WONG LUEN HANG AND ANOTHER v. CHAN YUK LUNG AND OTHERS

CACV 112/2012

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF APPEAL

CIVIL APPEAL NO. 112 OF 2012

(ON APPEAL FROM HCA NO. 2654 OF 2007)

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REASONS FOR JUDGMENT

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Hon Yuen JA:

1. I agree with the reasons for judgment of Chu JA and have nothing to add.

Hon Chu JA:

2. This is the 1^st and 2^nd plaintiffs’ appeal against the judgment of Reyes J (“the Judge”) given on 30 April 2012 dismissing their derivative claim against the 1^st and 2^nd defendants and ordering them to pay 80% of the costs of the 1^st and 2^nd defendants.  We dismissed the appeal with costs to the defendants.  Our reasons appear below.

The relevant facts

3. The 1^st plaintiff (“Wong”) is the father-in-law of the 2^nd plaintiff (“Tsui”).  The 1^st and 2^nd defendants (“the Chan Brothers”) are brothers.

4. Wong, Tsui and the Chan Brothers are the shareholders of the 3^rd defendant (“Topmix”), each holding 25% of the shares.  The directors of Topmix used to be Tsui and the Chan Brothers.  On 20 January 2006, Tsui was ousted from the management of Topmix.  At an extraordinary general meeting of Topmix held on 25 Mach 2006, Tsui was removed as a director.

5. Topmix is in the business of making fiberglass automobile parts. Amax Motor, Inc (“Amax”), a US company, is and was at all material times the single largest customer of Topmix, accounting for 60% of the business turnover of Topmix in the year 2005 to 2006, which was in excess of HK$20 million.

6. The subject matter of the derivative claim against the Chan Brothers relates to their decision to forego trading debts in the amount of HK$2,336,620 due from Amax to Topmix in settlement of a claim of HK$2,722,685 made by Amax against Topmix for defective goods and over-charging.  

7. The pleaded case against the Chan Brothers is that in accepting Amax’ claim and agreeing to forego the trading debts, they had acted in breach of their fiduciary obligations.  At the trial, it emerged that the complaint is that they had acted in breach of their duty of care to Topmix.  There is no suggestion of dishonesty on their part.  The Judge took the view that the essential facts had been pleaded and explored at the trial and proceeded to determine the case on the basis of whether the Chan Brothers had breached their duty of care to the company.

8. The circumstances surrounding the complaint of breach of duty can be summarized as follows.

9. Before he was ousted from the management of Topmix, Tsui was responsible for taking overseas orders and handling the financial and accounting matters of the company.  He was also the company’s main contact person with Amax.  At the same time as Tsui was removed from the management of the company, the accounts clerk of Topmix, Ms Chan, was also dismissed.

10. After the Chan Brothers took over the company’s account, they had a meeting with Chan Miu Ying (“Chan”) of Amax in April 2006. During the meeting, the Chan Brothers pressed Amax for payment of outstanding trading debts for purchase orders placed between 15 September and 22 December 2005 amounting to HK$2,336,620 (“Topmix Claim”). Chan refused to pay, claiming that Topmix owed Amax a substantial amount of money (“Amax Claim”) and that Tsui had orally agreed to waive Topmix Claim. 

11. In a without prejudice letter dated 5 September 2006 from Amax’ solicitors (Iu, Lai & Li, “ILL”) to Topmix’ solicitors, it was said that Topmix had committed numerous breaches of the Licence Agreement and Manufacturing Contract made between Topmix and Amax, and that Topmix was indebted to Amax for the “balance of purchase price overpaid and/or advances made by Amax in connection with business or purchase orders placed with Topmix …, or refund for defective/ damaged Products; the amount outstanding as at December 2005 was HK$2,722,685”.  The letter recorded that after negotiations, Topmix and Amax had reached agreement on certain principal terms of settlement, which included a return by Topmix of production samples and moulds previously provided by Amax, and payment by Topmix by monthly instalments of at least HK$200,000 each to be deducted from the invoiced amounts of purchase orders placed by Amax. 

12. Thereafter, negotiations between Topmix and Amax continued.  According to the 2^nd defendant, whose evidence was accepted by the Judge, despite repeated requests from Topmix for details of the Amax Claim, Amax did not provide further or better information than that contained in ILL’s letter.  Topmix had also written to Amax on 25 April 2007 requesting it to sign to confirm that its reason for refusing to settle Topmix Claim was because Tsui had verbally agreed to a waiver, but it was refused by Amax.

13. In the audited financial statement for the year ending 31 March 2006, Topmix made a provision for doubtful debts in the amount of HK$2,487,253.  On 18 May 2007, in reply to queries raised by Inland Revenue Department, Topmix’ auditors explained that the provision was mostly to do with Amax’ refusal to pay the Topmix Claim on the ground that the quality of the goods delivered did not meet the required standard and that Tsui had agreed to waive the amount.  The letter went on to state:

“Since Amax was an overseas company, legal proceedings to recover an overseas debt would be very complicated and time-consuming. Besides, legal costs incurred would be enormous. Also taking into account the fact that Amax was one of the major customers of the Company contributed to about 60% of the total sales during the year ended March 31, 2006 and had on-going business relationship with the Company, therefore it would be for the long-term benefit and the best interest of the Company if it did not take any legal action against Amax.”

14. Eventually by an agreement dated 15 August 2007, the Chan Brothers (on behalf of Topmix) and Chan (on behalf of Amax) agreed that the Topmix Claim and the Amax Claim would be settled by way of a mutual set off.

15. In the meantime, Tsui having noticed the provision of doubtful debts in the audited financial statement of Topmix, made enquiry of it through his solicitors by letter dated 14 June 2007.  Topmix’ solicitors replied on 28 June 2007 and requested Tsui to explain Amax’ claim that he had verbally agreed to waive the Topmix Claim.  They also demanded Wong to release moulds specifically made on Amax’ orders at what was referred to as the CMS factory. 

16. There was no reply from Tsui or his solicitors to Topmix’ request. Instead, on 6 August 2007, Tsui’s solicitors wrote to Amax to deny that Tsui had agreed to waive the Topmix Claim.  ILL replied on 20 August 2007 and stated that Tsui had previously agreed with Amax to set off the Topmix Claim against the Amax Claim and that this agreement was confirmed by the settlement agreement dated 15 August 2007, which had the effect of fully and finally settling the two claims.  In a subsequent letter dated 17 October 2007, ILL clarified that Tsui had not agreed to a set off (see paragraph 18 below). 

17. On 1 September 2007, Topmix’ solicitors wrote to Tsui’s solicitors suggesting that he had not offered any explanation on Amax’ allegation of an oral agreement to waive the trading debts and why he had allowed Amax’ trading debts to accumulate to “unexpected and abnormal” level.  The letter also requested the release of moulds from the CMS factory so as to complete Amax’ purchase orders.  

18. Tsui’s solicitors wrote on 25 September 2007 to suggest that the settlement was a sham and fraud, and that the Chan Brothers and Amax had conspired together to make false allegation against Tsui in order to defraud Wong and Tsui and also the Hong Kong and US tax authorities. ILL replied on 17 October 2007, recounting the negotiations between Amax and Topmix and the fact that a settlement agreement had been reached whereby the Topmix Claim had been set off against the Amax Claim.  

19. Regarding Amax’ allegation that Tsui had orally agreed to waive its trading debts, the Judge accepted Tsui’s evidence. The Judge held that what Amax told the Chan Brothers was hearsay, observing (at paragraph 36 of the Judgment):

“[Amax] could have claimed that Tsui had agreed to a waiver purely as a negotiating ploy to get the Chan Brothers’ agreement to foregoing payment of the $2,336,620. Indeed, in all likelihood, by alleging defects and overcharging to a tune of $2.7 million plus and by referring to an agreement with Tsui, [Amax] was merely engaging in some tough bargaining with Topmix to get out of paying as much of the $2,336,620 as possible.”

20. The Judge also noted that notwithstanding the allegations of fraud and conspiracy made by Tsui’s solicitors in the letter dated 25 September 2007, there was no evidence to substantiate such allegations (see paragraphs 28 and 29 of the Judgment).

The Judgment

21. The Judge held that the Chan Brothers did not act in breach of their duty of care owed to Topmix for the following reasons:

(1) When Tsui ceased to be involved with the management of Topmix, the Chan Brothers did not have in-depth knowledge of the company’s day-to-day dealings with Amax. With the departure of Ms Chan, there was no staff, other than a cleaner and a driver.

(2) Amax was aware of the difficulties faced by Topmix and the Chan Brothers, which made the company vulnerable to hard bargaining by Amax.

(3) Amax was Topmix’ main customer.  Topmix would not be able to cope financially if it were to lose the business of Amax.

(4) Topmix had problems retrieving the moulds from the CMS factory and could not manufacture products ordered by Amax, hence faced a real possibility of future justifiable claims from Amax.

(5) The orders of Amax accounted for 60% of the revenue of Topmix in 2005/2006 (i.e. approximately $22.33 million).  The Amax claim was effectively a 10% discount on Topmix’ sales to Amax.

(6) There is commercial justification for the decision having regard to the observation of Topmix’ auditors on the impracticality of suing Amax in the United States. 

22. The Judge held that the decision to forego the Topmix Claim in settlement of the Amax Claim was a tough executive decision, and did not accept that the Chan Brothers had acted in breach of their duty of care owed to Topmix in not verifying the Amax Claim and making enquiry with Tsui, doubting whether it would have made any difference.  The Judge explained (at paragraphs 61 to 67 and 69 of the judgment):

“61. Assume that [Amax] was making up false claims of defective goods and over-charging. That is a common bargaining strategy when one is seeking some sort of discount.

62. Assume also that, if consulted, Tsui would have said that there had been no over-charging and no complaints about defective goods. That would almost certainly not have stopped [Amax] if (as seems likely) it was minded to engage in “hardball” bargaining. [Amax] would have merely continued to assert, regardless of what Tsui said, that there had been over‑charging and there had also been defective deliveries.

63. Nor would the existence or non-existence of defective goods or over-charging necessarily be apparent from a mere scrutiny of invoices. The invoices would probably be of minimal help. [Amax] could simply say that incorrect quantities had been recorded in any relevant invoices and defective goods were only subsequently discovered.

64. The Chan Brothers could of course have insisted on all defective claims and all alleged over-charges being established by cogent particulars and evidence. But that would probably have entailed protracted negotiations which could have impacted severely on Topmix’ cash flow.

65. The reality is that, as Topmix’ most important customer, [Amax] enjoyed the upper-hand in any negotiations with Topmix. On the evidence (for example, ILL’s letter of 5 September 2006), [Amax] did not shy away from exploiting that upper-hand.

66. I have held that Tsui did not enter into any waiver agreement with Topmix. In their more emotional moments, the Chan Brothers have been critical of Tsui insofar as they believed that he had agreed a waiver. But that does not mean, as a matter of dispassionate objective analysis, that it was a wrong business choice (much less a breach of duty) to have waived the $2,336,620.

67. I have suggested that the net effect of what the Chan Brothers agreed was to give [Amax] a 10% discount on sales. Discounts of that magnitude are commonplace in the commercial world, particularly where important customers are concerned. I therefore find it difficult to conclude that the Chan Brothers were negligent by doing that which they criticized Tsui for ostensibly agreeing.

68. …

69. Thus, even if Tsui had entered into a waiver agreement, there are ample grounds for holding such arrangement to have been reasonable in all the circumstances facing Topmix at the time.  The Chan Brothers would have been wrong in any complaint against Tsui for agreeing a waiver.”

23. The Judge added that even if somehow there were a breach of a duty of care, he would be prepared for the reasons he had given to apply section 358 Companies Ordinance, Cap 32 to relieve the Chan Brothers of liability for loss to Topmix, noting that there was no suggestion that they acted dishonestly in concluding a settlement with Amax.      

The appeal against finding of no breach of duty

24. The main thrust of the 1^st and 2^nd plaintiffs’ appeal is directed against the Judge’s finding that there was no breach of duty of care. The challenge is premised on the following arguments: (1) Company directors owe a duty to exercise reasonable and skill; (2) The Chan Brothers had made no or no serious attempt to verify the Amax Claim; (3) The Chan Brothers were aware of the bogus nature of the Amax Claim; and (4) The decision to settle with Amax was not a sound business judgment.

25. There is no dispute on the general proposition that company directors owe a duty to exercise reasonable care and skill in the performance of their office: Re City Equitable Fire Insurance Co [1925] Ch 407, 427; Daniels v. Anderson (1995) 16 ACSR 607, 668.  Romer J observed in Re City Equitable Fire Insurance Co (at 428) that the degree of care required of a director is measured by the care an ordinary man might be expected to take in the circumstances on his own behalf; and that a director needs not exhibit in the performance of his duties a greater degree of skill than may reasonably be expected from a person of his knowledge and experience.

26. It is to be recognized that in the performance of their office, directors will from time to time have to make business judgments and business decisions.  The court should be slow to interfere with the business judgment and business decisions of directors. As explained in Harlowe’s Nominees Pty Ltd v. Woodside (Lakes Entrance Oil) Co NL (1968) 121 CLR 483, 493,

“Directors in whom are vested the right and duty of deciding where the company’s interests lie and how they are to be served may be concerned with a wide range of practical considerations, and their judgment if exercised in good faith and not for irrelevant purposes is not open to review in the courts.”

27. In the present case, the decision to forego the Topmix Claim in settlement of the Amax Claim is clearly a business decision.  The plaintiffs contend there was no proper basis for the decision because the Chan Brothers made no proper attempt to verify the Amax Claim and they were aware it was a bogus claim.  These criticisms had been considered by the Judge when he concluded that the decision did not amount to negligence or breach of duty.  

28. As the Judge observed, the Chan Brothers were in a difficult position when Tsui left the management of Topmix since Tsui was the main contact with Amax and used to be in charge of the overseas order and accounting matters of the company.  The difficulty was compounded by the departure of the accounts clerk at the same time.  Mr Sarony SC for the plaintiffs submitted that the Chan Brothers could and should have requested assistance from Tsui. Given that Tsui was ousted from the management of Topmix, the Judge could not be faulted in doubting whether “Tsui would in fact have been happy to co-operate with the Chan Brothers” (paragraph 59 of the Judgment). It is further to be noted that despite the request by Topmix’ solicitors in the letter dated 28 June 2007 (which was before the Chan Brothers made the 15 August 2007 settlement agreement with Amax) to explain Amax’ claim that he had orally agreed to waive the Topmix Claim, Tsui never replied to it. Even though Tsui’s solicitors wrote to Amax’ solicitors on 6 August 2007 to dispute the oral waiver agreement, they did not copy the letter to Topmix or its solicitors.  It is thus not a case that the Chan Brothers deliberately refrained from taking steps to establish the veracity of the Amax Claim.  On the contrary, there was not much that they could do. 

29. It is correct that the Chan Brothers had reservations about the genuineness of the Amax Claim, and it is the 2^nd defendant’s evidence that with all the indications that Amax was making up the claim, he was still prepared to enter into the settlement agreement.  His explanation was:

“On the premises that Amax was our largest customer, well, we could not afford to lose such a big client. We simply could not see it go because how on earth are we going to sustain our business, even though we found Amax very unreasonable.”

(Transcript 81S-T/ Core Bundle 2:129S-T)

“Well, because our blood and our source of income mainly lie on our business with Amax. Well, actually, it had been a longstanding relationship starting from when we were at the beginning of our incorporation of our business, and together with the fact that in meeting certain purchase orders placed by them, we lacked some raw materials, but they delivered the raw materials to us from the States to Hong Kong for us to do some semi-production process. Well, apart from that major dispute, for all other repayments, Amax was able to repay all those invoices to us. Well, even talking about very recently, Amax still placed the newest kind of purchase orders to make some goods for them. Well, for the past business relationship for five to six years, we never faced such a substantial claim made by them to us and I still think there might be a reason for them to do so. Well, talking about nowadays, sometimes when we issued certain invoices to them, if they found certain goods were broken or defective, they would have made the deduction, made a certain relevant deduction before they finally made the payment of goods for us.”

(Transcript 132L-S/ Core Bundle 2:180L-S)

30. Mr Sarony SC was critical of these answers.  But the Judge, as he was entitled to, had accepted the evidence of the 2^nd defendant and that the above answers shed light on the considerations underlying the decision to forego the Topmix Claim in settlement of the Amax Claim.  In particular, the Judge found that, as Topmix’ most important customer, Amax enjoyed the upper-hand in any negotiations with Topmix and that protracted negotiations could have impacted severely on Topmix’ cash flow.

31. It was suggested that if indeed Amax was behaving so badly, the appropriate response was to stop having business with it.  But this is to take a blinkered view of the matter. With Amax accounting for 60% of its business turnover, it is difficult to see how Topmix could have afforded to instantly stop doing business with it without first securing alternative source of business.  

32. It was also said that the likely consequence of the decision was to encourage Amax to continue making unsubstantiated demands in the expectation that Topmix would capitulate unconditionally.  This may well be the case.  On the other hand, however, if Topmix were to lose its single large customer, its business would be put into immediate jeopardy.  As the Judge recognized, the Chan Brothers had to make a tough decision. It was a business judgment for them.  They decided to settle with Amax so as to preserve the business of Topmix.  The Judge considered it an acceptable decision having regard to all the circumstances. I see no reason to disturb the finding.

33. For the reasons set out above, the appeal against the Judge’s finding of no breach of duty fails.

The appeal against the costs order

34. The plaintiffs also seek to appeal against the Judge’s costs order whereby they were ordered to pay 80% of the 1^st and 2^nd defendants’ costs. It was argued that the Judge having found that this was a classic case for a derivative action and not having held that the plaintiffs acted in bad faith or without reasonable grounds, the plaintiffs ought, in accordance with the principle in Wallersteiner v. Moir (No. 2) [1975] 1 QB 373, to be indemnified by the company in respect of their own costs and the costs they were ordered to pay to the 1^st and 2^nd defendants.

35. Mr Sarony SC accepted that the plaintiffs could have before commencing the action or at an early stage of the proceedings applied to the court for leave to bring or continue with the derivative action and for an order sanctioning their costs to be indemnified by the company: see Wallersteiner v. Moir (No. 2) at 392D-F; Tan Eng Guan & Another v. Southland Co Ltd & Others [1996] 2 HKC 100, 106A-B; see also section 168BC of Companies Ordinance.  There is no explanation for not doing so.

36. In the absence of an order for indemnity, the matter falls to be determined by the general principle.  The award of costs is an exercise of the Judge’s discretion.  While accepting that the action is, as a matter of procedure, properly brought as a derivative action, the Judge did not accept that the principle in Wallersteiner v. Moir (No. 2) applies.  In his oral reasons refusing the plaintiffs’ application to vary the costs order nisi, the Judge explained:

“To begin with, the plaintiff[s’] pleadings alleged breaches of fiduciary obligation, none of which were found. … what was found to be the actual subject matter of the case, an alleged breach of care, the plaintiff[s] failed to substantiate. [The plaintiffs] failed to show that there was any breach … by the Chan Brothers of their duty of care owed to the company, and I don’t think that the plaintiff[s] came anywhere towards discharging [their] burden of showing a case of breach.

In those circumstances, I see no reason why I should apply the principle in Wallersteiner v. Moir. Insofar as the [2^nd] plaintiff  was successful in defending [himself] against the allegation that [he] had entered into a waiver with Amax, that is catered for in the costs order by saying that the plaintiff[s] [are] not required to pay all the costs, but only a percentage of the costs of the defendants.”  

37. There is no proper basis to interfere with the Judge’s exercise of discretion. The appeal against the costs order must fail.

Hon Au J:      

38. I agree.