, despite the mandatory requirement that such payments must be disclosed as related party transactions.  Bai said that the payments were recorded in the “management accounts” of the Company and explained the non-disclosure by asserting that the auditors have exercised professional judgment in auditing the accounts, suggesting that it was the auditors’ decision not to make the disclosure.  Bai is not even an employee of the Company.  She is in no position to speak on behalf of the auditors.  This is a matter of evidence for trial to be established by cross-examination of the Plaintiff and evidence of the auditors.

37.  Furthermore, Bai does not have personal knowledge of the matters she asserted.  She is an in-house counsel of WDI Technology but not an employee, officer or director of the Company.  She does not even reside in Hong Kong.  She joined WDI Technology seven years ago and could not possibly have personal knowledge of the back-to-back arrangement which, according to her evidence, had been in place for ten years ago.  She claimed to have knowledge of these matters in her capacity as Frank’s personal assistant.  This assertion was made belatedly.  She claimed that she had confirmation from the other director of the Company, Keith.  But, there is no explanation why Frank, Keith or indeed any of the Company’s local staff who have personal knowledge of these matters were not asked to give an affirmation relating to these matters.  I give no weight to Bai’s evidence.

38.  I have doubts as to the existence of the long standing back-to-back arrangement and the authenticity of the entries in the books of the Company.  As such, Bai’s argument that Frank had given consideration for the payments by the Company must fall apart. I also reject her argument that the claims are premature as not being supported by any proper letter before action.

39.  Summing up this part of the defence, there is an admission by the Corporate Defendants that their operating expenses for the past ten years had been paid by the Company and not reimbursed until 8 November 2012 after commencement of the present action.  The defence are that there was a long standing back-to-back arrangement of payment and reimbursement; that the Plaintiff knew about and approved the arrangement and that the payments were properly entered in the books of the Company.  The existence of this alleged long standing back-to-back arrangement and associated allegations is hotly disputed by the Plaintiff. Viewed objectively, the alleged long standing back-to-back arrangement is inherently incredible and inconsistent with the incontrovertible fact that the reimbursement was the only one in ten years.  The delay in production of the books of the Company casts serious doubts on their authenticity.  It must also follow that the defence that Frank had given consideration for the payment of the operating expenses must fail.  Adverse inference may be drawn against the Corporate Defendants because of their failure to adduce evidence from people who are expected to have personal knowledge of the matters in dispute.  This inference further undermines the credibility of their defence. 

40.  I am only left with the evidence of the Plaintiff which is largely incontrovertible or not disputed.  For the purpose of these proceedings, I am satisfied that the Plaintiff has proved a prima facie that the Company is entitled to claim.  Though the damages are likely to be nominal, on the evidence, the irresistible inference is that but for the commencement of this action, the reimbursement would not have been made and the wrongful conduct would have continued.  Furthermore, even if the operating expenses have been fully reimbursed, the Company is entitled to claim interest for the unauthorized payments over the past ten years.  Thus, the Plaintiff has established a prima facie that the Company is likely to succeed if it brings the action itself.

Prima facie case of the Company’s claim – use of the Company’s office and administrative support services for the Corporate Defendants

41.  There is no dispute that the office of the Company had been  and is still being used by the Corporate Defendants as their registered office without payment and approval by the board of directors or shareholders in general meetings. Initially under the SOC, the Plaintiff claimed damages in the sum of $342,000.  In the ASOC, the Plaintiff pleaded that Frank caused or permitted the Corporate Defendants to make use of the administrative resources of the Company and increased the claim to $4,666,548.  The amount of claim was assessed on the basis of 40% of the actual administrative expenses of the Company inclusive of rental for each financial year between 2002 and 2012 less those related to the Company.     

42.  In her second affirmation, Bai asserted that the Company could not have suffered any other than nominal loss as the use of the office of the Company by the Corporate Defendants as their registered office was only nominal.  She asserted that other than adopting the registered office by way of company registration and formal filings, the Corporate Defendants have not physically occupied or possessed the registered office of the Company or performed any acts or had use of the registered office to the exclusion of the Company, including any employees or had used any administrative resources identified by the Plaintiff.  Bai said that she had confirmed the above with Keith.  As analysed above, Bai does not have personal knowledge of the matters she asserted.  There was no explanation why Keith or the local staff of the Company were not asked to give an affirmation to this effect.  I can give no weight to her evidence. 

43.  However, I cannot ignore the very forceful argument of Mr Shieh that the loss and damage was not particularised in the SOC or ASOC or explained by the Plaintiff in his affidavit.  He submits that the Plaintiff’s assertion that Frank caused or permitted the Corporate Defendants to make use of the administrative resources of the Company is a bare assertion.  There was no averment in the SOC or ASOC that other than adopting the registered office of the Company as their registered offices, the Corporate Defendants occupied or possessed the registered office or used the Company’s staff for the business of the Corporate Defendants or did any acts on the registered office to the exclusion of the Company and/or the Company’s rights in the use of the registered office have been affected or prejudiced as a result.  The salaries of the staff and rental of the registered office have to be paid in any event.  Hence, Mr Shieh submits that the Plaintiff’s claim of 40% of the total administrative expenses of the Company under the cloak of a “broad brush” approach is arbitrary and that put to the highest, the Company would only be entitled to nominal damages.

44.  There is no dispute that despite his position as a director, the Plaintiff was refused access to the books of the Company by its staff on the instruction from “headquarters in Xiamen”, which could not mean anyone but Frank.  Bai explained that the books were unavailable, but that explanation is incredible.  It is clear that Frank is in control of the Company and obstructed the Plaintiff’s inspection.   If the Company is under a wrong-doer’s control, it would be difficult for the Plaintiff to obtain evidence of the wrongful acts committed by Frank in collaboration with the Corporate Defendants, at least not until after discovery.

45.  On the evidence, Solut and particularly Swell International are substantial companies which are expected to have operating offices in Hong Kong.  Bai has not tendered any evidence that these or any of the other Corporate Defendants have operating offices in Hong Kong.  If they have, there is no reason why their offices could not be used as the registered offices of the Corporate Defendants.  From these circumstances, the inference could be drawn that they do not and their use of the registered office of the Company is more than nominal.  If it is, the apportionment of the administrative expenses by the Plaintiff is not unreasonable and is a matter for trial.

46.  Furthermore, one would expect Frank as the director in overall control of the Company and the Corporate Defendants, Keith as the only other director of the Company other than the Plaintiff and the local staff of the Company would be called to give evidence, if the Corporate Defendants are serious and acting in good faith in contesting the Plaintiff’s claim.  Frank is the corporate will of the Company and Corporate Defendants. It is no answer to argue that as he is not a party to the application he is not required to give an affirmation.  No explanation was given for the Corporate Defendants’ failure to call them.  Adverse inference could therefore be drawn that the Corporate Defendants have much to hide in relation to their use of the registered office of the Company.  This inference lends further support to the Plaintiff’s apportionment.  I therefore find that in the absence of evidence from Frank and Keith, the Plaintiff has shown a prima facie case that the Company has more than a nominal claim against the Corporate Defendants for the use of its registered office.  In any event, in my view, nominal damages would be sufficient for the purpose of proving a prima facie case to enable the Plaintiff to bring the action against the Corporate Defendants on behalf of the Company.

Prima facie case of the Company’s claim – conclusion

47.  There are other claims made by the Plaintiff against Frank such as engagement of legal representation by the Company and other acts of misappropriation of the Company’s funds.  They are not relied on by Ms Chan as Frank is not before the court.  In view of the interest element, the damages are not likely to be nominal.  But even if they are, the inference is that but for the commencement of this action, the wrongful conduct of Frank and the Corporate Defendants would have continued.  On the evidence, I am satisfied that the Plaintiff has shown a prima facie case of the Company’s claim. 

Exception to the rule in Foss v Harbottle

48.  The Plaintiff relies on the generally recognised exception of fraud on the minority to justify bringing the derivative action. As submitted by Ms Chan, the fraud is not confined to “fraud” in the Derry v Peek sense, but includes equitable fraud where a director has misused the company’s assets to make interest-free loans to himself and other corporate defendants in which he was interested (see: Tan Eng Guan v Southland Company Ltd at 121G-122F).  The Plaintiff therefore relies on the payment by the Company of the operating expenses of the Corporate Defendants in the past ten years as Frank’s misuse of the Company’s assets.  Had there been no reimbursement, the payment would have been caught as “fraud” in the Derry v Peek sense.  

49.  Mr Shieh argues that the Plaintiff’s claim of fraud on the minority under the original SOC which was premised on the failure to record and/or writing off of the amounts due is bound to fail as being contrary to the evidence.  Though the payments were entered in the books and management accounts of the Company, because of the delay in producing the books for inspection and for other reasons as explained in paragraph 34, the Corporate Defendants’ case is not credible.  The entries in the books are of doubtful authenticity.  I have found the Plaintiff has proved a prima facie case of a claim against the Corporate Defendants. Of course, whether he can discharge the burden of proof, ie that the entry was a concoction, is a matter of evidence to be established at trial.  At this stage, it must necessarily follow that he has also proved a prima facie case of fraud on the minority.

50.  Next, Mr Shieh submits that there could be no right of action if the alleged breaches of duties are capable of ratification. Hence, he argues that as the Plaintiff’s pleaded case is that the payment was not disclosed or authorized by the board of directors or the Company in general meeting, it is implicit that the payment could have been disclosed and authorized by the Company, and therefore capable of ratification.  Particular reliance is placed on the fact that the payments were recorded in the books of the Company.

51.  However, it is well established that a director is precluded from self-dealing or from entering into engagements in which his duties may conflict with his personal interest.  The liability to account does not depend upon proof of mala fides (see: Regal (Hastings) Ltd V Gulliver [1967] 2 AC 134 at 137G-138G, per Viscount Sankey and 147A-F and 149A-150B, per Lord Russell).  As I have observed, the Corporate Defendants belong to a different camp from WDI Technology.  They belong to Frank who is their controlling mind and corporate will.  On the basis that the entry in the books of the Company are concoctions afterthought, which the Plaintiff has established a prima facie case, the payments were, at the very least, interest free loans by the Company to Frank and the Corporate Defendants and therefore a fraud on the minority.  Furthermore, appropriation of company’s money by a director is not a matter which can be ratified by shareholders (see: Burland v Earle [1902] AC 83 at 93-94, per Lord Davey; Cook v Deeks [1916] 1 AC 554 at 564, per Lord Buckmaster LC).

52.  Under this subsection, Mr Shieh also relies on the repayment by the 5^th Defendant on behalf of the Corporate Defendants on 8 November 2012 as having extinguished the cause of action.  As the ASOC is related back to the date of the SOC, the Company had a valid cause of action against the Corporate Defendants before the repayment.  The cause of action was not extinguished.  Besides, the Company has a valid claim of interest which has not been satisfied.  For reasons as explained in paragraphs 27 and 28, I dismiss this line of argument.

53.  Accepting that the Plaintiff has established a prima facie case of fraud on the minority, he has no difficulties in proving wrongdoer’s control.  Frank is the president of the Company and, hence, the person vested with the power to bring legal proceedings on behalf of the Company. It is inconceivable that he would agree to bring legal proceedings against himself.  This is amply demonstrated by the obstruction he caused to the Plaintiff’s inspection of the books of the Company since October 2012 and the striking out action which must have been taken out by the Corporate Defendants at his instruction.  In this regard, it is curious to note that while Skadden acted for Frank and the Corporate Defendants up to and including the date of repayment, they ceased to act for him thereafter, but continued to act for the Corporate Defendants of which Frank is the corporate mind and will.

54.  Keith has been accustomed to act in accordance with Frank’s direction.  As such, Frank has control over two out of the four directors of the board.  Even if the board has power to procure the Company to commence action against Frank and the Corporate Defendants, the board would be unable to do so because of the deadlock.  Thus, Bai’s suggestion that the Plaintiff did not attempt to convene a board meeting to consider bringing action against the Corporate Defendants prior to commencement of this action is simply unrealistic.

55.  Furthermore, even if the company in general meeting has the residual power to authorise the commencement of an action against Frank and the Corporate Defendants, as Frank holds 60% of the issued shares in the Company, he would be able to defeat any such resolution for that purpose proposed to be passed by the Company at general meeting.

56.  Accordingly, I am satisfied that The Plaintiff has shown a prima facie case that the claim falls within an exception to the rule in Foss v Harbottle.

Conclusion

57.  For the above reasons, I am satisfied that the Plaintiff has shown a prima facie casethat the Company has a claim against the Corporate Defendants and that the claim falls within an exception to the rule in Foss v Harbottle.  The Plaintiff is entitled to bring the action on behalf of the Company against the Corporate Defendants.  As a prima facie case having been shown, it must necessarily follow that the writ and ASOC cannot be said to be scandalous, frivolous or vexatious or otherwise an abuse of the process of the court. 

58.  As for the application for alternative relief that there be a determination or trial of a preliminary issue as to the Plaintiff’s locus in bringing the action, the Corporate Defendants only adduced the affirmations of Bai who does not have personal knowledge of the facts asserted in her affirmations.  In any event, for reasons as I have given, her evidence is inherently incredible and inconsistent with other incontrovertible evidence.  The persons who have personal knowledge of the controversy in dispute are Frank and Keith.  For reasons best known to themselves and therefore the Corporate Defendants, they chose not to give any affirmation.  There is no evidence from the Corporate Defendants to contradict the Plaintiff’s.  It is therefore not possible to conduct a trial of the preliminary issue as to the Plaintiff’s locus in bringing the action or to make any determination as to his locus beyond finding that he has shown a prima facie case of a claim against the Corporate Defendants.

59.  Accordingly, the 2^nd and 4^th to 8^th Defendants’ two summonses dated 7 December 2012 and 23 May 2013 must be dismissed. 

Costs

60.  Mr Shieh contends that the ASOC must be taken as an admission that the SOC was defective and hence the Corporate Defendants should be entitled to costs at least up to the date of the filing of the ASOC. Ms Chan argues otherwise on the ground that the 1^st Summons was issued by the Corporate Defendants in breach of the usual practice.

61.  The practice enshrined in Practice Direction 19.1 is that before issuing a striking out summons a party should write to the other side pointing out the alleged deficiencies in the pleading.  At the time when the Corporate Defendants issued the 1^st Summons, pleadings were not yet closed.  Under Order 20 rules 1(1) and 3(1), the Plaintiff was entitled to amend the Writ and SOC without leave.  In issuing the 1^st Summons before the close of pleadings, the Corporate Defendants must be taken to have accepted the risk that the costs incurred in preparing the 1^st Summons would be wasted if the defects in the SOC will be rectified by amendment.  The Corporate Defendants contend that they were only following the practice which requires a strike out application to be made promptly and before close of pleadings.  However, that is no answer to their failure to inform the Plaintiff of the alleged defects in the SOC and their issue of the 1^st Summons without any warning or letter preceding the application.  While the Plaintiff was at fault in filing the SOC which was defective, the Corporate Defendants should have followed the usual practice of alerting him of the defects before issuing the 1^st Summons.  The Plaintiff’s fault would be penalised in costs by having to bear the costs of and occasioned by the amendments under Order 62 rule 3(3), unless the court orders otherwise.  But there is no reason why he should be penalised for the costs wasted as a result of the Corporate Defendants’ failure to follow the usual practice and issuing the 1^st Summons without prior letter.  Had the Corporate Defendants followed the usual practice, the Plaintiff would have amended the SOC in time and all costs of preparing the 1^st Summons and Bai’s 1^st affirmation could have been saved.  The Corporate Defendants’ departure from the usual practice unnecessarily generates costs and offends the underlying objectives of the Rules of the High Court as stated in Order 1A rule 1 of increasing cost-effectiveness of any practice and procedure and promoting a sense of reasonable proportion and procedural economy in the conduct of the proceedings.  The Corporate Defendants should not be awarded costs which they need not have incurred had they followed the usual practice.  They should be deprived of their costs prior to 14 February 2013. 

62.  The Plaintiff is successful in resisting the application.  There is nothing in the circumstances of this case to suggest that there should be a departure from the ordinary costs principles.  Accordingly, I make an order nisi that the 2^nd and 4^th to 8^th defendants shall pay the plaintiff’s costs of these proceedings incurred after 14 February 2013 with certificate for two counsel.