TOPPING CHANCE DEVELOPMENT LTD v. CCIF CPA LTD formerly known as CHARLES CHAN, IP & FUNG CPA LTD

CACV 279/2015

[2020] HKCA 478

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF APPEAL

CIVIL APPEAL NO 279 OF 2015

(ON APPEAL FROM HCA NO 1609 OF 2012)

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J U D G M E N T

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Hon Kwan VP:

1.  This is the appeal of CCIF CPA Limited (“CCIF”) from that part of the decision of Deputy High Court Judge Leung on 27 February 2015[1] (“the Decision”) in which he declined to strike out a part of the claim brought by Topping Chance Development Limited (“TCD”) for infringing the rule against recovery of reflective loss. The appeal was brought with leave granted by the judge on 22 December 2015.

2.  TCD is the assignee of the right of action from First Natural Foods Holdings Limited (“FNF”).  The claim in question is for recovery of RMB 241,995,035, being taxes paid by the Mainland subsidiary of FNF, Fuqing Longyu Food Development Co Ltd (“Longyu”), to the authorities in China from 2003 to 2007.

3.  The controversy is whether the rule against recovery of reflective loss does not apply here because this is the kind of situation envisaged in the 2^nd proposition of Lord Bingham of Cornhill in Johnson v Gore Wood & Co [2002] 2 AC 1 at 35G to H, namely, that where a company (Longyu in this instance) suffers loss but has no cause of action to sue to recover that loss whereas the shareholder (FNF in this instance) has a cause of action to do so.

Background

4.  The relevant background matters may be stated as follows.

(a)  General background

5.  FNF was incorporated in Bermuda and registered as an overseas company having its principal place of business in Hong Kong in 2001.  Its shares were listed in the Main Board of the Hong Kong Stock Exchange. Trading in its shares was suspended in December 2008. On 7 January 2009, FNF presented a petition for its own winding up and provisional liquidators were appointed. In September 2011, the Hong Kong Stock Exchange approved a scheme of arrangement for FNF and the resumption of the trading of its shares on conditions.  As part of the approved scheme of arrangement sanctioned by the court, on 4 September 2012, FNF assigned to TCD absolutely all the rights, title and interests in all causes of action in the property of FNF. The provisional liquidators were discharged by a court order on the same day.  On 6 September 2012, the shares of FNF resumed trading and TCD took the place of FNF as the listed company.

6.  CCIF started practice as certified public accountants in 1998 under its former name and changed to its current name in 2004.  It was the statutory auditor of the accounts of FNF and its tax representative for the period between 2001 and 2007.

7.  At all material times, FNF had direct and indirect interest in six subsidiaries, which were incorporated in Hong Kong, the British Virgin Islands and Mainland China.  FNF and its subsidiaries are referred to as “the Group” in the pleadings and the Decision.  Longyu was the major operating arm of the Group, generating 95% of the Group’s profits and possessed the majority of the assets of the Group.

8.  The writ in this action was issued by TCD against CCIF on 6 September 2012 and a statement of claim was filed on 31 October 2012.  CCIF issued a summons for striking out under Order 18 rule 19 on 14 November 2012 and another summons to strike out the amendments in the amended statement of claim on 27 February 2013.  The judge dealt with these summonses together in the Decision.  After both summonses were dismissed, TCD obtained leave to further amend the statement of claim and the re-amended statement of claim (“RASOC”) was filed on 20 March 2015.  The account to be given of TCD’s pleaded case is taken from RASOC.

(b)  TCD’s pleaded case

9.  By agreements made between FNF and CCIF, as contained in or evidenced by the engagement letters concluded between them, CCIF was appointed as an auditor to conduct the Hong Kong statutory audits of FNF and the Group and to provide auditors’ reports on the consolidated financial statements of the same for the financial years ended 31 December 2001 to 31 December 2007. Pursuant to the Hong Kong Standards on Auditing, the consolidated financial statements combined the financial statements of FNF and its subsidiaries and presented financial information about the Group as that of a single economic entity[2]. CCIF did not audit the financial statements of Longyu.  Longyu’s accounts were audited by Mainland auditors.

10.  By reason of the audit engagements aforesaid, CCIF owed contractual duties to FNF to conduct the statutory audits with due diligence and in compliance with the relevant accounting and auditing standards, duties of care in tort of like content and effect to FNF and the Group, and fiduciary duties to FNF including the duty to act loyally in the best interest of FNF.

11.  In purported performance of the said duties, CCIF gave unqualified opinions on the consolidated financial statements of the Group for the years of 2003 to 2007.  Longyu had paid taxes in respect of each of the tax years from 2003 to 2007.

12.  It was subsequently discovered by the provisional liquidators of FNF that Longyu had maintained two sets of accounts for the years of 2003 to 2007, one set (“Longyu’s First Audited Accounts”) being kept at the office of Longyu while the other set (“Longyu’s Second Audited Accounts”) was filed with the State Administration for Industry and Commerce in Fuqing.  The two sets of audited accounts of Longyu were apparently prepared by the same Mainland auditors engaged by Longyu, who expressed unqualified audit opinions on each set on the same date for each of the financial years.

13.  There were substantial discrepancies in all material aspects of the financial affairs in the two sets of Longyu’s accounts. Longyu’s Second Audited Accounts represented the true state of its financial affairs, showing inter alia that Longyu’s First Audited Accounts had inflated its profits.  Hence, the consolidated financial statements of the Group for the years of 2003 to 2007 could not have shown a true and fair view of the financial affairs of the Group.

14.  CCIF ought to have discovered the existence of Longyu’s Second Audited Accounts.  Further, it did not comply with the then prevailing professional standards in carrying out the statutory audits.  In giving unqualified opinions on the consolidated financial statements of the Group for 2003 to 2007, CCIF breached its contractual, tortious and/or fiduciary duties as auditor.

15.  But for CCIF’s breaches, CCIF would have detected material mis-statements or ought to have discovered that Longyu’s Second Audited Accounts were accurate but Longyu’s First Audited Accounts were not, and would have informed FNF and its audit committee.  By reason of the breaches, FNF did not discover that the Group did not have retained earnings available for distribution of dividends and the Group did not discover that the alleged tax liabilities of Longyu did not exist.  Had the discoveries been made, Longyu would have recovered from the Mainland tax authorities the taxes paid in the said years.

16.  The losses claimed by TCD against CCIF in this action comprise (1) dividends paid by FNF in excess of RMB 100 million; (2) taxes paid by Longyu to the Mainland authorities in respect of profits it did not generate; and (3) fees and expenses paid by FNF for CCIF’s services as auditor which were valueless.

17.  CCIF sought to strike out the claim for taxes paid by Longyu on the basis that this would infringe the rule against recovery for reflective loss, as any loss suffered by FNF by reason of Longyu’s payment of taxes would be purely reflective of Longyu’s loss.  The judge declined to strike out the claim for the reasons given in §§72 to 78 of the Decision.  He accepted the submission of TCD that this is a situation akin to the 2^nd proposition of Lord Bingham in Johnson v Gore Wood mentioned at the outset of this judgment.

This appeal and the no reflective loss principle

18.  The issues in contention in this appeal are within a narrow ambit.  On behalf of CCIF, Mr Alexander Stock, SC[3] argued on appeal that this case is not within the 2^nd proposition of Lord Bingham, in that there are available claims by Longyu to recover the taxes it had paid.  Firstly, Longyu has a claim for the tax losses against CCIF on the basis of TCD’s own pleaded case.  Secondly, Longyu can sue for such losses against parties other than CCIF, such as the Mainland tax authorities, its own auditors and directors.

19.  There is no dispute on most of the relevant law governing the no reflective loss principle and this may be summarised as follows.

20.  The two seminal authorities in Hong Kong are Johnson v Gore Wood and Waddington Ltd v Chan Chun Hoo (2008) 11 HKCFAR 370. In Johnson v Gore Wood at 35, Lord Bingham set out three guiding propositions: (1) where a company suffers loss caused by a breach of duty owed to it, only the company may sue in respect of that loss; no action lies at the suit of a shareholder suing in that capacity to make good a diminution in the value of the shareholder’s shareholding where that merely reflects the loss suffered by the company; (2) where a company suffers loss but has no cause of action to sue to recover that loss, if the shareholder has a cause of action to do so, the shareholder may sue in respect of it even though the loss is a diminution in the value of the shareholding; (3) where a company suffers loss caused by a breach of duty to it, and a shareholder suffers a loss separate and distinct from that suffered by the company caused by a breach of duty independently owed to the shareholder, each may sue to recover the loss caused to it by breach of the duty owed to it but neither may recover loss caused to the other by breach of the duty owed to that other. We are here concerned with the proposition in (2).

21.  The underlying rationale for the no reflective loss principle is twofold.  If the shareholder is allowed to recover in respect of loss that merely reflects the loss suffered by the company, either there will be double recovery at the expense of the defendant, or the shareholder will recover at the expense of the company and its creditors and other shareholders. Neither course can be permitted.  This is a matter of principle, no discretion is involved[4].

22.  The no reflective loss principle is engaged not only where the company had the right to sue but also where it had declined or failed to sue, whether for lack of merits or lack of financial resources caused by the wrongdoer[5]. It is not concerned with barring causes of action but with barring recovery of types of loss.  It is based on the nature of the loss; what is important is that the company’s loss would be made good if the shareholder should recover from the defendant[6].

23.  As the no reflective loss principle is an exclusionary rule denying a plaintiff what otherwise would be his right to sue, the onus is on the defendant to establish its applicability.  In considering whether the company has an available claim for the purpose of Lord Bingham’s 2^nd proposition, it is for the defendant to establish not merely that the company has a claim to recover the loss in question, but that such claim is “available on the facts”[7].  The merits threshold is not whether the available claim of the company is likely to succeed but whether this is a realistic claim with some prospect of success[8].  A distinction is drawn between cases where the company has no claim and a claim existed but was subject to a defence; only in the former may the shareholder’s claim for reflective loss be allowed[9].

24.  The court must be astute to ensure that the party who has in fact suffered loss is not arbitrarily denied fair compensation.  At the strike out stage, any reasonable doubt must be resolved in favour of the plaintiff[10].

Whether Longyu has an available claim against CCIF

25.  Before the judge, it was not contended by the former counsel of CCIF that Longyu would have an available claim against it.  It is Mr Stock’s contention that Longyu would have such an available claim on the basis of the pleaded case of TCD in RASOC[11].

26.  He referred to Wah Nam Group Limited v Roderick John Sutton & Anr at §20.2, in which Yuen JA referred to a claim of the company being “available on the facts” and rejected the contention it does not mean that absent an admission from the defendant, the court can only determine whether the company would have a cause of action at the trial.  Yuen JA said what is required is for the defendant to take the court through the company’s pleadings “to see if it contains all the facts necessary for [the company] to prove, to support its right to judgment, in other words, a “cause of action” … If the necessary facts are pleaded, then the claim is “available on the facts”.”

27.  Mr Stock then prayed in aid the words of Reyes J at §141 in East Asia Satellite Television (Holdings) Ltd v New Cotai LLC, HCA 2189/2009, 16 July 2010[12]. Reyes J stated that the facts and matters said to give rise to a claim for reflective loss under Lord Bingham’s 2^nd proposition are material averments that need to be set out in one’s pleading “with precision and rigour”.  This is to assure the court at an early stage that the claim for reflective loss should be allowed to proceed. Without such assurance, the court may well strike out the claim for reflective loss at an early stage as an abuse of process and an unwarranted waste of time and expense.

28.  This was not done in the pleading of TCD.  But this has to be viewed in light of the considerable practical difficulties of the provisional liquidators in obtaining relevant information.  The provisional liquidators were thwarted in their attempts to obtain assistance from the former officers of FNF, Longyu, other Mainland parties and authorities.  Nor did they appear to have full co-operation from CCIF when they turned to it for assistance[13]. TCD was not even aware that the taxes pleaded in the amended statement of claim were not paid by FNF but by Longyu, and it was only with that realisation at the hearing before the judge that gave rise to the issue whether the claim for taxes paid should be struck out for reflective loss[14].  Further, there was no suggestion on the part of CCIF before the judge that Longyu might have an available claim against it. In these particular circumstances, it is understandable that TCD was not able to follow the salutary pleading requirement of Reyes J.

29.  Mr Stock raised a further point that TCD has not clearly or sufficiently pleaded how it is said that FNF has suffered a loss in respect of Longyu’s tax payments. For instance, it has not been pleaded that FNF’s loss is the diminution in value of its shareholding in Longyu.  But the present situation is a far cry from the complexities of the claims in Webster v Sandersons [2009] 2 BCLC 542[15], a case relied on by Mr Stock.  As Mr José Maurellet, SC[16] pointed out on behalf of TCD, by arguing that the no reflective loss principle applies, CCIF’s contention must be that the loss which TCD seeks to recover is nothing more than a diminution in value of FNF’s shareholding in Longyu. There is nothing in this point.

30.  Mr Stock took the court through RASOC and pointed to these paragraphs which he submitted are material to show that Longyu would have an available claim against CCIF as pleaded:

(1)   “12.   The Defendant knew and/or ought to have known that the Auditor’s Reports[17] were to be relied on by the directors (both executive and independent non-executive directors), the audit committee, shareholders of [FNF] and its subsidiaries, and/or public investors.”

(2)   “16.   Further or in the alternative, the Defendant, at all material times, owed [FNF] and the Group duties of care in tort of like content and to like effect as the duties and obligations set out in paragraphs 13-15 above.”

(3)   In §§30(11) and 31(23), TCD pleaded the failure of CCIF to investigate the irregularities of the two sets of audited accounts of Longyu and to inform “appropriate persons of the Group” of the irregularities.

(4)   In §§32B(2) to (3), it is pleaded that had the Group been made aware of Longyu’s Second Audited Accounts, it would have discovered the alleged tax liabilities did not exist and Longyu would have recovered the tax paid from the Mainland tax authorities.

31.  Mr Stock contended that on the basis of the above pleading, the basis of the tax claim is that the Group, which included Longyu, relied on the Auditor’s Reports, as a result of which Longyu failed to reclaim the taxes it had paid.  On TCD’s own pleaded case, if there was any breach by CCIF of the duties it owed to FNF, there would also be a breach of duties of “like content and to like effect” owed by CCIF to “the Group”, which included Longyu, and there is causation of Longyu’s tax losses by CCIF’s breaches, such that Longyu would have a cause of action against CCIF for the tax losses claimed.  At the very least, the merits threshold – that the company has a claim with realistic prospect of success – would be met.  As this is a clear case that on TCD’s own pleaded case the reflective loss claimed does not fall within Lord Bingham’s 2^nd proposition, on this basis alone the claim for tax losses should be struck out.

32.  I do not agree with Mr Stock it is clear on TCD’s pleaded case that Longyu would have an available claim against CCIF.  As pleaded, “the duties of care in tort of like content and to like effect” were owed by CCIF to “the Group”, which comprised FNF and its six subsidiaries.  It is not pleaded that any duties were owed to Longyu separately.  It is alleged that CCIF knew or ought to have known that the Auditor’s Reports were to be relied on, among others, by “shareholders of [FNF] and its subsidiaries”. There is an ambiguity whether the latter part of the phrase meant reliance by shareholders of FNF’s subsidiaries, or by FNF’s subsidiaries.  In any event, it is not clearly alleged that CCIF knew or should have known that the Auditor’s Reports were to be relied on by Longyu.

33.  As for the causation of Longyu’s tax losses by the alleged breach of duties, what is pleaded is the failure to inform “appropriate persons of the Group”, with the consequence that “the Group” was not made aware of the irregularities of the two sets of audited accounts of Longyu.  It is not alleged if Longyu was aware of the irregularities or whether it was unaware of the malpractice of those in control[18].  And if Longyu was aware of the irregularities, even if CCIF had not been in breach of duties as alleged, it is not apparent from the pleading whether Longyu would have taken action to recover the taxes paid.  The plea of causation in respect of any claim of Longyu against CCIF is beset with difficulties and uncertainties.

34.  For the above reasons, I am not persuaded that Longyu would have a realistic claim against CCIF on the pleaded case of TCD.  RASOC does not appear to contain all the facts necessary for Longyu to prove, to support its right to judgment, so the claim envisaged may not be “available on the facts”.  As any reasonable doubt must be resolved in favour of TCD at the strike out stage, it would not be right to strike out the claim for tax loss on this ground.

Whether Longyu has an available claim against other parties

35.  There are two difficulties regarding whether Longyu should have an available claim against any party other than CCIF, and both were canvassed before the judge, who refrained from drawing a conclusion in the strike out application adverse to TCD.

36.  The first difficulty is the “identity issue”.  The judge reasoned that in the context of Lord Bingham’s 2^nd proposition, the reference to the company’s cause of action is to a cause of action against the same defendant as that which is sued by the shareholder for its reflective loss, such that if the company has a claim only against some other defendant, the case falls within the 2^nd proposition and the shareholder may recover its reflective loss.  The judge considered this makes sense, in light of the explanation of the rationale for the principle, namely, that justice to the defendant permits no double recovery by the company and the shareholder[19].

37.  Mr Stock cited two cases at first instance which held to the contrary[20].

38.  In Hotung v Hillhead [2008] 3 HKLRD 200, the plaintiff was the assignee of beneficial interests under two trusts which held shares in two companies. The plaintiff claimed compensation against the trustee for allowing the trusts’ settlor to divert assets from the companies, causing a diminution in the value of the shares.  In striking out the claim, Reyes J rejected the argument that the rule against recovery of reflective loss was inapplicable because the companies’ claim lay against the settlor whereas the plaintiff’s claim was against the trustee.  Reyes J reasoned that the focus was on the type of loss claimed as opposed to the cause of action asserted, so even though the defendants might be different, the loss asserted by the plaintiff beneficiary could be made good if the companies took action against the alleged wrongdoer (at §§19 to 27)[21].

39.  In Suen Kwai Kam v Zhong Hua International Holdings Ltd, HCA 1691/2005, 27 March 2013, Registrar K W Lung applied the no reflective loss principle to strike out the plaintiff’s claim against the 1^st and 3^rd defendants in a situation where the plaintiff’s loss could be made good by a BVI company (into which the plaintiff had transferred the shares of another company wholly owned by her) enforcing its rights against the 2^nd defendant.  Even though there would not be double recovery at the expense of the defendant, as the defendants were different, the Registrar considered that if the plaintiff was allowed to claim against the 1^st and 3^rd defendants, recovery “will certainly take away” the claim of the BVI company against the 2^nd defendant for the same loss and so the plaintiff would recover at the expense of the BVI company and its creditors and other shareholders (at §§17 to 28).

40.  There are however two decisions of the Court of Appeal[22] which indicated that it would not be appropriate to strike out on the strength of the no reflective loss principle where this involved a different defendants scenario.

41.  In Hotung v Ho Yuen Ki (No 4) [2011] 2 HKC 149, which was a trusts case, the Court of Appeal considered the law on the “identity issue”[23] and came to the view that as “the law most certainly is not settled” and the case called for “a fine judgment”, it would not be appropriate to strike out the plaintiff’s claim on the basis it was precluded by the reflective loss principle (at §§19, 21 and 33).

42.  In Wah Nam Group Limited v Roderick John Sutton & Anr, reference was made to Hotung v Ho Yuen Ki (No 4) and it was not disputed in the Court of Appeal that it was not sufficiently plain and obvious the no reflective loss principle applied where there was a difference in defendants (at footnote 16).

43.  Mr Stock submitted that in the shareholder/company context, if a shareholder’s claim is permitted despite a potential claim by the company for the same loss against a different defendant, then either (i) the company’s claim for the same loss would subsequently be regarded as barred, or (ii) the company’s claim could still proceed, in which case the shareholder would be compensated twice, and neither outcome is acceptable.  But in the present case, I do not think it is clear, for the reason mentioned below, that Longyu’s claim against other parties in the Mainland (the tax authorities, Longyu’s auditors and directors) for the same loss would subsequently be barred if TCD’s claim against CCIF is permitted to proceed. If this is unclear, it is far from plain and obvious that TCD would recover at the expense of Longyu or its creditors.

44.  The second difficulty pertains to the fact that Longyu was incorporated in the Mainland and other parties against whom it is said to have a claim are all Mainland parties.  There is no evidence whether Mainland law, being the law of the place of incorporation, does or does not recognise the principle against recovery of reflective loss (Zhang Hong Li v DBS Bank [2018] HKCA 435 at §§27 to 28; Joe Zhixiong Zhou v Saif Partners II LP & Anr [2020] 1 HKC 32 at §§125, 126).  CCIF in its defence has pleaded that Longyu would have causes of action under Mainland law to recover any overpaid tax[24] but made no averments of any claims Longyu might have against its auditors and directors under Mainland law.  As the judge has noted, whether any right of action would exist against any of the Mainland parties would be a matter of Mainland law and legal expert evidence on this is lacking[25].

45.  The striking out procedure is not suitable on a difficult point of law which requires serious analysis.  Besides, in these particular circumstances, the court must be careful before striking out a claim on assumed facts.  Without a full trial, it could not be clearly established that Longyu was in fact entitled to recover the taxes paid from one or more of the Mainland parties.

Conclusion and costs

46.  For the above reasons, I would dismiss the appeal.  There is no dispute that costs of the appeal should follow the event and there should be a certificate for two counsel.  I would make an order for costs accordingly.

Hon Cheung JA:

47.  I agree with the judgment of Kwan VP.