NINOTRE INVESTMENT LTD AND ANOTHER v. L & A INTERNATIONAL HOLDINGS LTD

HCMP 64/2018

[2018] HKCFI 2555

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

MISCELLANEOUS PROCEEDINGS NO 64 OF 2018

________________

________________

________________

________________

D E C I S I O N

________________

1.  On 16 January 2018, the plaintiffs issued an originating summons for an order allowing inspection of documents of the defendant (“Company”) pursuant to section 740 of the Companies Ordinance, Cap 622.

2.  The Company is listed on the GEM.  Its business as described in the annual report for 31 March 2016 divides into two business arms: (i) an OEM business segment which entails the production and design and development of raw materials for the production of cashmere products; (ii) the apparel retail industry.  The annual report records that the Company had a turnover of HK$210,354,000 and a loss before tax of HK$26,107,000.  Its current and non-current assets total HK$150,132,000.

3.  On 28 April 2016 the Company acquired 47.63% of the shares in Red 5 Studios, Inc, (“Red 5”) a company incorporated in Delaware developing online gaming software and platforms.  The consideration for the acquisition was approximately HK$596,700,000 which was to be paid by newly allotted shares.  Because of the share price at that time, this represented approximately 5.65% of the Company’s then capital.

4.  In a public announcement issued by the Company at the time of the acquisition, Red 5 is described as—

“principally engaged in the development of innovative entertainment software and online games…. It has developed an online game called ‘Firefall’, a massively multiplayer online first-person shooter game, for which the Target Company has conducted a limited commercial release in the PRC in November 2015 and is expected to have a large-scale commercial launch in the PRC in the second half of 2016. It has entered into license and distribution agreements with minimum guarantee on licensing and royalties with two distributors for publishing and operating Firefall for a five-year term in the PRC and for a six‑year term in the Southeast Asia respectively. Pursuant to the said license and distribution agreements, it is expected that the Target Company will receive minimum license fee and royalties of approximately US$171 million (equivalent to approximately HK$1,333.8 million) in the coming five years….”

The reasons for the acquisition were explained in the following terms:

“The Directors consider that the Acquisition could provide an opportunity for the Group to diversify its business into online game business so as to further enhance its revenue sources as well as to bring positive return to the Shareholders. The Target Group has signed license and distribution agreements with minimum guarantee on licensing and royalties with two distributors. Pursuant to the said license and distribution agreements, it is expected that the Target Company will receive minimum license fee and royalties of approximately US$171 million (equivalent to approximately HK$1,333.8 million) in the coming five years. The Directors believe that the guaranteed income on licensing and royalties would be able to bring positive contribution to the Target Group in the future.”

5.  Unfortunately, the investment quickly proved to be a mistake.  This is apparent from Note 13 to the 2017 interim report:

“In late July 2017, the Company was informed by Red 5 that the online game ‘Firefall’ has been suspended, but it is planning to develop a mobile version for ‘Firefall’ to replace the online game version. As at the date of this report, despite the Company’s repeated requests for more information in relation to the development of mobile version for ‘Firefall’, no concrete plan has been provided to the Company.

On 28 August 2014, Red 5 Singapore Pte. Ltd., an wholly-owned subsidiary of Red 5, and System Link Corporation Limited entered into a license and distribution agreement (the ‘Agreement’) with minimum guarantee on licensing and royalties (the ‘Minimum Guarantee’). The licensing and royalties of the online game ‘Firefall’ depends on the usage and consumption level by the players. Given the fact that the launch of the said game has been suspended, no licensing and royalties has been received and generated and the Minimum [G]uarantee could not be met.

The basis of determining the impairment loss is based on the difference between the cost of investment in 47.63% shareholding in Red 5 and fair value of the 47.63% shareholding in Red 5 owned by the Group as at 30 September 2017.  Impairment loss of approximately HK$156,391,000 million [sic] and HK$273,143,000 were provided for the year ended 31 March 2017 and for the six months ended 30 September 2017 respectively.”

6.  The plaintiffs are concerned that the decision of the board to approve the acquisition was negligent and resulted in considerable loss to the Company, and indirectly to their economic interests as shareholders. In particular they are concerned that as early as 12 March 2016 there was an announcement on Red 5’s website that the online game “Firefall”, which was the anticipated source of Red 5’s revenue, had been suspended pending the development of a mobile version which, as Note 13 explains, had not by September 2017 been introduced, and no reason for this had been provided. 

7.  The plaintiffs are concerned about the board’s decision to make a substantial investment in a business of which it had no experience, and which has been proved disastrous.  The plaintiffs assume that there was a connection between the acquisition and the collapse in the Company’s share price of in excess of 90% within weeks of the completion, thus adversely affecting the value of, in particular the 1^st plaintiff’s interest in, the Company.  It is, in my view, understandable that in these circumstances, the plaintiffs want to investigate the way in which the Company dealt with the negotiation of the acquisition.

8.  I explain the principles that govern the operation of section 740 and the way in which the court approaches such applications in [24]­–[25] of my judgment in Artan Investments Ltd v The Bank of East Asia Ltd (unrep, HCMP 125/2015, 5 June 2015):

“24. Section 740 gives the court a discretion on the application of 5 or more shareholders, or members representing 2.5% in value of the voting rights, to order inspection of a company’s records or documents if it is satisfied that:

(1) the application is made in good faith; and

(2) the inspection is for a proper purpose

25. The expression ‘proper purpose’ is not defined in the section, but its meaning and how the 2 requirements are to be understood and applied has been considered in a number of cases in relation to section 740 and its predecessor sections 152FA and 152FB of the former Companies Ordinance, Cap. 32, which are in all material respects the same. In Wong Kar Gee Mimi v Hung Kin Sang Raymond [1] I considered in detail the characteristics of the 2 requirements. I will not repeat the discussion here. In summary those which are relevant to the present case are as follows:

(1) The ‘good faith’ and ‘proper purpose’ requirements constitute two separate and independent tests. The applicant must first, establish that he is acting in good faith and second, the court must believe the circumstances are such that the inspection sought is for a proper purpose: §§14-16.

(2) The burden of proof is borne entirely by the applicant: §42.

(3) The fact that an applicant has only recently acquired a small holding in the company may be strong evidence that the application is either not made in good faith or not made for a proper purpose: §23.

(4) Section 740 is not an opportunity for shareholders to challenge the commercial decisions of the company's management: §36.

(5) In order to satisfy the ‘proper purpose’ criteria it is not necessary to satisfy the court that the applicant has a specific or personal right that can only be protected through the inspection of records. A wish to inspect documents to investigate a genuine and credible belief that there has been corporate mismanagement is capable of constituting a proper purpose[2]. Generally, where the court is satisfied that the ‘purpose’ is germane to a shareholder’s economic interest in the company a ‘proper purpose’ will have been satisfied[3].

(6) ‘As I have already explained, in my view the court should incline to a liberal interpretation of “proper purpose” with a view to advancing the protection of shareholder rights and interest and the maintenance of appropriate standards of corporate governance. This is particularly true in the case of publicly listed companies ……… the court should be more willing to grant inspection orders to protect the interests of members in publicly listed companies’[4]. This view was endorsed by Deputy Judge (as he then was) L Chan in Choi Chi Wai v Hong Kong Agriculture Special Zone Limited [5] as being ‘more in line with the prevailing disposition of the community on corporate governance’.

(7) As part of establishing a proper purpose, the applicant has to show that there is a sufficiently reasonable ‘case for investigation’ as regards past or future wrongful or other undesirable conduct. The shareholder may fail to obtain inspection where he fails to make out on his own material some kind of case for investigation, or where the corporation is able by leading evidence to dispel whatever suspicion has reasonably been aroused: §39.

(8) Once the court is satisfied that the applicant has established a ‘proper purpose’ the company should be required to be transparent[6].”

9.  Section 740 requires the application to be made by the required number of members.  Sub-section 6 defines “required number” as 2.5% of the voting rights of all members with the right to vote or at least five members.

10.  At one time the 1^st plaintiff, which is a subsidiary of a Hong Kong listed investment company, owned more than 2.5% of the Company’s shares.  But as a result of dilution and sale of some of its holdings, its interest has dropped below 2.5%.  The 2^nd plaintiff acquired shares specifically to ensure that the 2.5% threshold was met.  This seems to me to give rise to the only issue which requires consideration in this application, namely, whether this in some way diminishes the strength of the plaintiffs’ application, as otherwise it seems to me fairly clear that the plaintiffs’ application is brought in good faith and for a proper purpose, namely, to understand how the acquisition came to take place and whether the board failed in its duties to the Company.

11.  In my view, the correct approach is to ask first if sub-section 6 is satisfied.  In the present case, it is.  One then moves on to consider whether the application is made for a proper purpose and brought in good faith.  It may be that the acquisition of shares, after a matter of which complaint is made has occurred, and which is known at the time the shares are bought, may be relevant to an assessment of one or other of these factors.  This will turn on the facts of each case.

12.  It is not in dispute that the 1^st plaintiff is the driver of this application.  As I have said, the application, in my view, is made for a proper purpose and I see no sensible reason for thinking that the 1^st plaintiff does not have a genuine wish to understand how the acquisition came to be made as, on the face of the matter, its investment in the Company suffered substantially as a result. 

13.  The fact that in order to do so the 2^nd plaintiff acquired shares in order to satisfy sub-section 6 does not in my view alter the purpose of the application.  Neither does it seem to me that it follows, as the Company seems to suggest, that the 2^nd plaintiff is acting in bad faith and therefore sub‑section 2C is not satisfied as a consequence. 

14.  I will make an order.  I will, however, alter the descriptions of the documents which are set out in the schedule to the originating summons.  The order will provide that—

(1)   the defendant do provide the documents in the schedule to the order for the plaintiffs and/or their representatives to inspect and make copies thereof;

(2)   there be liberty to apply; and

(3)   there be a costs order nisi that the defendant pays the plaintiffs’ costs of the application.  

15.  The schedule to the order will list the following documents:

(1)   Para 1 will be in the form of [1] of the schedule to the originating summons.

(2)   Para 2 will provide “All documents provided to a Director of the Company concerning the Transaction up to and including 28 April 2016.”

(3)   Para 3: “Board minutes concerning the Company’s interest in Red 5 Group and all documents provided to a Director concerning the aforesaid interest.”

16.  I have included liberty to apply in the event that having had the opportunity to inspect the documents described in the schedule to the order, the plaintiffs wish to seek any additional documents, and also to give the Company the opportunity to return to court if it should become apparent, when documents are being compiled, that there are any in respect of which it feels that it can legitimately and properly assert privilege.