XCHRX RE FORLUXE SECURITIES LTD.

HCCW 310/98, 311/98

HEADNOTES

(1) Forluxe Securities Ltd held shares acquired for its clients through CCASS as trustees for the clients under individual trusts (Re CA Pacific (No.1) [1999] 2 HKC 632 applied).

(2) However, the method of allocation adopted in CA Pacific (decision delivered on 20 December 2000) where there was a shortfall cannot and should not be applied because the documentation and operations of the Forluxe companies were prepared and carried out in such a haphazard manner that it is virtually impossible to identify between cash clients and margin clients.

(3) The speediest and most economical solution for allocation of shares where there was a shortfall was the pari passu ex post facto approach, where clients claiming shares in each line of stock would share rateably in the shares available.

(4) The SFC is entitled to a right of subrogation under s.118 Securities Ordinance to shares recovered by the clients, but only to the extent which its payment of compensation bears to the loss claimed.

HCCW 310/98, 311/98

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

COMPANIES (WINDING-UP) ACTIONS NO. 310 and 311 OF 1998

---------------------------

--------------

DECISION

--------------

1. This is an application by the Liquidators of Forluxe Securities Ltd and Forluxe Finance Ltd for directions as to:-

(i) the allocation to clients of shares held by the companies,

(ii) the incidence of costs, remuneration and disbursements of the Liquidators and

(iii) the extent of the right of subrogation of the Securities and Futures Commission ("SFC") pursuant to s.118 of the Securities Ordinance.

Nature of clients' claims

2. Before I deal with the issue of allocation of shares, I first have to determine the nature of the clients' claims.

3. I have in Re CA Pacific (No.1) [1999] 2 HKC 632 found that stockbrokers who had acquired shares for clients through CCASS held the shares as trustees for the clients under individual trusts.

4. There is nothing in the facts of the present case which leads to a different conclusion.  The Securities Trading Agreement here contains clauses that point to an intention that the shares would be held on trust for the clients. 

5. In theory, therefore, clients of Forluxe ought to be in the same position as clients of CA Pacific regarding allocation of shares.  However, as will be seen below, the facts in this case do not permit that result.

Distinguishing this case from CA Pacific

6. This hearing took place one day after the hearing of an application by the liquidators in Re C.A. Pacific for directions as to the allocation of shares to clients.  The cases are similar in this respect:- that in both, there is a shortfall in some of the shares claimed by clients. 

7. In the decision in CA Pacific that I have just delivered, I held that a distinction should be drawn between cash clients (meaning those clients who were only clients of the securities company) and margin clients (meaning those clients who were also clients of the finance company).  I decided, for the reasons set out in that decision which I will not repeat here, that cash clients who had acquired shares in any particular line of stock should have priority, with the rest of the shares in that line being recovered by the margin clients, the clients in the same class sharing pari passu among themselves.

8. That distinction could be properly drawn in CA Pacific because the documentation and records were clear, and the evidence was that the distinction was generally implemented in practice as only shares attributable to margin clients were considered for the finance company's pledge to its lenders.

9. Unfortunately, that distinction cannot be drawn in the present case.  In the 3rd Affirmation of Mr Nicholas Hill, one of the Liquidators, he deposes to the fact that the documentation and operations of the Forluxe companies were prepared and carried out in such a haphazard manner that it is virtually impossible to identify between cash clients and margin clients.

10. Prior to early 1998, the accounting records of the companies did not distinguish between cash clients and margin clients.  In the 3-4 months between that date and their collapse, the companies apparently did attempt some sort of internal classification, but the basis of the attempted  classification was by no means clear.  Further, the classification appears to be far from reliable.

11. Clients were identified as "A" and "M" clients in the companies' records, but there were some clients who appeared as both "A" clients and "M"clients. 

12. Further, the clients (whether "A" clients or "M" clients) appeared to have signed different combinations of 7 types of client documents, with different provisions and with no apparent logical connection. 

13. Moreover, some documents were undated, so that where a time limit for permission to pledge was given, it would be difficult or at least expensive to trace whether that period had expired at the time of pledge.

14. The companies' record-keeping was so poor that there were some documents bearing signatures of clients but comprising only a signature page, so that it would be impossible to discover to what terms the clients had agreed. 

15. Some clients for whom trading had been undertaken had not signed any documents at all, whereas some names purporting to be the names of clients in the companies' documents have been untraceable to actual persons.

16. When the underlying facts are so uncertain and unreliable, it would not be safe for the Court to draw any distinction between cash clients and margin clients when that distinction would lead to significant differences in recoveries.

17. Further, unlike the situation in CA Pacific where the shortfall was largely due to sale and retention of shares by CAP Finance's lenders, the shortfall here (in the region of about $46 million based on the value date of 31 December 1999) appears to be due partly to the disposal of clients' shares by the Mui family to satisfy their personal commitments, a use of the shares which was not, on any view, authorised by any clients.  Judgment has been obtained by the companies against them in a total amount of nearly $39 million.

18. In those circumstances, the Court cannot and should not adopt the method of allocation of shares adopted in CA Pacific.  With no distinction to be drawn between cash clients and margin clients, all clients should be considered identically. 

(i) Allocation of shares

19. That is not to say, however, that all shares now remaining should be merged in one pool and all clients should be able to take from that mixed pool.  It must be remembered that the clients' acquisition of shares (albeit shares in CCASS) was not a collective investment scheme - on the contrary, each client was a beneficiary of the shares that he had acquired under an individual trust.

20. With that in mind and within the factual confines of this case, the Liquidators have classified the shares held by the companies into 5 categories, which may be described briefly as follows:-

A where the shares available are equal to shares claimed;

B where there are more claims than shares;

C where there are claims, but no shares at all;

D where there are more shares than claims;

E where there are shares, but no claims.

21. For those clients claiming shares in categories A and D, it is clear that they should be able to recover the shares claimed, subject to the payment of proper and reasonable costs and expenses and subject to any lien of the securities company.  Any dispute as to the validity or extent of any charge on any client's shares claimed by the finance company should be referred to the Court.  This need not, however, hold up recovery of shares by other clients. 

22. The allocation and delivery of shares should of course also be subject to the SFC's right to statutory subrogation to the extent decided below.

23. For those clients claiming shares in category B, I have referred above to the reasons why the method of allocation in CA Pacific cannot be applied by reason of the facts in this case.

24. In that case, I have also explained why adoption of the rule in Clayton's case would be unjust, inapplicable and impractical.

25. Given the relatively small value of the shares available in this case ($19 million based on the value date of 31 December 1999), it would not be worthwhile to expend further costs on more sophisticated methods of allocation, such as the "North American" or "rolling charge" approach. 

26. The speediest and most economical solution here would be the pari passu ex post facto approach, where clients claiming shares in each line of stock would share rateably in the shares available.  In respect of the balance of their claims, they would of course be able to prove in the liquidations against the companies' free assets.

27. For those clients claiming shares in category C, they will not be able to recover any shares, as there are simply none available, although they would be able to prove in the liquidations against the companies' free assets, which would include proceeds from the surplus of shares in category D and all the shares in category E.

(ii) Incidence of costs and expenses

28. I have in CA Pacific (No.2) [1999] 2 HKC 652 ordered that the liquidators' fees and expenses be allowed to be paid out of trust assets, following the reasoning in Re Berkeley Applegate [1989] Ch 32 which I will not repeat here.

29. I see no reason why a similar order should not be made in the present case.  The question of the quantum of those fees and expenses will have to be dealt with subsequently.

(iii) SFC's right to subrogation

30. Part X of the Securities Ordinance ("the Ordinance") contains provisions governing the establishment, maintenance and control of a fund known as the Unified Exchange Compensation Fund ("the Fund").

31. Members of the Exchange are obliged to deposit sums of money into the Fund which is administered by a committee. 

32. Section 109 of the Ordinance provides for claims to be made against the Fund in certain circumstances.  The relevant parts are as follows:-

"(1) Where, in consequence of any act done in the course of or in connection with the stockbroking business of an exchange participant [stockbroker], a person has a cause of action against that [stockbroker] in relation to any ... securities or other property entrusted to ... the [stockbroker] ..., that person shall be entitled ... to claim compensation from the compensation fund in respect of any pecuniary loss suffered by him.

(3) ... the total amount that may be paid ... to all persons who suffer loss through any default mentioned in ss.(1) shall not in any event exceed $8,000,000 in respect of each [stockbroker] concerned in or connected with the default; ...

(5) ... the amount which any claimant is entitled to claim as compensation from the compensation fund is the amount of the actual pecuniary loss suffered by him, including the reasonable costs of and incidental to the making and proving of his claim".

33. Section 112 provides time limits for claims against the Fund, beyond which limits claims are barred.  Section 112(1) gives a discretion to the committee to publish notices specifying a date by which claims must be made.  If no notices are published, s.112(2)(b) provides that claimants must lodge their claims within 6 months of being aware of the default giving rise to the claim.

34. Pursuant to those provisions, claims have been made against the Fund not only by Forluxe's clients, but also by CA Pacific's clients.

35. The Fund has made payments to these clients, I am told, by first making payments of up to $150,000 to each client, and then by making further payments proportionately to the claims, but subject to the statutory maximum amount.

36. It is consequent to these payments that the SFC has now asserted a right of subrogation to shares that are to be delivered by the Liquidators to the clients.  Directions have been given earlier by the Court for clients to make submissions against the SFC's position if they so wished, and this hearing (although held in chambers) has been opened to all clients, but no real opposition has been raised.  Nevertheless, it is incumbent on the court to consider the issue on this summons.

37. That the statute gives a right of subrogation to the SFC is not disputed.  What requires examination is the extent of that right.  That turns on the true interpretation of s. 118.

38. Section 118 provides:-

"On the Commission making any payment out of the compensation fund in respect of any claim under this Part, -

(a) the Commission shall be subrogated to the extent of that payment to all the rights and remedies of the claimant in relation to the loss sustained by him by reason of the default on which the claim was based; and

(b) the claimant shall have no right in bankruptcy or winding up or by legal proceedings or otherwise to receive in respect of the loss any sum out of the assets of the [stockbroker] concerned or any dealing partnership in which he is a partner, or where the loss was caused by the defalcation, fraud or misfeasance of a servant or partner of the [stockbroker], the assets of that servant or partner , until the Commission has been reimbursed the full amount of its payment".

39. Three different interpretations have been put forward for consideration.  The first interpretation is that suggested for the Court's consideration by the Liquidators.  This is that where the client is simply recovering his trust property, i.e. where the claimant's rights and remedies are proprietary in nature, the SFC is not entitled to any subrogation rights.

40. I would not agree with this interpretation.  Section 118(a) provides that the SFC shall be subrogated to all the rights and remedies of the claimant in relation to the loss sustained by him by reason of the default on which the claim is based. 

41. There is no restriction on the rights and remedies to which the SFC is subrogated, as long as

(a)   those rights and remedies are in relation to the client's loss,

(b)   that loss has been sustained by the client by reason of a default of the stockbroker and

(c)   the claim is based on the default.

42. The reference to the word "loss" is not confined to purely monetary loss.  The references to pecuniary loss in s.109 should be interpreted liberally to mean losses of a financial nature, as opposed to say, losses of a personal nature.

43. "Default" is defined in s.98(1) to include any breach of trust committed by the stockbroker, and "claims" are defined in s.109(1) to include any cause of action against a stockbroker in relation to securities or other property entrusted to the stockbroker. 

44. Thus interpreted, claims to the beneficial interest in missing shares entrusted to the stockbroker would be included, albeit proprietary in nature, with the result that the client's rights and remedies under these claims would be included in the SFC's right of subrogation.

45. The second interpretation is that postulated by counsel for the SFC.  He says that the effect of the words "the Commission shall be subrogated to the extent of that payment to all the rights and remedies of the claimant" gives the SFC priority to recoup from the recovered shares the full amount of its payment, even though the client would still be suffering a serious deficit in his shares.

46. An example would be as follows.  A client has entrusted the stockbroker with shares worth $500,000.  The stockbroker defaults and the client makes a claim for his loss.  The Fund compensates him with $150,000.  The client would still have lost $350,000.  If shares worth $100,000 are then recovered, the SFC (on Mr Shieh's argument) would take all of those shares in priority to the client.

47. I am not inclined to accept that submission.  There is nothing in the language of s.118(a) which gives the SFC a prior right.  That may be contrasted with the language of s.118(b) which states expressly that the claimant shall have no right to recover from the free assets of the stockbroker "until" the SFC has been reimbursed the full amount of its payment. 

48. Mr Shieh relied on the words "to the extent of that payment".  However these words merely mean that the SFC as subrogatee cannot get anything more by way of subrogation than what he has paid.  That is consistent with general principles of subrogation.  These words do not mean that he can get back his payment in priority. 

49. Therefore, a literal interpretation does not support the SFC's interpretation.  Nor can that result be achieved by a purposive interpretation.  There is no reason why the statute has to be read so that the SFC should be entitled to recoup its payment in priority to the client, irrespective of the full extent of the client's loss and the limited extent of any recovery.  Indeed, under the general law of subrogation, until an assured is fully indemnified, he can appropriate to himself all benefits accruing so as to diminish his loss (Goff & Jones, The Law of Restitution 5th ed 141).     

50. The third interpretation which I consider to be correct is that the SFC is entitled to a right of subrogation to the extent which its payment bears to the loss claimed.  This seems to be consistent with the application of the doctrine of subrogation exemplified in marine insurance cases such as The Commonwealth [1907] P 216.  The value of a ship sunk in a collision was stated in the policy as ￡1350, but the amount insured was only ￡1000.  As it turned out, ￡1000 was recovered from the owners of the offending ship.  It was held by the Court of Appeal that the owner of the ship was entitled to be treated as its own insurers for ￡350, and therefore the ￡1000 recovered must be divided between the owner and the insurers in the proportion of their respective interests, being 350-1350ths and 1000-1350ths.

51. Similarly in the present case, the SFC cannot be full "insurers" of clients because of the statutory constraints.  By giving it a statutory right of subrogation without reference to full recoupment by the client, the legislature clearly did not intend the SFC to have to wait until the client has fully indemnified himself before it is entitled to any rights and remedies.  On the other hand, the loss suffered by the client may be far greater than the amount of the SFC's payment, and his rights and remedies cannot be restricted except by the clearest language.  In such circumstances, the only sensible interpretation to be given to s.118(a) is to  hold that the SFC is entitled to a right of subrogation to the extent which its payment bears to the loss claimed.

52. Applied to the example given earlier, that would mean that the SFC would take 30% of the shares recovered i.e.  150,000/500,000 and the client, 70% i.e. 350,000/500,000.  Mr Shieh accepts that the reasonable costs of and incidental to the making and proving of the claim should be included in the denominator, so that if those costs were say $50,000, the proportion would be 150,000/550,000 and 350,000/550,000 respectively.

53. The Liquidators are accordingly directed to have regard to this right of subrogation prior to delivery of shares to the clients.

54. I would request that counsel for the Liquidators draft an appropriate order for my consideration and approval.