In Yu Yuchuan & Ors v China Shanshui Investment Company Limited (HCMP 360/2015, date of decision: 13 March 2015), the Court of First Instance (the “Court”) considered minority shareholders’ application for leave to bring unfair prejudice proceedings in the name of the company by way of statutory derivative action under Sections 732 and 733 of the Companies Ordinance (Cap. 622) (the “CO”).  

Background

The Applicants, who were minority shareholders of China Shanshui Investment Company Limited (the “Company”), applied to bring unfair prejudice proceedings in the name of the Company pursuant to Sections 732 and 733 of the CO against China Shanshui Cement Group Limited (“Shanshui Cement”), Zhang Caikui (”Zhang Sr”), Zhang Bin (“Zhang Jr”) and China National Building Material Co Ltd (“CNBM”).  The Company opposed the application.

Zhang Sr and Zhang Jr were directors of both the Company and Shanshui Cement, and Zhang Sr was an indirect shareholder of both the Company and Shanshui Cement.  The Company and CNBM were shareholders of Shanshui Cement.  The Applicants said that the boards of the Company and Shanshui Cement were controlled by the Zhang Sr and Zhang Jr.  

The Applicants’ complaints included the entering into of a subscription agreement by Shanshui Cement with CNBM and the granting of share option by Shanshui Cement, which the Applicants said had resulted in / would result in dilution of the Company’s shareholding in Shanshui Cement. 

The Law

Under section 732 of the CO, a member of a company, with leave of the court, may bring proceedings on behalf of the company in respect of “misconduct” committed against the company.  “Misconduct” is defined in section 731 as “fraud, negligence, breach of duty, or default in compliance with any Ordinance or rule of law”.  Section 733 sets out the circumstances in which the court may grant leave for the purposes of section 732.  Leave may be granted if the court is satisfied that:

1. On the face of the application, it appears to be in the company’s interests that leave be granted;
2. There is a serious question to be tried;
3. The company itself has not brought the proceedings; and
4. The member has served a written notice on the company of the member’s intention to apply for leave and the reasons for that intention.

Judgment

In the present case, the Court took the view that there was a serious question to be tried as to whether the subscription agreement was introduced and approved for impermissible reasons and without it being given proper consideration by the board, and whether the granting of the share option had been instigated to dilute the Company’s shareholding in Shanshui Cement.  The Court granted leave to the Applicants.

Meaning of the word “proceedings”
under section 732(1) of the CO

In opposing the application, a technical argument was advanced which concerned the meaning of the word “misconduct” as defined in section 731.  It was argued that the correct procedure to remedy a breach of duty is to bring a derivative action, but not an unfair prejudice petition which is for remedying mismanagement.

In addressing this argument, the Court referred to the Court of Final Appeal’s decision in Waddington Ltd v Chan Chun Hoo (2008) 11 HKCFAR 370, in which Lord Millett NPJ noted that there is overlap between unfair prejudice proceedings and derivative action, but they serve essentially different functions.  Lord Millett NPJ noted that:

 “Unfair prejudice proceedings are concerned to bring mismanagement to an end; derivative actions are concerned to provide a remedy for misconduct … While the court may have jurisdiction in the strict sense on a petition under s.168A to order payment of compensation to the company, the derivative action is the proper vehicle for obtaining such relief where the plaintiff’s complaint is of misconduct rather than mismanagement …”

In the present case, the Court opined that if a breach of duty is “a manifestation of mismanagement that requires remedying by the broad range of solutions available in section 725(1)”,  the appropriate procedure is to issue a petition pursuant to Part 14 Division 2 of the CO.  Although section 732(1) refers to “misconduct”, the word “proceedings” referred to in section 732(1) includes an unfair prejudice petition, and the Court may grant leave to commence derivative action by way of unfair prejudice petition.