CHINA FORESTRY HOLDINGS CO LTD (IN OFFICIAL LIQUIDATION)AND OTHERS v. KPMG (a firm)

HCCL 9/2019

[2020] HKCFI 2614

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

COMMERCIAL ACTION NO 9 OF 2019

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D E C I S I O N

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1.  There are 2 applications before the court: (1) KPMG’s Summons filed on 4 June 2020 (amended on 7 September 2020) for, inter alia, a further and better list of documents described in the Amended Schedule (“Discovery Summons”); and (2) KPMG’s Summons dated 20 August 2020 requiring the Plaintiffs to identify the documents amongst their own discovery which they dispute authenticity (“Authenticity Summons”).

2.  The discovery sought concerns 3 classes of documents :

(1)  Notes, transcripts or recordings of interviews conducted by the Joint Official Liquidators of the 1^st Plaintiff (“Liquidators”) in connection with their investigations into the business and affairs of the 1^st Plaintiff’s group of companies (“Group”) with specified directors, officers or members of management of the Group (no less than 36 persons) (“Key individuals”);

(2)  Written communications between the Liquidators and the Key Individuals in connection with the Liquidators’ investigations into the Group’s business and affairs;

(3)  Reports provided by the Liquidators to the Group’s creditors, to the extent they refer to the Group’s business and affairs.

3.  The “business and affairs” of the Group are defined as follows :

(1)  The “true state of the Group’s business and financial position, and any suspected fraud, wrongdoing or negligence of the Key Individuals” from “1 January 2009 to 18 June 2015”;

(2)  Any “actual or potential choses in action” that may be available to the Liquidators to pursue or get-in which “concern some or all of the losses which the Plaintiffs seek to recover from” KPMG;

(3)  “[R]easons for and events leading to the 1^st Plaintiff’s insolvency”.

Respective case

4.  The following is a high-level summary.  KPMG audited the 1^st Plaintiff’s consolidated financial statements for the years ended 31 December 2009 (“2009 Audit”) and 2010 (“2010 Audit”).

5.  The Plaintiffs allege that the Group was the victim of an extensive fraud perpetrated by Mr Li Han Chun (“Li”), the Group CEO.  It is alleged that KPMG negligently failed to detect any of the alleged irregularities in 5 areas in respect of the 2009 Audit.

6.  It is KPMG’s case that it did identify irregularities in the key areas of alleged fraud and performed extended audit procedures in response.

7.  The Plaintiffs allege that if KPMG had carried out additional audit procedures or reached a different judgment, KPMG would have concluded that Li and the Group’s management had forged the documents supplied to KPMG and given fraudulent explanations to KPMG, and KPMG would have reported this to the 1^st Plaintiff’s board of directors (“Board”) and/or audit committee (“Audit Committee”), which would have taken steps that would have prevented the Group from suffering the claimed losses.

8.  The Plaintiffs allege that if KPMG had reported the irregularities to the Audit Committee in March 2010, the Board would immediately have taken steps to safeguard the Group’s assets and to dismiss Li and persons acting under his direction.

9.  Further, the Plaintiffs would have immediately taken action to prevent certain payments made pursuant to sham transactions defined as the KUB[1] Prepayments, 2010 Guizhou Sham Transactions and 2010 Yunnan Sham Transactions.  The 1^st Plaintiff would not have paid a final dividend of RMB 157,911,060 in June 2010 (“2010 Dividends”), and it would not have issued US$300 million Senior Notes on 22 November 2010 and would therefore have avoided wasted expenses.

10.  KPMG has denied the chain of causation.  In addition, KPMG has pleaded defences of contributory negligence, failure to mitigate loss, reflective loss and limitation, and advanced a Counterclaim of circuity of action based on the fraudulent misrepresentations of management. 

Issues on Discovery Summons

11.  In opposing the application, the Plaintiffs say that the documents sought are irrelevant and, insofar as they are relevant, they are covered by legal professional privilege.  The Plaintiffs also say that it is now practically impossible to establish the true state of the Group’s business and financial position over the period of time in question.

Applicable principles

12.  The principles on discovery applications are trite.  They were summarised in Li Tak Yee v Sociéte Générale, unrep, HCA 2478/2009, 16 April 2013, §§24-54.  I do not propose to repeat them here.

13.  In relation to legal professional privilege (“LPP”), the following is a useful summary :

(1)  Legal advice privilege attaches to communications between a client and his lawyer, where the lawyer is acting in the course of his professional relationship and within the scope of the lawyer’s professional duties, under conditions of confidentiality, and for the purpose of enabling the client to seek, or the lawyer to give, legal advice or assistance in a relevant context: Passmore on Privilege, 4^th edn (2020), at [2-003];

(2)  Litigation privilege attaches to confidential communications between a client or his lawyer and a third party for the dominant purpose of use in litigation that, at the time the communication is made, is either proceeding or pending, or reasonably anticipated or in contemplation, and to which the client is or reasonably anticipates becoming a party, for the purpose of either (i) enabling legal advice to be sought or given or (ii) seeking or obtaining evidence or information to be used in or in connection with the litigation concerned: Passmore, at [3-006].

Lateness of these applications

14.  This is a late application in light of (a) the complexity of this case; (b) the stage at which these proceedings have reached (the first round of witness statements was exchanged on 24 August 2020 and the parties are to exchange supplemental statements no later than 30 October 2020); and (c) the fact that a 50-day trial for this case will begin on 28 June 2021.  Regrettably, there remain unresolved interlocutory applications.  In addition to the 2 Applications before the court, there are 2 outstanding applications for adducing expert evidence.

15.  The lateness of the present applications requires the court to consider its potential effect on trial preparation on which the parties should be focused, and to scrutinise the Applications with the Underlying Objectives in mind: see O 1A, r 1 and Li Tak Yee, §§29-34.

Relevance and necessity of the documents sought

16.  For the present purposes, the pleadings are to be considered broadly and relevance is determined by reference to the wide Peruvian Guano test: Li Tak Yee, §§26 and 28.

17.  KPMG says that the Liquidators’ investigations (and the documents sought) are relevant to 2 main pleaded issues:

(1)  What was the extent of the alleged fraud and who was implicated in the fraud or otherwise responsible for the losses claimed?

(2)  What was the true state of the business and financial position of the Group from 2009 and onwards?

True state of business

18.  Dealing firstly with the 2^nd issue, I have not been able to find from KPMG’s 112-page Substituted Defence and Counterclaim (“D/CC”) any positive case pleaded in respect of the “true state of business”.

19.  Of the arguments advanced by KPMG, the strongest one on relevance was rested on one of the losses claimed by the Plaintiffs, namely, the 2010 Dividends of RMB 157.9 million.  It was said that that the court can only assess the likelihood of whether the 2010 Dividends would have been paid in any event (ie, even if KPMG had disclaimed the 2009 Audit opinion or reported additional matters to the Board) if there is evidence as to the true financial position of the Group in 2009.  The decision whether to issue a dividend necessarily required the Board and its shareholders to reach a conclusion as to whether the Group was solvent or insolvent and whether it had sufficient distributable reserves from which a dividend could be paid.

20.  The Plaintiffs’ pleaded case on the 2010 Dividends is quite simple.  It is averred that the Dividends were paid in reliance on the misstated Financial Statements for 2009 and KPMG’s unqualified audit opinion in respect thereof.  Had KPMG reported findings of fraud or indicia of fraud requiring further investigation, the Dividends would not have been paid (see Substituted Statement of Claim (“SOC”), §§144-145).

21.  Apart from putting the Plaintiffs to proof, KPMG’s case is that the Plaintiffs in fact had substantial business (albeit not properly documented), was holding substantial cash and further dividend of RMB 63.5 million was paid in February 2012 by the 1^st Plaintiff after they had reported irregularities to the Audit Committee in respect of the 2010 Audit (see D/CC, §§177.6, 188-189).

22.  I have not overlooked section D1 of the D/CC, §§34-40.  The section contained much submission which can only serve to obfuscate.  Stripped of the submissions, the section contained little more than the findings of the Independent Board Committee (“IBC”) to the effect that the Group had a substantial cash business and a large cash balance. 

23.  In the Substituted Reply and Defence to Counterclaim (“R/D”), §111, it was pleaded that apart from the special dividend of RMB 63.5 million[2] paid in March 2012 no other dividend was declared and paid by the 1^st Plaintiff.

24.  The Plaintiffs had made it abundantly clear in their submissions that it is not part of their case that the Group had no business (such a case was repeated attributed to the Plaintiffs by KPMG).  Indeed, one would have thought that any suggestion that the Group had no business would not sit well with the fact the 1^st Plaintiff had paid out substantial dividend in 2010. 

25.  I agree with KPMG’s submission that the Plaintiffs’ case on loss is counterfactual.  The court will likely have to rely on inferences in the adjudication of such case.  However, in my view, the relevance of “true state of business” is at best marginal in light of the pleaded cases summarised above. 

26.  This brings me to the Plaintiffs’ case that it is now practically impossible to establish the true state of the Group’s business and financial position over the period of time in question.  The Plaintiffs rely upon the fact that KPMG and their successor, Crowe Horwath, were unable to establish the true state of the Group’s business.  KPMG disclaimed the 2010 consolidated financial statements.  Crowe Horwath disclaimed the 2011 and 2012 consolidated financial statements (2012 being the last set of audited accounts prior to the appointment of Liquidators in 2015 to the 1^st Plaintiff).

27.  As an example, Note 2 to the 1^st Plaintiff’s 2010 consolidated financial statements, which was referred to in KPMG’s disclaimer of opinion, stated as follows : 

“Following Mr. Li’s admissions to the Board, the Independent Committee was able to locate the Cash Records but has not been able to locate the related supporting documents of Kunming Ultra Big for year ended 31 December 2010 or the Cash Records or related supporting documents relating to before 2010.”

…

… As a consequence, the Board has reason to believe that the financial statements in previous years might not reflect the true and fair view of the company’s financial performance and position.  Due to loss of some books and records, and lack of cooperation from Mr Li, Ms Wu and Mr Zhang the Board believes that it is almost impossible, and not practical to verify the financial information as reported in the consolidated financial statements of the Group for the current and past years.”

[emphasis added]

28.  It should be highlighted that the Liquidators had taken extensive steps to recover documents from numerous third parties.  Altogether, there are some 1.5 million documents in the Liquidators’ possession; about 1.25 million documents had been disclosed in these proceedings after agreement was reached by the parties on the scope of discovery.  However, the Liquidators are not in any better position than KPMG to say what the “true state of business” was. 

29.  The suggestion by KPMG that the discovery sought is “likely to provide significant general observations about the Group which will be informative and assist the Court in its assessment of this case” is both unconvincing and tends to lend weight to the Plaintiffs’ complaint that this is a fishing exercise. 

30.  I am not satisfied that the discovery sought will materially improve the picture provided by the existing material such as the financial statements and the IBC investigations for which it was assisted by 2 international firms of accountants (see D/CC, §§37-40).

31.  Moreover, the breadth of the discovery sought lends weight to the Plaintiffs’ complaint that the scope of the Application is too board and oppressive.  Given the stage of these proceedings, the parties should be focusing their time and energy on narrowing the disputes and preparing for the trial. 

32.  For these reasons, I disagree with KPMG on the relevance or necessity of the documents pertaining to the “true state of business”. 

Fraud

33.  In respect of the extent of the fraud and the perpetrators (see para 17(1) above), the Plaintiffs had made specific allegations in relation to 5 key areas of fraudulent activity within the Group’s business in 2009, which KPMG ought to have identified and reported to the Audit Committee.  The Plaintiffs claim loss in respect of specific payments made in 2010 and 2011, which they say would have been prevented had KPMG identified the aspects of fraudulent activity in the Group’s business.

34.  The Plaintiffs allege that Li was assisted by, inter alia, 7 identified individuals (“7 Individuals”) in his wrongdoings[3].

35.  KPMG’s case on the fraud is quite opaque.  The closest to a plea on the extent of the fraud and the people involved is to be found in paras 168.2 and 168.4 of the D/CC :

“168.2. If the Plaintiffs prove the fraud, it will be shown to be a sophisticated and wide-ranging fraud involving the collusion of numerous members of the 1^st Plaintiff’s Board, Audit Committee, management and 420 employees, as well as various third party banks and government officials. To the extent the Court finds that every reasonably competent auditor would have raised additional questions or sought additional evidence, those requests would have been met with further falsified information and documentation and additional staged site visits orchestrated by the dishonest members of management and those charged with governance and the fraud would have remained undetected in any event.

…

168.4.  Even if the Plaintiffs prove the alleged fraud and that every reasonably competent auditor would have detected and reported it, it is denied that the Audit Committee would have avoided the losses claimed by taking the steps pleaded in paragraph 135.  The alleged fraud could only have been carried out with the collusion or gross incompetence and apathy of the 1^st Plaintiff’s Board, executive management and Audit Committee.  Those persons would not have acted to prevent the alleged losses regardless of the matters reported.”

36.  These paragraphs did not contain any proper plea of material facts.  Instead, they contain generalised assertion (“will be shown”) of widespread fraud involving numerous unnamed individuals.

37.  In Schedule A to the D/CC, an “Overview of the 2009 Audit” was set out, the generalised allegation of widespread fraud was repeated in para 2 :

“The audit work pleaded in this Schedule demonstrates that, if the Plaintiffs are successful in establishing the alleged fraud, it was a wide ranging and elaborate fraud involving collaboration with numerous third parties, voluminous falsified documentation and dishonesty among those at the highest levels of the Plaintiff companies. Further audit procedures would not have uncovered such a fraud, because such procedures would have been met with additional false documents and explanations.”

38.  Paragraph 2 was pleaded to in para 3.1 of Schedule 1 of the R/D as follows :

“Regarding the first sentence, the Plaintiffs admit only that the fraud was wide ranging and involved voluminous falsified documentation and dishonesty among those at the highest levels of management. Further, KPMG’s case that no fraud is admitted, alternatively if there was a fraud it was wide ranging and elaborate, is not coherent.”

39.  I bear in mind that serious allegations are made against professionals in this action, which may affect their livelihood.  Further, it might have been the case that KPMG was hoodwinked by the fraudsters in the course of the 2009 Audit.

40.  On the other hand, there is no issue that there was a wide ranging fraud involving people in the top management.  By its very nature, it is quite unlikely for the parties to be able to get to the bottom of a sophisticated and wide ranging fraud. 

41.  Importantly, the trial of this action will not be about the fraud, although it is an important backdrop against which the court will have to inquire into the adequacy or otherwise of the 2009 Audit. 

42.  Without properly defined parameters in the pleadings or the Discovery Summons (the relevant part of the definition (see para 3(1) above) is hopelessly wide and no attempt had been made to narrow it down), it would not be right to allow discovery at this late stage of the proceedings (with the filing of the witness statements, the parties’ factual case had been laid out) with the hope that something useful may be turned up. 

43.  This brings me to the probative value of the materials sought. It must be borne in mind, first and foremost, that the Liquidators had shared with KPMG the documents available to them.  There is equality in analysing and making use of those documents.

44.  Amongst the discovery sought, the materials which are most relevant to the issue of fraud must be the interview records of the Key Individuals.  These interviews could only have taken place no less than 4 or 5 years after the events.  According to the Liquidators’ evidence, none of the 7 Individuals had been interviewed by them[4]. It would be wishful thinking to believe that any of the interviewees had confessed to taking part in the fraud upon interview 4 or 5 years later. 

45.  The most which one may expect would be allegations made by interviewee(s) against one or more people in the management.  At the highest, it would be hearsay evidence which requires careful scrutiny before it can be relied upon, if at all, because the interviewee might have a motive to lie, eg, to exculpate himself/herself and lay the blame on someone else.

46.  The meeting notes of Mr Su Xiaoming[5], which had been disclosed by the Liquidators, serve to illustrate the point.  Mr Su was recorded to have said that Li had falsified the accounts on behalf of Li Kwok Cheong, the Group’s Chairman, who was “trying to get money from the Group and … run off”.  However, it was recorded also that Mr Su had suffered considerable loss from his investment in China Forestry, his relationship with the Chairman Li went soured over monetary dispute and he was looking to bring action to recover his loss (including against KPMG).  Self-evidently, such evidence has to be treated with considerably caution by the court.

47.  It will not be right for any part of the trial to be turned into an inquiry of the fraud based on a collection of hearsay evidence of questionable probative value. 

48.  It is incumbent for the court, having in mind the Underlying Objectives, to take a balanced view of the value of the materials sought to KPMG and to the court, and how discovery of such material at this stage may impact on the trial. 

49.  For these reasons, I am unable to agree with KPMG that the fraud materials are relevant or necessity.

50.  For completeness, no submission was made by KPMG in respect of the documents which may fall within the definition as stated in paras 3(2) and (3) above.  Para 3(3) is irrelevant.  In respect of para 3(2), KPMG had pleaded no positive case under its allegation of failure to mitigate loss[6] (it is therefore not a proper plea: see Hong Kong Civil Procedure 2021, vol 1, [18/8/23]), and is likewise irrelevant.  It may be added that the Liquidators’ documents were available to KPMG, and the latter is free to bring third party proceedings if it sees fit.

51.  In respect of the class of documents referred to in para 2(2) above, the sheer breadth of it is oppressive and should be rejected. 

52.  As regards the Liquidators’ Reports (see para 2(3) above), apart from the lack of relevance or necessity of “business and affairs” discussed above, I am unable to see why it is relevant or necessary to know, as Mr Yu (who appeared for KPMG) submitted, the view of the Liquidators on those matters.  The court will be required to examine the facts of this case and to adjudicate on the allegations made against KPMG. 

LPP

53.  In light of the above discussions on relevance and necessity, the analysis on LPP can be succinctly stated.

54.  The Plaintiffs claim that the documents covered by para 2(1) above, insofar as they may be relevant and save for a limited number of possible exceptions (which had been disclosed), are covered by litigation privilege because the relevant interviews were conducted for the dominant purpose of investigating, instigating and pursuing court proceedings. 

55.  The Plaintiffs rely on Akai v Ernst & Young (2009) 12 HKCFAR 649, in which the Court of Final Appeal held that interviews conducted by liquidators were covered by litigation privilege.  It was submitted that this case is analogous to Akai.  Akai’s liquidators were suing the company’s former auditors EY.  EY sought disclosure of transcripts and notes of interviews and examinations conducted by the liquidators. 

56.  The test for litigation privilege may be seen from the dicta of Lord Hoffmann (§117) as follows :

“The case in my opinion depends upon the answers to two simple questions. First, did the liquidators conduct the examinations for the sole or dominant purpose of obtaining advice from their solicitors as to bringing or conducting legal proceedings? Secondly, were such proceedings reasonably anticipated at the time? These questions are an application to the facts of this case of the general principles of legal professional privilege stated by the House of Lords in Waugh v British Railways Board [1980] AC 521.”

57.  The focus of KPMG’s criticisms concerned the evidence advanced by Mr Borrelli in support of the privilege claim.  In assessing the evidence, it is important to note that the 1^st Plaintiff was hopelessly insolvent with few assets to be realised aside from legal claims against third parties.  Therefore, a key focus of the Liquidators’ work was to investigate available claims[7].  KPMG’s reliance on the possible sale of the listing status of the 1^st Plaintiff as part of the focus of the Liquidators is misplaced, because the 1^st Plaintiff’s listing was cancelled in February 2017 and the earliest of the interviews over which privilege is claimed took place in August 2017.

58.  Further, all the allegedly privileged interviews took place after the writ was issued against KPMG. 

59.  Viewed in light of these facts, the evidence set out in paras 64 to 70 of Borrelli 5^th is, in my view, sufficient to answer the 2 questions identified by Lord Hoffmann in the affirmative.

60.  In respect of the documents identified in para 2(3) above, the Plaintiffs claim that they are largely relevant, and where they may be relevant, they are subject to LPP because they (a) contain legal advice received by the Liquidators or the 1st Plaintiff, (b) report on work undertaken by the Liquidators and their legal advisers in relation to legal claims, or (c) make observations about the merits of such claims.

61.  KPMG says that reasons (b) and (c) are not sufficient reasons for either of the 2 types of LPP :

(1)  Legal advice privilege does not attach to communications between a client and a third party save where it records legal advice: see §13(1) above;

(2)  Litigation privilege attaches to documents created for the dominant purpose of litigation.  The Plaintiffs have not made any claim as to the purpose of the Liquidators’ Reports.  It is plain that the dominant purpose of such reports was to keep the creditors informed of the progress of the liquidation, rather than to obtain legal advice or use in litigation.

62.  KPMG accepts reason (a), ie, a document is protected by legal advice privilege if it reveals the substance of legal advice.  However, it is contended the Plaintiffs should be ordered to disclose the Liquidators’ Reports, with liberty only to redact portions of the reports that reveal the substance of legal advice.

63.  Despite the fact that the Liquidators were reporting on the legal claims and making observations on their merits, I am inclined to agree with KPMG’s contention on the dominant purpose of the Reports. 

64.  However, as stated in para 52 above, I fail to see the relevance or necessity of these Reports and I would not accede to the Application even with the legal advice redacted.   

65.  For these reasons, I only agree with the Plaintiffs’ claim to privilege in relation to the documents required under para 2(1).

Authenticity Summons

66.  There is merit on the Plaintiffs’ submission that by this application KPMG seeks to impose a reverse O 27, r 4 burden on them.  Under that rule, if “a party on whom a list of documents is served” wishes to dispute the authenticity of a document disclosed in that list, he must do so within 21 days of inspection or dispute the authenticity in his pleadings.  Otherwise, the party receiving the list will be deemed to admit authenticity “unless the Court otherwise orders”.

67.  The burden of identifying from the 1.25 million of disclosed documents those which are not authentic is self-evidently oppressive.  In any case, I fail to see why that can be possible in a case of widespread fraud. Nor why the exercise is required in light of the pleadings in this case. 

68.  The Plaintiffs had identified in their pleadings the false documents they rely upon.  Further, in his 6^th affidavit, Mr Borrelli had set out in Schedule 1 the falsified primary documents in the 5 areas of fraudulent activity with references to how they can be located in the discovery.  In addition, Schedule 2 set out the ancillary documents which are likely to have been falsified as a matter of inference. 

69.  Mr Karas had confirmed that the documents identified in Schedules 1 and 2 are consistent with and taken into account Mr Borrelli’s witness statement.  I believe that the assurance is sufficient to answer KPMG’s concern that the Plaintiffs might shift their case in the course of the trial by making new allegation of false document.

Disposition

70.  For these reasons, both the Discovery Summons and the Authenticity Summons are dismissed with a costs order nisi that the costs be to the Plaintiffs. 

71.  As Mr Karas had agreed in the course of the hearing, the Plaintiffs should file and serve a supplement affidavit confirming that the table of summary contained in para 67 of Borrelli 6^th had set out all the interviews or meetings which the Liquidators had with the Key Individuals. That should be done within 7 days from the date of this Decision.

72.  Last but not least, I am grateful for the assistance provided by Mr Yu and Mr Karas.

[1] Kuming Ultra Big Forestry Resource Development Co Ltd, the Group’s principal operating subsidiary.

[2] The court was informed by Mr Karas, who appeared for the Plaintiffs, that their factual evidence is that the dividend was paid with the view of having the suspension of trade imposed on the 1^st Plaintiff’s shares lifted. 

[3] SOC, para 13 and Schedule 3.

[4] See Borrelli 6^th, §67.  It was confirmed by Mr Karas that all the interviews had been set out in §67.

[5] Mr Karas informed the court that Mr Su went to the Liquidators’ office uninvited. 

[6] D/CC, §§205-206.

[7] Borrelli 5^th, §62.