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

HCA 2654/2007

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

ACTION NO. 2654 OF 2007

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J U D G M E N T

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I. INTRODUCTION

1. This is a derivative action brought by Wong and Tsui on behalf of Topmix against the Chan Brothers.

2. Topmix makes fiberglass automobile parts.  Tsui is Wong’s son-in-law.  Each of Wong, Tsui and the individual Chan Brothers holds 25% of Topmix’ issued shares.  Formerly, Tsui and the Chan Brothers acted as Topmix’ directors.  But on 20 January 2006 the Chan Brothers ousted Tsui as a director and since that date the Chan Borthers alone have acted as Topmix’ directors.

3. As of January 2006 then, there have been 2 equal warring camps of 50% shareholders within Topmix, one comprising Wong and Tsui, the other comprising the Chan Brothers.

4. AMAX, based in the United States, has been (and continues to be) Topmix’ main customer.  About 60% of Topmix’ business is with AMAX.  So, in a given year, AMAX might place orders with Topmix for automobile parts worth between $20 to $30 million in total.

5. In 2006 AMAX claimed that Topmix owed AMAX $2,722,685.  AMAX alleged that this debt had arisen because Topmix had supplied defective goods to AMAX between October 2004 and December 2005 and because Topmix had over-charged AMAX in a number of invoices.  AMAX never appears to have particularised its claim to Topmix, despite the Chan Brothers pressing AMAX to provide more details.

6. As emerged at trial, the real dispute among the parties is whether, as directors, the Chan Brothers were negligent in agreeing in August 2007 to forego an outstanding amount of $2,336,620 due to Topmix from AMAX in settlement of AMAX’ alleged claim against Topmix for $2,722,685.

7. Wong and Tsui contend that, by accepting AMAX’s claim and failing to pursue the amount due from AMAX, the Chan Brothers did harm to Topmix.  Topmix (Wong and Tsui say) lost the amount due from AMAX. Because the Chan Brothers control 50% of Topmix, there was (Wong and Tsui argue) no way apart from a derivative action of getting Topmix to claim the loss inflicted by the Chan Brothers’ negligence in the handling of Topmix’ affairs.

II.  BACKGROUND

8. In April 2006, following Tsui’s ouster as director, the Chan Brothers met with AMAX.  The evidence of Chan Yuk Wai (which I accept) is that at the meeting AMAX said that Topmix owed AMAX a substantial amount of money.  Chan Yuk Wai says that AMAX did not state precisely how much was owed.  But AMAX appears to have refused to pay the $2,336,620 for which Topmix was pressing.  AMAX (Chan Yuk Wai says) also claimed that Tsui had previously agreed that the $2,336,620 would be waived.

9. The exact amount claimed by AMAX’s was not specified until 5 September 2006 when AMAX’s solicitors (Iu, Lai & Li (ILL)) wrote to Topmix’ then solicitors.  In its letter, ILL contended:-

“(i) Topmix had on numerous occasions committed breaches of the terms and conditions in the License Agreement and Manufacturing Contract, and both Amax and VIS are taking steps and/or contemplating taking steps against Topmix for such breaches, and

(ii)  Topmix is currently indebted to Amax for balance of purchase price overpaid and/or advances made by Amax in connection with business or purchase orders placed with Topmix pursuant to the Manufacturing Contract, or refund for defective/ damaged Products; the amount outstanding as at December 2005 was HK$2,722,685.  The amount owing by Topmix to Amax as aforesaid (the ‘Debt’) varies from time to time.”

10. ILL proposed that the Debt be settled by monthly installments of “at least HK$200,000.00 each” to be “deducted by Amax from the invoiced amounts of purchase orders placed by Amax”.

11. ILL also instructed Topmix to return certain moulds which AMAX had provided to Topmix.

12. Thereafter, AMAX and Topmix continued their negotiations.  According to Chan Yuk Wai, Topmix repeatedly asked AMAX to provide details of the alleged over-charging by Topmix and the alleged defective parts delivered to AMAX.  But AMAX never provided better information than that contained in ILL’s letter.

13. On 25 April 2007 Topmix asked AMAX to sign a document stating that Amax was not paying the $2,336,620 invoiced by Topmix “because ... Tsui ... had made a verbal agreement to waive the said outstanding amount”.  Topmix requested AMAX’s signature “[w]ithout prejudice to our right of recovery of the above said sum”.  But AMAX refused to sign the document.

14. Meanwhile, sometime in April 2007, Tsui had noticed from Topmix’ audited financial statement for the year ended 31 March 2006 that a provision of $2,487,253 had been made for doubtful debts.

15. Tsui’s evidence was that he was alarmed by reading this.  Tsui (who has no training in accountancy) assumed that the provision for doubtful debts meant that Topmix could no longer legally pursue the debts for which provision had been made.  He did not realise that the provision only reflected the company’s assessment that the relevant debts would be extremely difficult to recover for one reason or another.

16. In March 2007 the Inland Revenue had actually asked Topmix to substantiate the provision for doubtful debt in its 2005/2006 financial statement.

17. In May 2007 Topmix by its auditors replied to the Inland Revenue that most of the provision had to do with AMAX.  That was because the latter was refusing to pay the $2,336,620 “on the ground that the quality of goods delivered did not meet with the required standards”.  Topmix’ auditors further wrote that, while a director, Tsui “had ... agreed to waive the outstanding amount of $2,336,620 by a verbal agreement”.  The auditors observed that Tsui lacked the authority to waive the debt and Topmix had reported Tsui’s “misconduct” to the ICAC for investigation.

18. The auditors concluded their letter as follows:-

“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.”

19. By letter dated 14 June 2007 from his solicitors to Topmix, Tsui described the provision for doubtful debts in Topmix’ financial statement as “wholly unprecedented”.  Tsui’s solicitors asked for details and threatened court action if the information was not forthcoming.

20. Topmix’ solicitors wrote back that the bulk of the provision covered the $2,336,620 due from AMAX to Topmix.  According to Topmix’s solicitors, AMAX had told Topmix that, before Tsui’s removal as director, Tsui had agreed to waive payment of the $2,336,620 due from AMAX. Topmix’ solicitors asked that Tsui’s solicitors “take instructions from Mr. Tsui on such serious allegation and revert”.  This was “so that the Company may confront Amax Motor with Mr. Tsui’s version, if it is helpful at all to the Company’s continuous efforts to press Amax Motors for repayment”.

21. Topmix’ solicitors also complained that Wong “has been wrongfully locking up many of the Company’s moulds specifically made on Amax’s orders at the old Shipai Chuang Mei Shi Factory plant [the CMS factory] since mid-May 2006”.  As a result, Topmix could not complete orders placed by AMAX and that was causing AMAX not to place further orders with Topmix.  The solicitors noted that “[s]uch situation further added to the difficulties of the Company in its dealings with Amax”.  The solicitors requested Wong to release the relevant moulds from the CMS factory.

22. By letter dated 6 August 2007 Tsui’s solicitors wrote to AMAX to deny that Tsui had ever agreed to waive the $2,336,620 owed by AMAX.  The solicitors hinted that the “false allegations” being levied in that respect against Tsui were “frequently-used ploys to defraud commercial concerns and the tax authorities”.

23. On 15 August 2007 Topmix (acting by the Chan Brothers) and AMAX (acting by Chan Yiu Ming) agreed in writing as follows:-

“1. [B]etween October 2004 to December 2005, Topmix was indebted to Amax in the sum of HK$2,722,685 being compensation for defects of Topmix’s products supplied to Amax for the period from October 2004 to December 2005 (the Claim).

2. [A]s per the purchase orders set out in the Schedule hereto (comprising 3 pages), there was due to Topmix from Amax for Topmix’ products supplied to Amax the total sum of HK$2,336,620 (the ‘Outstanding Amount’).

We further confirm that the agreement reached between Amax and Topmix (through [Tsui], ex-director of Topmix at the time) provided for Amax to set off the Outstanding Amount against the amount due to Amax under the Claims, to the intent that Amax should no longer be indebted to Topmix for the Outstanding Amount.

By signing this agreement, Amax and Topmix agree the Outstanding Amount and Claims of the said period between two parties are completely settled.”

24. On 1 September 2007 Topmix’ solicitors followed up on their letter of 14 June 2007.  The solicitors observed that Tsui had not commented on AMAX’ allegation of an agreement with Tsui to waive AMAX’ $2,336,620 debt.  Nor (the solicitors continued) had Tsui “offered any explanation as to why and how he allowed Amax’s trading debts to accrue and accumulate to such ‘unexpected and abnormal’ level”.  Tsui had instead “failed to account for what he has done, if any, to reduce [AMAX’ debt] during his directorship with special responsibilities for the financial and accounting matters of the Company”.  The solicitors then renewed their request for the release of AMAX’ moulds from the CMS factory to allow completion of AMAX’s purchase orders.

25. Tsui’s solicitors wrote back on 25 September 2007 to accuse AMAX and the Chan Brothers of striking “a secret deal for their mutual unlawful benefit by fabricating a false case against Mr. Tsui behind his back and by keeping him and Mr. Wong in the dark”.

26. Tsui’s solicitors suggested that “the only reasonable inference to be drawn” from the levying of the false allegation was that “[t]he Chan brothers and Amax have conspired to defraud the other shareholders of Topmix, namely, Mr. Tsui and Mr. Wong, by falsely representing that Mr. Tsui had agreed to waive the said debt”. The Chan Brothers and AMAX (according to the solicitors) had further “conspired to defraud the Hong Kong tax authorities by falsely representing that Mr. Tsui had agreed to waive the said debt”.  For good measure, the solicitors added that the Chan Brothers and AMAX had “conspired to defraud the US tax authorities by falsely representing that Topmix owed a debt to AMAX in the sum of HK$2,722,685 which Amax had been unable to recover from Topmix”.

27. The letter ended:-

“In view of the serious nature of the matters involved in this case and that Mr. Tsui has already assembled the necessary evidence required for action, Mr. Tsui has been advised by counsel that speedy steps need to be taken to protect his interest.”

28. Needless to say, there is not a shred of evidence to support the outrageous allegations of conspiracy to defraud contained in Tsui’s solicitors’ letter.  Such allegations of fraud should never have been made by Hong Kong solicitors in the absence of cogent evidence.

29. Although there are hints of the same allegations in the Statement of Claim (for example, in the use of the word “sham” in paragraphs 11 and 21(b)), at the start of the trial Mr. Ronald Tang (acting for Wong and Tsui) unequivocally stated that he was not advancing a case of fraud against the Chan Brothers.

30. On 17 October 2007, ILL wrote to Tsui’s solicitors as follows:-

“.... Ms. Chan [Miu Ying of AMAX] met the Chan brothers to negotiate on our client’s [that is, AMAX’] Claim. The Chan brothers represented to our client that Topmix was having financial difficulties and cashflow problem, and requested our client to deduct our client’s Claim from payment due under future purchase orders commencing March 2006. In about March or April 2006 (which exact time our client cannot now recall due to the lapse of time), our client reached an agreement in the office of Topmix with the Chan brothers to the effect that our client’s Claim would be deferred, and set off against or deducted from payment due to Topmix under future purchase orders (‘the Arrangement’). On about 15 August 2007, our client and the Chan brothers met for the purpose of confirming in writing that our client’s Claim had been settled in manner provided in the Arrangement, and our client is no longer indebted to Topmix in the sum of HK$2,336,620 (‘the Alleged Indebtedness’) being payment due under purchase orders and which has been set off against our client’s Claim pursuant to the Arrangement.”

31. On 20 April 2006 AMAX paid Topmix $816,875. According to Topmix, the payment was specifically made in respect of invoices rendered by Topmix to AMAX in November 2005.  As a result, in Topmix’ financial statements for 2006/2007 the provision for doubtful debt in Topmix’ 2005/2006 financial statement has been reversed by $816,875.

32. Wong and Tsui, however, do not accept that the characterisation in the 2006/2007 financial statement is the correct one for the payment of $816,875.  For present purposes, it is enough for me to note the payment.  It is unnecessary for me to determine whether the payment has been properly characterised.

III.  DISCUSSION

A.  Preliminary issues

33. Before dealing with the main issue identified in the Introduction to this Judgment, I should briefly deal with some preliminary matters.

34. First, apart from hearsay, there is no evidence that Tsui agreed to waive the payment by AMAX of the invoiced amount of $2,336,620.  In the witness box, Tsui denied that he had ever made such an agreement.  I accept that.

35. The only evidence to the contrary is Chan Yuk Wai’s statement that AMAX told him that Tsui had agreed to waive the $2,336,620.  But Chan Yuk Wai’s statement is hearsay evidence.  Chan Yuk Wai has no personal knowledge that Tsui actually agreed to a waiver.  Even if I were to accept (which I do) that AMAX told Chan Yuk Wai that Tsui had agreed to a waiver, it would not necessarily mean that AMAX was telling the truth.

36. 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.

37. Second, Mr. Kwok Kam Kwan (appearing for the Chan Brothers) submitted that this was not an appropriate case for a derivative action.

38. I disagree.

39. Assume for a moment that the Chan Brothers have breached their duty of care to Topmix.  The Chan Brothers are currently in control of Topmix’ board.  Given that Topmix’ shareholders are in deadlock as pointed out above, there would be no practical way to cause Topmix to sue the Chan Brothers for wrongdoing other than through the bringing of a derivative action.  The present situation seems to me to be a classic case for a derivative action.

40. I appreciate that the allegation here is not of a breach of fiduciary obligation, but rather of a breach of a duty of care.  In allowing a derivative action in such situation, the Court must be alert to the possibility of being used by a dissatisfied faction of shareholders to second guess the board’s decisions and to manage a company’s affairs in place of the board.  The Court is undoubtedly ill-placed to assume such role of a shadow manager.

41. However, the possibility of abuse by an unhappy minority of shareholders is not an argument against entertaining a derivative action procedurally.  It is instead an argument against granting substantive relief otherwise than in clear-cut cases where, through obvious or glaring incompetence, directors have inflicted substantial harm on a company.

42. I note in this connection that by Companies Ordinance (Cap.32) (CO) s.358 the Court has a discretion to relieve a director from liability where the latter “has acted honestly and reasonably and ..., having regard to all the circumstances of the case, ... ought fairly to be excused for ... negligence, default, breach of duty or breach of trust”.

43. In short then, a derivative action might be appropriate purely as a matter of procedural form in a given case.  But it does not follow from the resort to such procedure that a director is automatically to be held liable to a company whenever, possibly with the benefit of hindsight, the Court takes the view that the director could or should have handled the company’s affairs differently.

44. Third, it will be noticed that the real issue in dispute as it emerged at trial is not among the specific complaints in the Statement of Claim.  The pleaded complaints are about breaches of fiduciary obligation, rather than the breach of a duty of care.  Nonetheless, the essential facts having been pleaded and explored at trial, it seems to me that I can still fairly determine what now appears to be the real question between the parties.

B.  Main issue

45. Prior to his ceasing to be a director, Tsui handled the AMAX account.  After he left, Topmix was in some disarray.

46. The Chan Brothers had handled other aspects of Topmix’ business and lacked an in-depth knowledge of Topmix’ day-to-day dealings with AMAX.  Chan Yuk Wai, for instance, was largely responsible for Topmix’ Yuen Long facility and, by his own account, was not so familiar with the details of shipping goods from Topmix’ Mainland factory to AMAX in America.

47. Following Tsui’s departure, Topmix also found itself lacking staff.  The person who had been handling Topmix’ accounts (a Ms. Chan) was fired on the same day that Tsui left.  In Chan Yuk Wai’s graphic evidence, he soon found he was trying to run Topmix’ business with only a staff of two, one of whom was the cleaner, the other of whom was the driver.

48. From ILL’s correspondence with Topmix, it appears that AMAX was aware that there had been a change in Topmix’ board and Topmix was in some difficulty.  Topmix’ difficulties undoubtedly made it vulnerable to hard bargaining by AMAX.

49. As we have seen, the claim of $2.7 million plus never appears to have been particularised by AMAX, except in vague terms.  Chan Yuk Wai was asked at trial why then the Chan Brothers had agreed to settle with AMAX by waiving the $2,336,620 due to Topmix.

50. In answer, Chan Yuk Wai accepted that $2,336,620 was a large amount.  But he stressed that AMAX was Topmix’ main customer.  If Topmix did not settle quickly with AMAX, AMAX would not place any further orders.  Topmix would not be able to cope financially with the loss of AMAX business.

51. Chan Yuk Wai also stressed that there were problems about obtaining AMAX’ moulds from the CMS factory.  Topmix was not in a position to return the moulds immediately as requested by AMAX.  Indeed, lacking access to the moulds, Topmix had itself not been able to manufacture parts in accordance with subsequent purchase orders placed by AMAX.  Therefore, whatever the validity of AMAX’ $2.7 million plus claim, Topmix faced a real possibility of future justifiable claims from AMAX.

52. The Chan Brothers therefore considered, in light of the annual volume of trade between Topmix and AMAX, that it would be appropriate to forego the $2,336,620 in settlement of AMAX’ claim.

53. Note in this respect that in 2005/2006 Topmix had a total revenue of $37,217,758.  If we assume that about 60% of that revenue is attributable to AMAX, that would mean that in 2005/2006 Topmix did some $22.330 million worth of business with AMAX.  In effect, by pushing hard its claim for alleged defective goods and overpayment, AMAX obtained a 10% discount on sales to it by Topmix.

54. Mr. Tang criticises the Chan Brothers for not seeking clarification from Tsui about the waiver agreement alleged by AMAX. Nor did the Chan Brothers (Mr. Tang says) attempt to verify, by reference to Tsui or to Topmix’ invoices, whether AMAX’s claims of defective goods and over-charging had any basis.  Instead, Mr. Tang characterises what happened as being “shrouded in mystery”.  The Chan Brothers appear to have simply capitulated to AMAX’ demands.

55. The Chan Brothers suggest that, prior to settlement, they repeatedly pressed AMAX for details of AMAX’ claim and for payment of the $2,336,620.  But Mr. Tang counters that only one email has been disclosed seeking payment of what AMAX owed Topmix and there has been no email disclosed wherein Topmix asked AMAX to particularise its claims.

56. Mr. Tang submits that the Chan Brothers cannot have it both ways.  They criticised Tsui for agreeing (at least according to AMAX) to waive the $2,336,620.  But in the end the Chan Brothers did the very thing which they say Tsui ought not to have done.

57. I am not persuaded by Mr. Tang’s submission.

58. The Chan Brothers made a tough executive decision.  Other directors might have decided differently.  But I do not think that I can fault the Chan Brothers for deciding as they did.  I do not think that they acted in breach of their duty of care owed to Topmix.

59. I am mindful that at the relevant time the Chan Brothers and Tsui were not on speaking terms.  The Chan Brothers had ousted Tsui from the board.  They later reported Tsui to the ICAC.  It is therefore doubtful that Tsui would in fact have been happy to cooperate with the Chan Brothers.

60. But let me proceed on the basis that Tsui was prepared to cooperate.  Even then, it is unclear how it would significantly have helped the Chan Brothers had they consulted with Tsui about AMAX’ claim or examined Topmix’ invoices.

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’ cashflow.

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 criticised Tsui for ostensibly agreeing.

68. I also note the remarks of Topmix’s auditors in relation to the impracticality of suing AMAX in the United States.  In those remarks, there is further commercial justification for the decision to forego the $2,336,620.

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.

70. Consequently, I do not think that in accepting the Chan Brothers’ justification I would be allowing the Chan Brothers “to have their cake and eat it” as Mr. Tang suggests.

71. I add that, if somehow there were a breach of a duty of care, I would be prepared for the reasons which I have just canvassed to apply CO s.358 to relieve the Chan Brothers of liability for loss to Topmix due to the arrangement which they entered into with AMAX.  Mr. Tang did not suggest to Chan Yuk Wai in cross-examination that, in doing a deal with AMAX, the Chan Brothers were acting dishonestly.

IV.  CONCLUSION

72. The derivative action fails.  It is dismissed.

73. There will be an Order Nisi that Wong and Tsui pay 80% of the Defendants’ costs.  I suggest 80% to reflect the fact that the Defendants have not entirely succeeded.  More particularly, the Defendants did not prevail on the question whether Tsui had entered into a waiver agreement with AMAX.  Costs are to be taxed if not agreed.

74. Although the parties appeared by 2 counsel.  I doubt that this is a case which merited the appearance of 2 counsel.