SECURITIES AND FUTURES COMMISSION v. GREAT HONEST INVESTMENT CO LTD AND OTHERS

HCMP 2251/2007

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

MISCELLANEOUS PROCEEDINGS NO. 2251 OF 2007

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REASONS   FOR   DECISION

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1.  This was the hearing of an application by Mr John Lees, the Administrator appointed in respect of Great Honest Investment Company Limited (“GHI”), Great Honest Finance Company Limited (“GHF”) and Pak Win Investment Limited (“Pak Win”) for directions as to how he should deal with securities and cash held by GHI for its clients.  The application had come before me on a number of previous occasions, when directions were given for the sending of notices and information to such clients to enable them to come forward and make submissions on the application if they wished to do so.

2.  At the end of the hearing I gave directions as to the manner in which the losses arising from lost or missing securities should be allocated among clients of GHI, and also gave further consequential directions to enable Mr Lees to return to GHI’s clients such securities and cash as were available.

3.  The background to the application can be briefly stated.  It is similar to that in a number of other cases which have come before the courts in recent years, in which the Securities and Futures Commission (“the SFC”) have had to seek the appointment of an administrator in respect of a licensed securities dealer under section 213(2)(d) of the Securities and Futures Ordinance.

4.  On 9 November 2007, the SFC issued a Restriction Notice in respect of GHI pursuant to sections 204 and 205 of the Ordinance, as a result of concerns which it had as to the position of GHI.  On 12 November 2007, Mr Lees was appointed as the Administrator of GHI on the application of the SFC.

5.  Following his appointment, Mr Lees and his staff investigated the affairs of GHI, GHF and Pak Win, all of which were companies under the ownership or control of Ms Lorrain Chung and her brother, Mr K.C. Chung.  GHI is a licensed securities dealer, while GHF is a licensed money lender, and Pak Win is the owner of properties which were used as the offices and storage facilities of GHI.  It appears that GHF had, in the past, provided margin financing facilities to customers of GHI.  However, this business seems to have ceased some time ago, in about June 2000.

6.  At the time of Mr Lees’ appointment, GHI had some 837 clients, some of whom held more than one account with it.  351 clients had active accounts (that is, accounts which had a cash and/or securities balance as at 1 November 2007, and/or transactions between 1 and 9 November 2007), 85 clients had more than one account, of which at least one was active, and 401 clients had inactive accounts.  Some of the clients were cash clients, while others were margin clients.

7.  Mr Lees’ investigations revealed that there is a shortfall in the number of securities which should have been held by GHI in respect of its cash and margin clients.  The reasons for this shortfall included apparent misappropriation of cash and securities by the directors of GHI and its related companies, the making of unauthorised sales of securities held on behalf of clients and the payment of the sales proceeds into accounts of directors of GHI and related companies instead of into GHI’s client accounts, failure to make purchases in accordance with clients’ instructions after funds for the making of such purchases had been received, possible unauthorised trading by GHI, pledging of margin clients’ securities to secure banking facilities and indebtedness of GHI, and the effects of closing out adjustments made by CCASS (the clearing company of the Hong Kong Stock Exchange) as a result of the inability of GHI to settle open transactions after the issue of the Restriction Notice.

8.  Following his investigations, Mr Lees classified the securities held by GHI for its clients as either “Unimpaired Securities” or “Impaired Securities”.  Unimpaired Securities were lines of securities in a listed company in respect of which GHI had on hand (either in its CCASS account or in the form of physical scrip) all of the securities which it should have held on behalf of its clients, so that there was no shortfall.  All such securities could be returned to the clients concerned, subject only to provision being made for a proportionate share of Mr Lees’ fees and expenses to be met by those clients.  Impaired Securities were those in which there was a shortfall between the number of securities which GHI should have held for its clients, and the actual number of securities that was available for distribution.

9.  The point for determination at this hearing was how such Impaired Securities should be distributed between the clients having claims to them.

10.  The same situation has arisen in a number of previous cases, such as Re CA Pacific Finance Ltd (in Liquidation) & Another (No. 1) [1999] 2 HKC 632, Re Forluxe Securities Ltd (in Liquidation) (unreported, HCCW 310 & 311/1998, Yuen J, 20 December 2000), Re Chark Fung Securities Co. Ltd (in Liquidation) (unreported, HCCW 362/1998, Kwan J, 13 November 2002) and Re Tiffit Securities (Hong Kong) Ltd (Adminstrators Appointed) (unreported, HCMP 1479/2006, Kwan J, 18 January 2007).

11.  It is by now well-established that a where a securities dealer acquires securities on behalf of his clients, he holds them as an agent for his client, who owns the beneficial interest in them (see the cases cited in the previous paragraph).  However, where the number of securities available falls short of the number to which such clients are entitled, it becomes necessary to determine how such securities as are in the hands of the Administrator (or liquidator, as the case may be) should be dealt with.

12.  In the previous cases in which this problem has arisen, it has been resolved by the court directing that the available securities should be distributed pari passu among the clients having a claim to them.  Thus, where the company’s records showed that its clients between them held, say, 10,000 shares in a particular company, but the liquidator or administrator was only able to locate, say, 8,000 such shares, the missing 2,000 shares were deemed to have been lost by all of the clients, proportionately to their respective holdings of such shares.

13.  However, it seems that in each of the earlier cases, the records of the security dealer in question were in a state of disarray, and were either incomplete or missing, so that its liquidator or administrator was unable to establish whether any particular client’s shares had been misappropriated.

14.  That is not the case here.  Mr Lees’ evidence discloses that the GHI had in fact instituted a computerised client accounting system from about 1999 or 2000 onwards.  From that time onwards, it has been possible for Mr Lees and his staff to identify, in relation to all the defalcations that have taken place, which clients’ accounts have suffered such defalcations, and when they occurred.  The unauthorised removal of shares from a client’s account was recorded on the system (although falsified account statements were sent to the clients concerned to conceal the defalcation from them), and the disposal of the shares in question could be confirmed by reference to movements in the number of such shares held in GHI’s CCASS account.

15.  In those circumstances, the question that arises is whether or not it is appropriate to use the pari passu method of distribution in the present case.  Initially, it was Mr Lees’ suggestion that the pari passu method should be followed notwithstanding that it might be possible to identify the particular client whose account had suffered a defalcation.  However, at the earlier directions hearings, I questioned whether this was necessarily appropriate.  In the result, Mr Lees and his staff have carried out further investigations into the state of GHI’s records, and are now satisfied that from the time at which the computerised client accounting system became operational, it is possible to identify which particular client’s shares were misappropriated, and when this happened.  Importantly, Mr Lees has indicated that he has no reason to doubt the accuracy of GHI’s records in this respect.

16.  Mr Dobby, who appeared for Mr Lees, referred me to the decision of Lindsay J in Russell-Cooke Trust Co v Prentis [2003] 2 All ER 478, in which it was held that the “first in, first out” rule (generally known as the rule in Clayton’s case) could be displaced by relatively slight evidence, and a pari passu method of distribution adopted instead.  He submitted that this suggested that the appropriate method of distribution was something that depended on the particular facts of any given case.  In the case of GHI, said Mr Dobby, the fact that GHI has maintained records which appear to be accurate and complete, from which it is possible for Mr Lees to ascertain with some confidence the identity of the accounts out of which the missing parts of the Impaired Securities have been wrongfully removed, means that there is here evidence which suggests that it would not be appropriate to adopt the pari passu method of distribution so as to distribute the losses among all the clients who should, as at the date of Mr Lees’ appointment, have had a number of such shares held by GHI, and that the correct approach would be to rely on the records of GHI to identify the particular client who has suffered the loss.

17.  I think that this is right.  Moreover, consideration of a simplified example confirms this.  Let us assume that, on a particular date, GHI held 1,000 shares in Company X on behalf of Client A.  If there was then a misappropriation of 500 of those shares, followed later by the acquisition of a further 1,000 shares in Company X by Client B, after which Mr Lees was appointed as Administrator, the position facing Mr Lees would be that GHI had 1,500 shares of Company X available for distribution, but there would be two clients (A and B), each with a claim to 1,000 shares.  The application of the simple pari passu method of distribution would mean that each of the clients would receive 750 out of the 1,500 shares available for distribution.  But this would clearly be unfair to Client B, because GHI’s records (which are supported, at least so far as the timing of the sales is concerned, by the trading records maintained by the Hong Kong Stock Exchange) make it absolutely clear that the defalcation took place at a time when only Client A maintained a holding of shares in Company X with GHI.  In those circumstances, I do not see how it could seriously be suggested that there is any rational or proper basis to, in effect, require Client B to contribute to the loss that Client A has suffered, when he held no shares in Company X at the time of the defalcation, and his shares were acquired thereafter.

18.  Thus, given that it is possible to identify with certainty the time at which the losses occurred, it cannot be right to adopt a simple global pari passu method of distribution.

19.  That being the case, Mr Lees has identified two possible approaches to the defalcations.

20.  The simpler approach is to rely on the records of GHI to identify the clients out of whose accounts securities were misappropriated, leaving the loss to lie where it falls (that is, as it was inflicted by the former management of GHI).

21.  The more complicated approach involves trying to ascertain how many shares in a particular line of Impaired Securities existed at the time of a defalcation, and then allocating the loss pari passu among the clients of GHI who such shares at the time.

22.  Mr Lees has said (in his sixth affidavit) that the latter method is extremely difficult to apply.  In my view, it would not, in any case, be the appropriate approach to adopt.  This is because it is not the case that all clients of GHI who owned shares which formed what is now a line of Impaired Securities at the time of a defalcation will in fact have suffered a loss.  For example, if, immediately prior to a defalcation, there should have been 3,000 shares in Company X, held by three clients (A, B and C), each holding 1,000 shares, and there was then an unauthorised removal of 600 shares from the account of Client A, the effect of this approach would be that each client would be regarded as having lost 200 shares.  However, if the defalcation went unnoticed for some time, Client B might decide to sell his 1,000 shares.  This could be done, as there would be sufficient shares available, and Client B would (according to the records of GHI) have sufficient shares to sell.  Would Client B then be regarded as having had the benefit of 200 shares which in fact belonged to Clients A and C, for which he should compensate them?  I think not.  Clearly, in such a situation, Client B has had the good fortune of not suffering any loss at all.  If it had been Client A who had decided to sell his shares, the defalcation would either have come to light, or (more likely, perhaps) further entries would have been made to shift the defalcation from Client A’s account to that of Client B or C.  It would still be possible for GHI to comply with Client A’s instructions, since the shares would be held by CCASS in an account of GHI, rather than of the specific client.  In this situation, the defalcation would, at the end of the day, have been in respect of the shareholding of Client B or C, as the case may be.

23.  Given that there are clear records as to the clients out of whose accounts with GHI securities were misappropriated from time to time, there does not seem to me to be any proper basis for the court or Mr Lees to attempt to second guess the fact that the former management of GHI chose, for whatever reason, to raid the account of one client rather than another, and seek to distribute the losses of securities in some other way, which may be thought to be in some respects be more “equitable”.  Although it will seem unfair, at least to the client whose account has been misused, that he should suffer the entire loss in relation to that particular defalcation, this is little different from a situation where a burglar or thief happens to choose one victim rather than another.  While the identity of the victim may seem to be a matter of chance, it seems to me that the court can only approach the matter on the basis of what is established by the evidence before it, which in this case does identify the accounts from which securities were wrongfully removed.  It is not, I think, to the point for the court to enquire why, or whether there was any particular reason for, that client to have been victimised, and seek on that basis to embark upon an attempt to distribute the loss in some other way.

24.  Thus, given that there are what appear to be complete and accurate records of the transactions involving defalcations from client accounts of GHI, the appropriate method for allocating the losses resulting from such defalcations is to treat the loss as being that of the client whose account was raided, and not of any other clients who may have had shares in the same line of Impaired Securities at the time.

25.  It should also be noted that not all losses of shares were due to defalcations on the part of GHI’s former management.  Some (relatively limited) losses arose as a result of the compulsory closing out of trades that was effected by CCASS on the imposition of the restriction notice on GHI.  As, in those cases too, it is possible to identify the clients whose shares have been lost, there is no reason in principle why the same approach should not be adopted in those cases.

26.  Two of GHI’s clients, Ms Liu Ngan Ling and Ms Tsang Kwei Lan appeared at today’s hearing.  Each of them asked that their shares be returned to them.  During the course of the hearing, I explained to them the reasons for my coming to the view which I have set out above.  Happily for both of them, it appears from Mr Lees’ investigations that the adoption of the method of allocating loss which I think should be used will in fact prove to be more favourable to them than any of the alternatives.

27.  I should also note that there is one other client in respect of whom there is a dispute as to whether particular transactions apparently undertaken on her behalf were in fact undertaken with her authority.  This is a matter which Mr Lees considers merits further investigation, and I shall leave it to him to carry out such further enquiries as he thinks necessary.  It does not however, impinge on the question of principle which arose for determination, and I therefore directed Mr Lees to distribute the securities and cash available in accordance with the principle identified in paragraph 24 above, subject to such deductions as were authorised by my order to cover the costs of the administration.