Something fishy seems to be going on in the company and as a shareholder you would love to get your hands on company records to allay or confirm your doubts. Are you on solid grounds though, for your application for inspection to succeed?

Things Fall Apart

In Leung Chung Pun v Masterwise International Limited & ors (HCMP 2681/2012), heard together with Orient Flight Company Inc v Foster Industries Company Limited (HCMP 2682/2012), two applications for inspection of records of two companies were before the court. The two companies in question were related in the sense of being owned directly or indirectly by the Leung family. The plaintiffs were shareholders of the subject companies – a Leung family member, Leung Chung Pun (“Chung Pun”) and a company under his sole beneficial ownership. Chung Pun had resigned as director of the two subject companies after family disputes arose when the companies started generating substantial profit. From then on, although he remained a shareholder, the management of the companies fell into the hands of other Leung family members. The actions were initiated because the Plaintiffs raised complaints suggesting improper conduct on the part of the directors.

Proper Purpose Principles

Before considering the grounds on which the complaints for inspection were based, the court examined the principles in relation to inspection of company records under section 152FA^[1] of the Companies Ordinance (Cap. 32) then in force, in particular the requirement that the inspection applied for be for a proper purpose. The purpose for inspection is to bear some reasonable relationship to the interest of the applicant as shareholder. Once the primary or dominant purpose of the application for inspection is deemed proper, then any further or secondary purpose in seeking the records is irrelevant. The proper purpose requirement is satisfied if the purpose is to protect the applicant’s economic interest by finding out if there has been some impropriety that adversely affects that interest. It is also satisfied where there is a genuinely held desire to assess the value of an applicant’s shareholding where there is the possibility of a disposal of his investment.

When the purpose threshold has been satisfied, the court will then move on to consider whether inspection sought ought nevertheless to be refused. The court may exercise its discretion to refuse inspection even where the purpose threshold is satisfied where nothing of utility would result from the inspection, or if the company would suffer undue prejudice as a result. It would also deny enabling a shareholder to challenge a commercial decision reached by the board of directors through recourse to section 152FA of the Companies Ordinance.

Solid or Shaky Grounds

Applying the above principles on proper purpose, the court granted inspection of records on certain grounds and denied inspection on others, holding that the Plaintiffs had failed to justify their application for inspection on the latter.

Successes

A complaint was made that the directors had procured the companies to pay excessive remuneration to themselves leaving disproportionately small sums or nothing to be paid to the shareholders as dividends. The defendants submitted that the amount of remuneration paid to a director is generally a commercial decision for the board and that Chung Pun had been fully aware of this but had done nothing about it. The payments had also been ratified at a shareholders’ meeting. Despite these arguments, the court held that there was at least a proper case for further investigation as to whether the directors had unjustifiably paid excessive remuneration to themselves while failing to pay adequate dividends to the shareholders thereby acting in a manner unfairly prejudicial to Chung Pun’s interests as a shareholder, and inspection was allowed on this ground.

Another complaint related to a suspected misappropriation of Masterwise’s assets because of a missing dividend payment of over RMB 1 million from its wholly-owned subsidiary. Masterwise’s case was that there was no actual payment of the dividend because the amount of the dividend had been set off against debts owing by Masterwise to its wholly-owned subsidiary. It produced in support a letter from the subsidiary’s auditor claiming that an entry in the subsidiary’s audit report showing a withdrawn sum corresponding to the misappropriated dividend payment was a “mistake”. The court was not convinced, holding that the amount of any substantial cash outflow ought to be reflected in its cashbook. Accordingly, a sufficient foundation had been laid for further inspection of records under this head.

The next successful ground related to significant irregularities in Masterwise’s accounting practices. Masterwise had not prepared group and consolidated accounts despite having a wholly owned subsidiary that owned and operated its manufacturing operations in the PRC. Masterwise cited tax reasons for which its auditors treated its subsidiary as Masterwise’s manufacturing department. Hence, all the subsidiary’s expenses and assets were incorporated in Masterwise’s financial statements as Masterwise’s “Manufacturing Account” and part of its fixed assets. It was claimed that the subsidiary generated no revenues. These claims were hotly contested by the Plaintiff as lacking credible support. The court held that on the basis of the existing materials, further investigation into the validity of this explanation was justified.

Failures

Unsuccessful complaints usually related to transactions which were commercial or managerial decisions which the board would be entitled to take without being under a duty to inform the shareholders. The Plaintiffs were therefore not able to succeed.

Chung Pun had complained that the directors of Masterwise had carried out significant transactions in a surreptitious and opaque manner, refusing to provide useful information to Chung Pun when he enquired. These transactions concerned the sale of a factory belonging to Masterwise’s wholly foreign owned enterprise and the relocation of the factory to another site. Chung Pun complained that information regarding the sale of Masterwise’s factory had not been forthcoming and what scant information he received had been vague, incomplete and unsatisfactory. The court held that the sale and relocation were commercial decisions and declined to allow Chung Pun to interfere as shareholder in them.

Chung Pun also complained that Masterwise had settled a tax dispute with the Inland Revenue Department (“IRD”) for about HK$11.8 million but no information or explanation had been provided to him. He further argued that there had been a suspicious surge in banking charges from around HK$84,000 to slightly under HK$450,000 in Masterwise’s recent audited financial statements. Masterwise had explained this as a result of a loan borrowed under the government’s SME scheme. The court however decided that these were managerial or commercial decisions falling within the board’s powers to decide and did not consider Chung Pun entitled to seek inspection of the records on this basis.

There was also a complaint regarding Foster Industries Company Limited (“Foster”)’s sale of a property. It was alleged the sale was to a third party in breach of an understanding amongst the shareholders that they should first be informed of the price offered and be given priority to purchase the property. The basis for such an understanding was however disputed by the defendants. Without deciding on this point, the court held that complaints regarding this contested disposal of property in breach of an alleged understanding could be dealt with without recourse to inspection of the documents. The inspection would thus not be of utility and so the application failed on this ground.

Tread Carefully

Where the grounds for inspection relate to matters impacting on the shareholder applicant’s economic interests in the company, the court is likely to allow inspection, particular where the adverse effect of the conduct complained of on the value of the applicant’s shareholding is obvious. On the other hand, where the alleged improper acts are managerial or commercial decisions, the court is likely to refuse the application as these are matters properly for the board of directors to decide upon. Potential applicants for inspection of company records should choose which grounds they rely on with care.