J. S. P. PACIFIC LTD (IN LIQUIDATION) v. NGAN CHUNG POR AND OTHERS

HCA 2000/2011

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

HIGH COURT ACTION NO. 2000 OF 2011

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D E C I S I O N

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1.  The plaintiff is a company under liquidation; and this is in essence an action by the liquidators for the company against the 1^st , 2^nd and the 3^rd defendants, who were the plaintiff’s shareholders and directors, for diversion of the company’s business to another company set up by them, namely, the 4^th defendant. The defendants applied for security for costs against the plaintiff; but it was refused by the master. This is the defendants’ appeal against the master’s decision.

BACKGROUND

2.  Before its liquidation, the plaintiff carried on business of trading gifts and consumer products.  The 1^st, 2^nd and 3^rd defendants were its only shareholders.

3.  In 2001, the 1^st, 2^nd and 3^rd defendants set up the 4^th defendant; and started carrying on similar business.  Some suppliers and customers of the plaintiff became those of the 4^th defendant.  Some staff of the plaintiff also joined the 4^th defendant.  The plaintiff ceased business but was only wound up upon creditor’s petition in 2004.

4.  The liquidators complain that this was diversion of the plaintiff’s business to the 4^th defendant in direct competition.  This, the liquidators say, amounted to breach of fiduciary duties of the 1^st to 3^rd defendants as directors of the plaintiff; and the 4^th defendant assisted them in such breach and is liable as constructive trustee.  The plaintiff claims damages against the defendants as well as account of profits.

5.  In defence, the defendants say that it was the unanimous decision of the shareholders in late 2000 that the operation of the plaintiff should cease and the 4^th defendant should be set up as their new corporate vehicle to carry on the business.  In any event, any cause of action that the plaintiff has against them is outside the 6-year limitation period under the Limitation Ordinance, Cap 347 and is therefore barred.

6.  By summons dated 7 February 2013, amended on 24 May 2013, the defendants applied for security for costs against the plaintiff pursuant to section 357 of the Companies Ordinance, Cap 32.  The application was heard and dismissed by Master de Souza on 29 May 2013.

7.  By notice dated 5 June 2013, the defendants appeal.

8.  By summons dated 3 July 2013, the defendants apply for leave to rely on a further affirmation for the purpose of the appeal.

9.  By nature, this is a re-hearing of the defendants’ application for security for costs.

10.  Section 357 of Cap 32 empowers the court to order security for costs against a company if there is reason to believe that the company will be unable to pay the costs of the defendant if successful in his defence.

Reason to believe the plaintiff will be unable to pay costs

11.  The plaintiff, in liquidation, is presumed to be unable to satisfy an adverse costs order: see Wing Fai Construction Co Ltd b Cheng Kit Yin Kelly, HCA 833/2004 (9 December 2005) at §14, per DHCJ Poon (as he then was); HBFP Ltd (in liquidation) v Jackin Total Fulfilment Services Ltd, HCCW 628/2006 (13 July 2007) at §4, per Barma J.

12.  That the plaintiff is impecunious and would therefore be unable to satisfy any adverse costs order was apparently not disputed before the master.

13.  The plaintiff argued that its impecuniosity was attributed to the conduct of the defendants under complaint.  That, in my view, could be a circular argument: see Sunchase International Group (China) Ltd v Vincor Group of Companies (Investment) Ltd [2004] 1 HKLRD 731 at §6.

14.  Objectively there is indeed reason to believe that the plaintiff will be unable to satisfy an adverse costs order.

MERITS

15.  It is trite that the court in an application like this will not embark on investigation into the merits except for a case of high probability of success one way or the other: see Trident International Freight Services Ltd v Manchester Ship Canal Co [1990] BCLC 263 at 271h.  But it was indeed the merits of the case that dominated counsel’s arguments.

Unanimous decision of all the shareholders

16.  As mentioned, the defendants contend that the plaintiff could not complain about the decision to cease the business of the plaintiff and to set up another company to carry on the business, because it was the unanimous decision of all the shareholders of the plaintiff.

17.  The shareholders’ decision did not take the form of a formal resolution.  The defendants relied on the principle in Re Duomatic Ltd [1969] 2 Ch 365 (at 373C), namely, where it could be shown that all the shareholders who had a right to attend and vote at a general meeting of the company assented to some matter which a general meeting of the company could carry into effect, that assent was as binding as a resolution in general meeting would be.

18.  The principle in Re Duomatic Ltd was applied subsequently: see Multinational Gas and Petrochemical Co v Multinational Gas and Petrochemical Services Ltd [1983] 1 Ch 258 (at 288D-H); and in Hong Kong: Re Boldwin Construction Company Limited, HCCW 340/2002 (20 August 2003) at §38, per Kwan J (as she then was); Timmerton Co Inc v Li Kwok Po David [2013] 1 HKLRD 1100 (at §43).

19.  But the principle has been applied subject to qualification.  The decision of the shareholders must be made honestly at a time when the company was solvent: see Multinational (above) (at 288D-E); and Bowthrope Holdings v Hills [2003] 1 BCLC 226 (at §§49-52) citing Multinational; Nicolson v Permakraft (New Zealand) Ltd (1985) and Kinsela v Russell Kinsela Property Ltd (1986).

20.  In the Hong Kong case of Tradepower (Holdings) Ltd v Tradepower (HK) Ltd (2009) 12 HKCFAR 417, one of the grounds of defence that the Court of Final Appeal had to consider was that the directors’ decision to dispose of the company’s property was ratified by the only shareholders of the company.  Ribeiro PJ held (at §§128-131) that a ratification, which might be effective where a company was perfectly solvent, was ineffective where a company was insolvent or in serious financial difficulties and the effect of the conduct was to prejudice its creditors.  Litton NPJ (at §134) described that as a matter of commonsense.

21.  Ms Wong SC, appearing with Mr Leung, for the defendants accepted that the power of ratification by the shareholders would be suspended when the company was insolvent.  However when it came to what Ribeiro PJ described as ‘serious financial difficulties’, she observed that the exact circumstances of that was not in issue before the final court and therefore his lordship’s formulation would need to be revisited in appropriate case.

22.  I am not prepared to share that observation.  His lordship in Tradepower, as I read with respect, was conscious of not limiting the qualification of the common law principle to actual insolvency of the company at the time of the shareholders’ decision.  After referring to Kinsela (above), which was noted to have been adopted by a number of English Court of Appeal cases, his lordship specifically turned to what Cooke J said in the New Zealand case of Nicolson (above), namely, that the creditors are entitled to consideration if the company is ‘insolvent, or near insolvent, or of doubtful solvency, or if a contemplated payment or other course of action would jeopardise its solvency’.  His lordship carried on by referring to what Chadwick LJ said in MacPherson v European Strategic Bureau Ltd, namely, that it is not open to the members and directors of a company in financial difficulties to distribute the company’s assets as if effecting an informal winding-up, to the prejudice of its creditors.

23.  The state of insolvency needs no explanation.  As to what is near insolvency, doubtful solvency and serious financial difficulties, it must be a question of fact and necessarily one of degree.  Circumstances of the cases vary; yet for the shareholders’ decision to attract condemnation, the state of the company at the relevant time, albeit solvent, should at least suggest that its solvency would be in apparent jeopardy.

24.  The master was asked to draw inference as to the insolvency of the plaintiff at the relevant time from the cessation of the company’s business, the claim of the plaintiff’s customer (which eventually succeeded) and the winding-up of the plaintiff in 2004.  Ms Wong argued that those materials did not suffice in supporting the inference that the plaintiff was insolvent or near insolvent at the time when the relevant decision was made by the 1^st to 3^rd defendants (which they say was late 2000).

25.  In this respect, as mentioned, there is the defendants’ application to rely on the financial statements of the plaintiff to show its solvency in terms of net asset-liability balance.  There is the further, and perhaps more controversial, issue of implication of the claim by one of the plaintiff’s customer, Guy Tinchant NV (later Adimex NV) (“Tinchant”), which eventually became the creditor which petitioned for the company’s winding-up.

26.  As to the new evidence, the rule is that no evidence that was not before the master may be received on appeal except on special grounds: O.58, r.1(5).  ‘Special grounds’ refer to the conditions set out in Ladd v Marshall [1954] 1 WLR 1489:

(1)   The new evidence could not have been obtained with reasonable diligence for use at the hearing below.

(2)   The evidence is such that, if given, it would probably have an important influence on the result of the case (although it does not need to be decisive).

(3)   The evidence is such as is presumably to be believed.

27.  There is no argument in respect of the third condition.  As to the first condition, I understand that both sides actually possessed copies of the financial statements for 2002 and 2003[1] prior to the hearing below.  Had they been alerted of the plaintiff’s intention to take the insolvency point, the defendants should have been able to produce such evidence.  As to the statement for 2001[2], the defendants obtained them from the former accountant of the plaintiff after the hearing below.

28.  The parties mainly differed in respect of the second condition in Ladd v Marshall.

29.  Ms Wong pointed out that the financial statements for the years end March 2001 and 2002 clearly showed that the plaintiff had net asset balance and was obviously solvent.  The business of the plaintiff ceased in March 2002.  Coupled with the provision made for Tinchant’s claim, the plaintiff became insolvent only in the financial year ended March 2003.  This, she argued, showed the solvency of the plaintiff at the relevant time.

30.  Mr Man argued that these financial statements of the plaintiff did not assist the defendants.  First and foremost, the liquidators dispute the alleged time of the shareholders’ decision to cease the plaintiff’s operation[3].  Second, whether or not the defendants’ decision was made in late 2000, the impact of Tinchant’s claim on the solvency of the plaintiff should in any event become apparent to the defendants in the course of implementing such decision.  That included the forming of the 4^th defendant in June 2001 only after Tinchant’s rejection of the goods and threat to sue.  Had that been, as it should have been, taken into account, the liability to Tinchant would have exceeded the apparent net asset balance of the plaintiff.

31.  The evidence showed the following events leading to the winding-up of the plaintiff:

(1)   During and after the time when Tinchant placed its purchaser order with the plaintiff in the latter half of 2000, the parties were corresponding with each other regarding the problematic quality of production samples.  Delivery dates had been postponed.

(2)   The goods eventually had to be delivered in February and March 2001.

(3)   In April to May 2001, Tinchant rejected the goods delivered, refused to pay and threatened to claim against the plaintiff.

(4)   In June 2001, the 4^th defendant was incorporated.

(5)   In December 2001, Tinchant commenced arbitration in Belgium claiming against the plaintiff for damages in excess of €518,000.

(6)   In April 2002, the arbitrators were briefed.

(7)   In October and November 2002, the arbitration was heard.

(8)   In July 2003, Tinchant obtained the arbitration award whereby the plaintiff was liable for damages in excess of €426,000 with interest.

(9)   In February 2004, Trinchant filed the petition to wind up the plaintiff.

(10)   In April 2004, the winding-up order was made.

32.  The major difference between the parties lies in whether the defendants had Tinchant’s claim in mind when they diverted the plaintiff’s business to the 4^th defendant.  Mr Man for the plaintiff argued in the affirmative; and went so far as submitting that it was a fraudulent scheme of the 1^st to 3^rd defendants to deprive Tinchant of satisfaction of its rightful debt by emptying the company.

33.  The pleaded case of the defendants is that the decision to divert the business was made in late 2000.  On that basis, Tinchant was not even a potential creditor then; and did not become one until it threatened to claim against the plaintiff in April to May 2001 at the earliest.  Therefore there was no question of insolvency of the plaintiff at the time of their decision to divert the business.

34.  Relying on BNY v Corporate Trustee Services Ltd v Eurosail-UK 2007-3BL [2011] 1 WLR 2524 (at §§115-117), Ms Wong argued that Tinchant’s claim remained a contingent liability[4]; and whether the same affected the plaintiff’s solvency would have depended on the probability that the contingency would materialise.  She pointed out that the defendants in fact caused the plaintiff to instruct legal representatives to contest the arbitration in Belgium.  The reasons for the arbitration award suggested nothing but serious contest by the plaintiff.

35.  Mr Man argued that liability did not become contingent simply because it was disputed.  He questioned how genuine the defendants were about their defence to Tinchant’s claim, as they did not tell us by affidavit their perception of the merits of Tinchant’s claim at the time when they proceeded with the diversion of the plaintiff’s business to the 4^th defendant.  The outcome of the arbitration, he argued, proved that Tinchant’s claim was wrongly disputed.

36.  Mr Man concluded that the defendants’ manoeuvres lacked bona fide.  In view of a substantive claim by Tinchant and the insolvency or near insolvency of the company, the defendants singled out Tinchant[5] to deprive it of just satisfaction of its claim by a systematic and deliberate scheme to empty the company.

37.  Ms Wong responded by arguing that whether the defendants had in mind the company’s potential liability to Tinchant when diverting the company’s business and whether the defendant was fraudulent in so doing are serious factual dispute that could not and should not be determined at this juncture.

38.  It may well be that the major argument between the two sides would not lie in whether the plaintiff had a net asset balance according to the financial statements at the relevant time.  Instead, it is the implication of the potential liability to Tinchant, which would have reversed the net asset balance.  However, I take the view that those financial statements, as directly relevant to the issue of solvency of the plaintiff during the relevant period of time, should have been there for the full picture.  Actually on a de bene esse basis, Mr Man also referred to them, albeit for the purpose of furthering his argument.

39.  I allow the reliance on them for the purpose of this appeal.

40.  I can see why the relevant events and their timing might attract suspicion about what was behind the defendants’ decision to cease the operation of the plaintiff and to divert the business to the 4^th defendant.  Nevertheless, the defendants have no burden of establishing a high probability of success of their defence for the purpose of the present application either.  In view of the nature of the plaintiff’s allegations and the relevant factual dispute between the two sides of the present action, I would not conclude at this stage that it is highly probable that the defence would fail.

Limitation

41.  The following provisions of Cap 347 are relevant:

Section 20

“(1) No period of limitation prescribed by this Ordinance shall apply to an action by a beneficiary under a trust, being an action-

(a) in respect of any fraud or fraudulent breach of trust to which the trustee was a party or privy; or

(b) to recover from the trustee trust property or the proceeds thereof in the possession of the trustee, or previously received by the trustee and converted to his use.

(2) Subject as aforesaid, an action by a beneficiary to recover trust property or in respect of any breach of trust, not being an action for which a period of limitation is prescribed by any other provision of this Ordinance, shall not be brought after the expiration of 6 years from the date on which the right of action accrued…”

Section 26

“(1) Subject to subsection (4), where in the case of any action for which a period of limitation is prescribed by this Ordinance, either –

(a) the action is based upon fraud of the defendant;

(b) any fact relevant to the plaintiff’s right of action has been deliberately concealed from him by the defendant; or

(c) the action is for relief from the consequences of a mistake,

the period of limitation shall not begin to run until the plaintiff has discovered the fraud, concealment or mistake (as the case may be) or could with reasonable diligence have discovered it.

…”

42.  For the purpose of limitation, the claim against the 1^st to 3^rd defendants and that against the 4^th defendant will be considered differently, in view of the different basis of claim against them.

1^st to 3^rd defendants

43.  The claim against the 1^st to 3^rd defendants is for breach of fiduciary duties as directors.  There is no dispute that such cause of action is prima facie caught by section 20(2), hence the 6-year limitation, subject to section 20(1).  The dispute lies in whether such claim is excluded from the limitation defence pursuant to section 20(1)(a) and/or section 20(1)(b).

44.  As to section 20(1)(b), counsel argued with extensive references to Paragon Finance plc v DB Thakerar & Co [1999] 1 All ER 400 (particularly 412-414, per Millett LJ) and Gwembe Valley Development Co Ltd v Koshy (No 3) [2004] 1 BCLC 131 (particularly §§86-96; 111-112; 119-120, per Mummery LJ) as well as the Court of Final Appeal judgment in Peconic Industrial Development Ltd v Law Kwok Fai (2009) 12 HKCFAR 139 (particularly §§19-23, per Lord Hoffman NPJ).

45.  The above authorities provide a consistent view that section 20(1)(b) applies only to a fiduciary who owed trustee’s responsibility in relation to the property in possession prior to the transaction being impeached or the wrongdoing in question.  This is what counsel referred to as Class 1 trust (so classified since Paragon (above)).

46.  There is no dispute that a director of a company is a trustee in relation to its assets.  But the parties differed in respect of whether the plaintiff’s claim against the 1^st to 3^rd defendants is based on Class 1 trust.

47.  Ms Wong argued that a claim for recovering trust property or proceeds thereof under section 26(1)(b) is proprietary in nature.  The plaintiff’s claim against the 1^st, 2^nd and 3^rd defendants for damages and account of profits, they argued, is not proprietary in nature and therefore not within section 26(1)(b).

48.  Mr Man disagreed.  He argued that the 1^st to 3^rd defendants, as directors, owed fiduciary duties in respect of the assets of the plaintiff, including its business, which they diverted for their own profits.  This is an action to recover the proceeds of the trust property (ie the business) once in their possession.  Therefore, the claim falls within section 26(1)(b).

49.  I notice that even Mr Man did not argue that the claim for damages, albeit as a result of the alleged diversion of the company’s business, could fall within section 26(1)(b).

50.  Is the claim for accounts of profits (from the diverted business) recovery of the proceeds of trust property under section 26(1)(b)?

51.  In Ultraframe (UK) Ltd v Fielding [2005] EWHC 1638 (Ch), the court stated (at §1355) that the law relating to the accountability of a director or former director for profits derived from the diversion of corporate opportunities is still developing.  But it is the following question that the court posed (at §1356) that is of particular relevance to our purpose, namely: if the business opportunity is treated as trust property, there still remains the question whether the exploitation of that opportunity (its ‘fruit’) can itself be regarded as trust property or a substitute for it.  That, the court said, would depend on the law of tracing.

52.  Referring to a number of decided cases (at §§1534-1546), Lewison J in Ultraframe held (at §1547) that account for profits is a personal liability.  This is an accounting concept, not an identifiable asset capable of being traced into property.  A proprietary remedy is not available for the alleged misappropriation of a business, as opposed to a proprietary asset such as shares in a company or specific business asset including an intangible but proprietary asset.

53.  Mr Man argued that section 20(1)(b) is not concerned about tracing; and the fact that profits are not traceable proceeds of the business opportunities does not mean that the opportunities are not trust properties.  One need not argue with him on that.  But in view of the nature of the remedy of account of profits, which is not traceable form of the diverted business (as trust property), I have doubt as to whether account of profits represents the proceeds of such trust property for the purpose of the section.  At least, I would not say it is highly probable that the plaintiff is right in arguing that it matters not whether it is claim for account of profits or equitable compensation for the purpose of the section.

54.  I see force in the defendants’ argument that the recovery of trust property or its proceeds under section 20(1)(b) refers to proprietary claim, which is not the pleaded claim of the plaintiff.

55.  As far as section 20(1)(a) is concerned, its application hinges upon the finding of fraudulent breach of trust.  As mentioned, there is serious dispute as to whether it was a fraudulent debt-dodging scheme to frustrate Tinchant as a creditor of the plaintiff.  I do not think a conclusion could be drawn at this stage that it is highly probable such claim will succeed.  I say the same for the purpose of this exception to section 20(2).

The 4^th defendant

56.  The claim for damages and/or account of profits against the 4^th defendant is based on dishonest assistance by accepting the diverted business and generating profits therefrom.  Such claim against non-fiduciary is subject to the 6-year limitation: see Peconic (above) at §§23-26.  But section 26 applies, which was also where the parties’ argument focused on.

57.  The question is when the liquidators came to realise the facts constituting the alleged fraud of the defendants and, if it was after 23 November 2005 (ie 6 years prior to the writ), whether they could not have discovered them with reasonable diligence before then.  It is the burden of the plaintiff to establish its reliance on section 26(1)(a): see Peconic (above) at §§26; 33; 56.

58.  The plaintiff was wound up by the court in April 2004; and the liquidators appointed in July 2004.  The liquidators argued that the 17 months between their appointment and 23 November 2005 simply did not suffice for handling the vast amount of work and investigation into the affairs of the plaintiff.

59.  The defendants pointed out that the incorporation of the 4^th defendant (which bears similar name to the plaintiff) and its composition were matters of public record.  But the liquidators deposed that they did not come to be aware of the overlap in business between the plaintiff and the 4^th defendant, and thus the diversion, until the section 221 examination of the 1^st defendant in May 2011.  I take their point that such evidence was not contradicted by affidavit.

60.  I see the force of the liquidators’ argument in this respect.  For the present purpose, I still have to ask if it is highly probable one way or the other; but it is this that I cannot conclude on the basis of such evidence untested.

Conclusion

61.  Taking a view of the merits at this stage, I say the prima facie case for ordering security remains.

62.  The liquidators did not suggest any countervailing factor against ordering security.

SECURITY AMOUNT

63.  The defendants submitted a bill of costs for HK$678,400, of which HK$199,200 has been spent.  Mr Man questioned the 4 most substantial items of the bill. Taking those into account, and in a broad-brush manner, I fix the security at the sum of HK$500,000.

64.  The plaintiff asked for 2 months to pay any security ordered.  I will give time, bearing in mind that it is the liquidators who would need to make arrangement for the payment.

ORDER

65.  I give leave to the defendants to rely on the 3^rd affirmation of the 1^st defendant filed on 3 July 2013 for the purpose of this appeal, with costs of their summons for such purpose in the cause of the appeal.

66.  I allow the appeal.

67.  I accept that the order proposed by the defendants is in the usual form: see Sunchase International Group (China) Ltd v Vincor Group Companies (Investment) Ltd, FAMV 21/2004 (22 February 2005) (at §6, per Ribeiro PJ).  I therefore also order that:

(1)   The master’s order dated 29 May 2013 be set aside;

(2)   The plaintiff do pay into court security for the defendants’ costs in this action in the sum of HK$500,000 within 42 days from the date hereof; and until such payment, all further proceedings be stayed;

(3)   In default of payment as aforesaid, the action against the defendants stand dismissed with costs without further order;

(4)   Liberty to the defendants to apply for further security;

(5)   Costs of the application for security for costs including this appeal be to the defendants in any event, to be taxed, if not agreed, with certificate for 1 counsel.

(6)   Costs order under (5) above is nisi; and shall become absolute in the absence of application in 14 days to vary.