Introduction

It is trite law that a company is a separate entity which can sue or be sued in its own capacity.What if minority shareholders are aggrieved by the misconducts of directors which cause harm and loss to the company?What can minority shareholders do to correct such wrongs of the directors when such directors, having control of the company, will unlikely allow the company to sue themselves?The solution would be to seek leave from the court to bring a derivative action in the name of the company against such misbehaved directors.The case Re Li Chung Shing Tong (Holdings) Ltd (HCMP 1516/2010, 5 September 2011) provides a thorough discussion of the tests and various issues in seeking for such leave.

Two Main Criteria

Under section 168BC(1) of the Companies Ordinance (Cap. 32) (“CO”), a shareholder of a company incorporated in Hong Kong or a non-Hong Kong company may bring proceedings on behalf of that company with the leave of the court.The shareholder has to show that:

1. It appears to be prima facie in the interest of that company that leave be granted.

2. There is a serious question to be tried and that company has not brought the proceedings itself.

Background

In Re Li Chung Shing Tong (Holdings) Ltd, three minority shareholders of Li Chung Shing Tong (Holdings) Ltd (the “Company”) sought leave from the court to bring proceedings on behalf of the Company against its director Karen Lee (“Karen”), the former managing director Derek Wong (“Wong”) and others.The shareholders also asked for court order that (1) an independent professional accountant be appointed to investigate and report to the court on the facts or circumstances that gave rise to the prospective proceedings and (2) costs of this application and the prospective proceedings be indemnified and paid by the Company.

The Company, established by the late Mr. Lee Chu Ho in 1988, manufactured and sold a traditional Chinese medicinal product called Po Chai Pills (保濟丸).Lee Chu Ho and his first wife had 12 children, two of whom and one of his grandsons being the minority shareholders of the Company were the plaintiffs in this action.Lee married Karen after his first wife passed away.Karen had been the majority shareholder of the Company until January 2010 and was also its director and supervised its operation and management.

The Company had always manufactured Po Chai Pills in its traditional form at its Hong Kong’s plants.In 2001, the Company launched a new capsule form of the pills, thus subcontracted the milling of the ingredients and manufacturing of the capsule pills to CMC and Wing Po, through the introduction of Wong to the general manager of CMC, Thomas Zheng, who then outsourced the powder milling to an unregistered factory in Guangdong where the capsule pills were subsequently contaminated.Following an announcement by the Hong Kong Department of Health, both the traditional pills and the capsule pills were recalled.An internal investigation report by the Company identified cause of the incident and source of the contamination and made recommendations to improve quality control and avoid repeating this incident, which were duly implemented.In May 2010, the Department of Health allowed the Company to resume the production and sale of the pills.

The plaintiffs alleged that Karen acted in breach of her duties as director of the Company, resulting in the Company’s significant loss and damage, by:

1. failing to carry out due diligence on the third party manufacturer;

2. failing to exercise reasonable care to ensure the safety and quality of the capsule pills as shown by her failure to implement adequate supervisory or quality control measures;

3. deliberately concealing the contamination incident from the relevant authorities;

4. making false and dishonest representations to the public;

5. failing to take adequate steps to mitigate loss suffered by the Company after the contamination incident went public.

In the Interests of the Company

The plaintiffs first have to prove that it is prima facie in the interests of the Company that leave be granted to bring such action against Karen and the others.It is well-established that the threshold for “interest of the company” criterion is low and requires only the presence of an arguable case when determining whether the plaintiff’s proposed action is prima facie in the interests of the company.In the present case, Harris J agreed that the plaintiffs were only required to surmount a relatively low threshold to satisfy the ‘interest of the company’ criterion.He also accepted in most cases if a ‘serious question to be tried’ had been demonstrated, it would follow that it was prima facie in the interests of the company to pursue such proceedings and vice versa.Further, he held that when a prospective claim was not against the directors, the board’s view of what was in the commercial best interests of the company should generally be given considerable weight and the court generally would be slow to override that decision.When the prospective claim was against a director, the board’s view was of less significance; although each case would turn on its individual facts.

Serious Question to be Tried

The plaintiffs also have to prove that there is a serious question to be tried.Harris J said that in most cases one would expect that this criterion should be examined first because if it could not be satisfied it would normally necessarily follow that it was not in the interest of the company to commence proceedings.This criterion was “likewise of a relatively low threshold”.Prospects of the plaintiffs’ success were to be investigated only to a limited extent and the court should be slow to find against the plaintiffs unless their prospects were so slim that they could not be said to have any expectation of success, but only a hope.

Application

The Company’s Counsel submitted that it was not in the interest of the Company for leave to be granted because (1) the contamination incident was only a one-off incident; and (2) costs of the proposed action would outweigh any benefit gained from the relief for the Company’s loss in the incident.Harris J disagreed.That the contamination incident might or might not have been a one-off incident was no answer to the fact that wrongdoing had been perpetrated against the Company.The Company should not in any way be hindered from bringing a claim against the directors simply because contamination was a one-off incident.Further, the ability of the Company to bear the costs of the proceedings was not directly relevant to whether or not it was in the interests of the company for leave to be granted, but was relevant to the terms on which leave was granted.

Notwithstanding commercial considerations in favour of avoiding unnecessary litigation expenses and further damage to the Company’s reputation, the plaintiffs’ case clearly disclosed serious questions to be tried.On the facts, Harris J was persuaded that the plaintiffs had a strong case that the defendants had breached a duty to the Company and thus there would be a strong presumption that it was prima facie in the interest of the Company to pursue the action.As the proposed action was mainly against Karen, who had sufficient means to satisfy any judgment, this factor coupled with the strong arguable case on the facts pointed to the conclusion that the proceedings were in the Company’s interests.The board of the Company was in a position of conflict in terms of assessing what was in the best interests of the Company, therefore less weight should be given to their views.Harris J was satisfied that it had been demonstrated that there were serious questions to be tried and it was in the interests of the Company to pursue the proposed proceedings.

Appointment of Independent Professionals

In addition, the plaintiffs asked the court to appoint an independent accountant to investigate the facts and circumstances giving rise to the proposed action.Section 168BG(1)(d) of CO provides that the court may make an order appointing an independent person to investigate and report to the court on the facts or circumstances that gave rise to the proceedings.Harris J held that the presence of conflicting evidence was not, in and of itself, a reason to appoint an independent person to look into the matter and the court should only exercise its discretion to appoint independent accounts in exceptional circumstances where, without such an appointment, the plaintiff would be unable to satisfactorily bring proceedings against the intended defendant.The plaintiffs could always engage an independent person on their own without an order from the court.

Indemnity of Costs

The plaintiff’s minority shareholders also sought an order that costs incurred by them in this application and the proposed proceedings should be paid and indemnified by the Company under section 168BI(2) of CO.The court would only make such an order if it was satisfied that the plaintiff was acting in good faith and had reasonable grounds for making the application (section 168BI(3)).Having regard to the Company’s financial position, Harris J held that it would not be appropriate at this stage to make such an order, but the plaintiffs could renew that part of their application when they were able to put forward further information regarding costs of the proceedings and financial state of the Company which could justify further consideration of this issue.

Decision

For the above reasons, Harris J granted leave to the plaintiffs to bring a derivative action on behalf of the Company but refused their application for appointment of independent professional accountant.Costs issue could be reconsidered under appropriate circumstances.