THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS

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1 THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS International Qualifying Scheme Examination HONG KONG CORPORATE LAW DECEMBER 2010 Suggested Answers The suggested answers are published for the purpose of assisting students in their understanding of the possible principles, analysis or arguments that may be identified in each question Page 1 of 14

2 SECTION A 1. (a) Under the Companies Ordinance, what information must be covered by the proper books of account? (a) Every company must keep proper books of account with respect to: (i) all sums of money received and expended by the company and the matters in respect of which the receipt and expenditure takes place; (ii) all sales and purchases of goods by the company; and (iii) the assets and liabilities of the company (section 121(1)). (b) Under the Companies Ordinance, what information must be covered by the proper books of account? (b) Under section 178, a company shall be deemed to be unable to pay its debts: (i) if a creditor to whom the company is indebted in a sum then due equal to or exceeding $10,000 has served on the company a written demand requiring the company to pay the sum so due, and the company has for three weeks thereafter neglected to pay or settle the sum; (ii) if execution or other process issued on a judgment, decree or order of any court in favour of a creditor of the company is returned unsatisfied in whole or in part; or (iii) if it is proved to the satisfaction of the court that the company is unable to pay its debts, and, in determining whether a company is unable to pay its debts, the court shall take into account the contingent and prospective liabilities of the company (c) Danny intends to form a non-profit limited company to promote arts called Visually Danny, without using Limited or Ltd as part of the name. Can Danny use the proposed company name? (c) If the Registrar of Companies is satisfied that a proposed limited company is to be formed for promoting commerce, art, science, religion, charity or any other useful object, and intends to apply its profits, if any, or other income in promoting its objects, and to prohibit the payment of any dividend to its members, the Registrar may allow that proposed company to use a name without the word "Limited" (section 21). (d) At a general meeting, does a proxy enjoy the same rights as the member who appoints him? (d) Under section 114C, any member entitled to attend and vote at a general meeting is entitled to appoint another person (whether a member or not) as his proxy to attend and vote instead of him, and a proxy so appointed shall also have the same right as the member to speak at the meeting. Unless the articles otherwise provide, a proxy shall not be entitled to vote except on a poll; this prohibition does not apply in the case of a company not having a share capital. Page 2 of 14

3 (e) Who is a reserve director? (e) Where a private company has only one member and that member is the sole director of the company, the company may in general meeting, notwithstanding anything in its articles, nominate a person (other than a body corporate) who has attained the age of 18 years as a reserve director of the company to act in the place of the sole director in the event of his death (section 153A(6)). (f) Describe the contents of the document that must be prepared by the board of directors in order to enable a company to enter into a members voluntary winding up. (f) The directors of the company should, at a board meeting, issue and sign a certificate in the specified form (certificate of solvency) to the effect that they have made a full inquiry into the affairs of the company and have formed the opinion that the company will be able to pay its debts in full within such period not exceeding 12 months from the commencement of the members voluntary winding up as may be specified in the certificate of solvency (section 233(1)). (g) What is a double derivative action? (g) In a double derivative action, the complaining shareholder of the holding company is effectively maintaining the derivative action on behalf of the subsidiary, based upon the fact that the holding company has derivative rights to the cause of action possessed by the subsidiary. The ultimate beneficiary of a double derivative action is the subsidiary that possesses the primary right to sue (Waddington Ltd v Chan Chun Hoo Thomas [2006] 2 HKLRD 896). (h) Explain the rule in Foss v Harbottle. (h) The rule in Foss v Harbottle has two limbs. First, the proper plaintiff in an action in respect of a wrong done to a company is prima facie the company itself. Secondly, where the alleged wrong is a transaction which might be made binding on the company and on all its members by a resolution of the members, no action in respect of that matter can be taken if such a resolution has been passed (King Pacific International Holdings Ltd v Cheung Yiu Wing [2002] 3 HKLRD 49). (i) A Ltd was found to have entered a 15-year contract in 1996, which was beyond its object clauses. Explain the validity of the contract. (i) Under section 5B, a company whose objects are stated in its memorandum must not carry on any business or do anything that it is not authorised by its memorandum. An act of a company (including a transfer of property to or by the company) is not invalid by reason only that it is not authorised by the objects. Section 5B applies in relation to a company notwithstanding that it was registered before the commencement of those sections, i.e. 10 February 1997 (section 367). However, section 367 does not validate any transaction entered into before 10 February 1997 which should have been void for ultra vires. Therefore, the 15-year contract is void ab initio. Page 3 of 14

4 (j) Explain what a pre-incorporation contract is and discuss whether it is binding on a company after its incorporation. (j) A pre-incorporation contract is one purports to have been made in the name or on behalf of a company at a time when the company has not been incorporated. Subject to subsequent ratification and any express agreement to the contrary, a pre-incorporation contract is binding on the person purporting to act for the company or as agent for it, and he is personally liable on and entitled to enforce the contract accordingly. The company may, after incorporation, ratify the contract to the same extent as if it had already been incorporated at that time and as if the contract had been entered into on its behalf by an agent acting without its authority (section 32A(1)). Page 4 of 14

5 SECTION B 2. Close friends Karen and Betty formed a partnership selling health food soon after their graduation. In 2001, they incorporated the partnership to a company, F Ltd. They were equal shareholders and the only directors of the company. John, Karen s husband, invested in the company and became a shareholder last year, with Karen, Betty and John each holding equal shares in F Ltd. Over time Karen and John have become tired of Betty holding the company back with her conservative business approach, and they removed her from the board in accordance with the articles of association of F Ltd and the Companies Ordinance. Betty is very unhappy about her removal, feeling that she has been betrayed by an old friend. REQUIRED: Advise Betty what legal action she can take based on her removal from the board. 2. First and foremost, it is relevant to consider if F Ltd should be regarded as a quasi-partnership to allow equitable principles considered in Ebrahimi v Westbourne Galleries Ltd [1973] AC 360 to be imported into the analysis. Apart from their long-term friendship, Karen and Betty were previously equal partners and then formed the company as equal shareholders and directors. One can reasonably argue that F Ltd is a quasi-partnership company and that the character of their business is one of good faith and mutual trust and confidence. Company law recognises there may be circumstances in which a limited company is more than a mere legal entity with a personality in law of its own (e.g. a quasi-partnership company). In such circumstances, there can be rights, expectations and obligations among the members which are necessarily submerged in the company structure as defined by the Companies Ordinance and the articles of association. The court can rightly subject the exercise of legal rights to equitable considerations so that it would be unjust to insist on the legal rights or to exercise them in a particular way. While there is no doubt that Betty was legally removed under the Companies Ordinance, it does not follow that in removing her Karen and John did not do Betty a wrong, so that Betty can take actions under other provisions of the Ordinance. Under section 177(1)(f), a member may apply to the court for a winding up order against his company if the court finds it just and equitable to do so. This provision may assist Betty if she can prove that there has been an expectation between her and Karen that so long as the business continues both of them shall be entitled to participate in the management of the business an obligation so fundamental that, if broken, the relationship should end and that F Ltd ought to be dissolved. The court in Ebrahimi explained that if a company is formed or continued on the basis of a personal relationship involving mutual confidence, and there is an agreement or understanding that all or some of the shareholders shall participate in the conduct of the business, a member can take out his stake and go elsewhere, if confidence is lost, or one member is removed from management. Betty can also argue that her removal from the board had destroyed the mutual trust and confidence between her and Karen, so that she has a case to wind up F Ltd because the basis of running their business through F Ltd no longer exists. Betty may consider an action under section 168A. Under this section, any member of a company who complains that the affairs of company are being or have been conducted in a manner unfairly prejudicial to the interests of the members generally or of some part of the members (including himself) may make an application to the court for remedy. To find relief under section 168A, Betty must satisfy the court that her removal is both unfair and prejudicial to her interests as a member. In considering the complaints, the court must subject the conduct complained of, and the result of such conduct, to an objective examination, taking all the Page 5 of 14

6 facts and circumstances into account, including the nature of the company and the relationship of the parties (Re Taiwa Land Investment Co. Ltd. [1981] 1 HKLR 297). The court in Re Taiwa stated that in a circumstance in which a company departs from any general intention and common understanding between the founders which is proved to have existed when the company was formed could be regarded as unfairly prejudicial to the complaining member s interest (i.e. an expectation to stay on the board). In effect, the Ebrahimi principles also apply to a section 168A case. Should Betty win the case, she can ask the court to order F Ltd to reinstate her position on the board. Alternatively, Karen and John may be ordered to buy out Betty s shares at an agreed price or a price fixed by an independent accountant. Page 6 of 14

7 3. Owen, the largest shareholder and only director of M Ltd, is considering retiring. Ian and Terry hold 11% and 9% of the shares in M Ltd respectively. Ian has convinced Owen that he is the best person to be his successor. As a result, Owen agrees to sell all his shares to Ian, despite knowing that Terry will be unhappy about this. The relevant clause of the articles of association provides that: A share may be transferred by a shareholder to any shareholder or outsider selected by the transferor. No share shall be transferred to an outsider so long as any shareholder is willing to purchase the offered shares at a fair price. Should there be more than one shareholder who is willing to buy, the said shares should be offered to them equally. REQUIRED: (a) What are the legal consequences if Owen transfers ALL his shares to Ian in breach of the articles of association and registers Ian as the shareholders of those shares? (a) Owen should be advised that under contract law he can enter into a valid contract with Ian and transfer his benefits under the shares to him. However, the legal title to shares in a company is not transferred until it is properly registered (Re Piccadilly Radio plc [1989] BCLC 683). It should be noted that the beneficial title to shares cannot be registered (section 101). The main issue here is whether Owen, as the only director of the company, can register Ian as the new owner of his shares when he knows that the transfer is in breach of the pre-emption clause. Tett v Phoenix Property and Investments Co Ltd [1984] BCLC 599 is a case concerned with a provision in the articles of a company which provided that no shares were to be transferred by a member of the company to an outsider if any member was willing to purchase them. A shareholder had died and her executors ignored the pre-emption provisions and sold the shares to Tett. The directors refused to register the transfer. According to the court, if a member should attempt to transfer his shares in breach of the pre-emption provisions in the company's articles, the directors may refuse to register it. The court further pointed out that the directors would indeed have no power to register a transfer which had to their knowledge been made in breach of the relevant article. Should Owen sell all his shares to Ian without offering a chance to buy to Terry, he has no power to register the transfer. He would remain on the register as a shareholder even though all the benefits under the shares have been transferred to Ian. (b) Ian is worried that even if he secures voting control over the company (no matter whether he takes up all or half of Owen s shares), a frustrated Terry may cause him trouble by not showing up at subsequent annual general meetings (AGMs) since the quorum is set at two. Advise Ian how he can make sure that subsequent AGMs can be validly conducted. (b) One solution would be for Ian to create a nominee shareholder, i.e. a person who would only hold shares on trust for the benefit of Ian. This can ensure that the presence of Ian and his nominee shareholder can constitute a quorum for a valid meeting. When it comes to issuing new shares to an outsider, Ian must note the effect of section 57B which states that the directors cannot without the prior approval of the company in general meeting exercise any power of the company to allot shares, provided that no such prior approval shall be required in relation to the allotment of shares in the company under an offer made pro rata by the company to the members Page 7 of 14

8 of the company (i.e. a rights issue). An issue of new shares in breach of section 57B is invalid unless the court is satisfied that in all the circumstances it is just and equitable to make an order validating the issue of those shares (section 57B). Ian should, with the co-operation of Owen, call a general meeting to pass the required resolution to authorise the company to issue shares to a nominee shareholder. Ian and Owen may consider making an amendment to the articles to reduce the quorum to one. Before Owen s retirement, Owen and Ian may call an extraordinary general meeting to pass a special resolution to amend the quorum requirement in the articles of association. One may argue that none of the above is necessary as Ian can ask the court to authorise the company to call a general meeting with a quorum of one. Section 114B provides that if it is impracticable to call a general meeting, the court may order a meeting to be called and conducted in such manner as the court thinks fit. The court may give a direction that one member present in person or by proxy shall be deemed to constitute a meeting. The refusal of another shareholder to form a quorum for a meeting is an example of a situation where it would be impracticable to call a meeting of the company. A quorum requirement does not confer a veto power on a minority shareholder by his ability to prevent a shareholders' meeting from being held (Re Opera Photographic Ltd [1989] BCLC 763). In other words, a numerical deadlock of shareholders can be broken by a court-ordered meeting of one shareholder, although it would be unlikely for such a meeting to be ordered to break a shareholding/management deadlock (Finedon International Ltd. v. Profit Chart Industries Ltd [2002] 3 HKLRD 560). However, Ian should assess whether it is practicable for the company to go to the court every year to ask for an order under section 114B. Many candidates argued that Ian did not need to do anything under reg. 56 of Table A because any number of members present at an adjourned meeting shall become a quorum. This is correct but it is a second best solution because it means that Ian must convene a meeting twice before any resolution can be passed. Page 8 of 14

9 4. Ken was the former head of research and development of P Ltd. His employment contract with P Ltd has a valid restrictive covenant under which Ken could not solicit the clients of P Ltd for his personal business. Ken urged his friend, Rick, to employ him as a personal assistant and to set up a company to compete with P Ltd. As a personal assistant, Ken accompanied Rick to solicit the clients of P Ltd. Rick has relied on Ken so much that he always asks Ken for his advice on important decisions and usually follows this advice. In fact, Rick always introduces Ken to the employees as a director. In order to reward Ken without breaching the restrictive covenant, Rick s company made a substantial interest-free loan to Ken with no repayment schedule. REQUIRED: Advise Ken whether he can avoid the restrictive covenant through this arrangement, and what procedures should be followed under the Companies Ordinance before Rick s company can provide a loan to him. (Note: Candidates are only required to advise on company law matters and NOT on employment law issues.) 4. It has been a fundamental principle of company law since Salomon v Salomon and Company Limited [1897] AC 22 that a company registered under the Companies Ordinance is a legal entity separate and distinct from its members, even in a one-man company situation. The company is neither an agent nor a trustee of its shareholders in respect of the company's assets, business and affairs. Under common law, the corporate veil may only be lifted in very limited circumstances, mainly for the prevention of the corporate form from being used for the purposes of fraud or as a device to evade a contractual or other legal obligation. As the court explained in China Ocean Shipping Co v Mitrans Shipping Co Ltd [1995] 3 HKC 123: Using a corporate structure to evade legal obligations is objectionable. The courts' power to lift the corporate veil may be exercised to overcome such evasion so as to preserve legal obligations. But using a corporate structure to avoid the incurring of any legal obligation in the first place is not objectionable. And the courts' power to lift the corporate veil does not exist for the purpose of reversing such avoidance so as to create legal obligations. In Gilford Motor Company Limited v Horne [1933] 1 Ch 935, it was held that a company had been formed in order to mask the effective carrying on of a business by Mr. Horne, the purpose being to enable him to carry on that business in breach of a covenant which restrained him from soliciting the customers of Gilford Motors. The shareholders and directors of the company were Mr. Horne's wife and Howard, an employee of the company. The court found that the business was obviously carried on "wholly" by Mr. Horne; that Mrs. Horne had taken no part in the business or its management; that Howard was an employee; and that those dealing with the company treated Mr. Horne as the boss. The court said that it was quite satisfied that this company was formed as a device, a stratagem, in order to mask the effective carrying on of the business of Horne. The purpose of it was to try to enable him under what is a cloak or a sham, to engage in business which, on consideration of the agreement which had been sent to him before the company was incorporated, was a business in respect of which he had a fear that [Gilford Motor] might intervene and object." In consequence, the court granted an injunction against Mr. Horne and his company from breaching the covenant. Applying these principles to Ken s case, it is arguable that he is in a very similar situation as Horne, as he had urged Rick to set up a company to help him avoid his obligations under the restrictive covenant. This makes it appropriate for the court to pierce the corporate veil as the facts indicate that the company in question is a mere façade concealing the true facts (Woolfson Page 9 of 14

10 v Strathclyde Regional Council 1978 SC (HL) 90). Ken and Rick s company should expect the same consequences as those in Gilford. A company shall not directly or indirectly make a loan to a director (including a shadow director) of the company or of its holding company (section 157H(1)). Although Ken has never been appointed a director of Rick s company, he could be regarded as a shadow director because he is a person in accordance with whose directions or instructions Ken, as the director of the company, is accustomed to act (section 2). One can argue that section 157H would prohibit the provision of the proposed loan to Ken. Ken and Rick will be pleased to know that section 157H does not prohibit a private company from providing a loan to a director if the loan has been approved by the company in general meeting (section 157HA(2)). Despite the fact that section 157H does not of itself invalidate any transaction or arrangement entered into in contravention of itself (section 157I(5)), a person who receives from a company a sum paid in pursuance of a transaction or arrangement entered into in contravention of section 157H shall be liable to repay that sum to the company forthwith (section 157I(1)). If the court is convinced that Rick wilfully authorised or permitted the provision of the loan to Ken, both he and the company will be liable to a fine. Further, Rick may be imprisoned (section 157J(3)). Page 10 of 14

11 5. G Ltd was ordered to be wound up by the court on 1 June 2010 because of its inability to repay debts. The court appointed Helen as the liquidator of G Ltd. When Helen reviewed the company s accounts and documents, she found that on 1 December 2008, G Ltd transferred its office premises to H Ltd at an undervalue and then leased them back at rent over the market value. However, the company s records do not reveal the fact that H Ltd is owned by some of the directors of G Ltd. In Helen s opinion, the sale and leaseback arrangement is the key reason leading to the downfall of G Ltd. REQUIRED: Advise Helen of what legal action, if any, she can take against the directors of G Ltd and in respect of the transactions between G Ltd and H Ltd. 5. As a liquidator, Helen has the statutory power to put the existing or former directors of G Ltd to justice if they were in breach of their duties to the company. It is stated under section 276 that if, in the course of winding up, it appears that a director his misapplied or retained or become liable or accountable for the money or property of the company, or been guilty of any misfeasance or breach of duty in relation to the company which is actionable at the suit of the company, then the court, at the action of certain persons, including a liquidator, may examine the conduct of the director and compel him to repay or restore the money or property, or contribute to the property of the company. This section provides a convenient procedure for the recovery of money and property from a person who has committed a wrongful act causing loss to the company when he was conducting the company s affairs. Helen must first find out whether the directors in question have breached their duties to G Ltd. A director has a fiduciary duty to act in good faith in the interests of his company and not (without the consent of the company) to put himself in a position where there is a conflict (actual or potential) between his personal interests and duties to the company or between his duty to the company and a duty to owed to another person. It must be emphasised that both direct and indirect conflict of interests are not allowed. This is a rigid principle so that no question can be raised as to the fairness of the terms of the contract in question. The imposition of liabilities does not depend on the absence of good faith. The facts indicate that some of the directors have an indirect interest in the transactions between G Ltd and H Ltd through their shareholding in the latter, and that G Ltd has suffered a substantial loss from those transactions. Under equity law, a contract entered into by the company in breach of the directors duties can be set aside by the company subject to the rights of the innocent third parties acting in good faith (Transvaal Lands Co v New Belgium (Transvaal) Land & Development Co [1914] 2 Ch 488). Since H Ltd is owned by the directors in question, Helen can argue that H Ltd can be deemed to have knowledge of the conflicts of interest and is thus not an innocent third party. In addition to the possible remedy of avoidance of the sale and leaseback arrangement, the court may order those directors of G Ltd to account for the profit they have made (e.g. dividends from H Ltd). If Helen concludes that the directors breach of duty is serious and that the directors are directly culpable for the insolvent liquidation of G Ltd, she can report the case to the Official Receiver (section 168I(3)). If the Official Receiver thinks fit, he may submit an application to the court, asking the court to make a disqualification order against the directors (for between a minimum period of one year and a maximum of 15 years) on the grounds their conduct as directors of G Ltd makes them unfit to be concerned in the management of a company (section 168H). During the time he is subject to a disqualification order, a person cannot work or be appointed as a director, liquidator of a company, or a receiver or manager of a company's property; or in any way, whether directly or indirectly, be concerned or take part in the promotion, formation or Page 11 of 14

12 management of a company (section 168D). Schedule 15 states that, among other things, a misfeasance or breach of any fiduciary duty and a misapplication of the company s property are indicative of a director s unfitness for office. Since no records show that some of the directors of G Ltd are also the shareholders of H Ltd, there is a strong case that those directors have breached section 162 of the Companies Ordinance, which requires a director who is directly or indirectly interested in a contract with the company to declare the nature of his material interest at the earliest directors meeting. As a result, the relevant directors are liable to a fine (section 163(3)). Page 12 of 14

13 6. Bank A provided a loan to D Ltd on the condition that the company provides security by way of a fixed charge on all its present and future accounts receivable. The loan contract states that D Ltd must not sell its accounts receivable and it must deposit the moneys which it may receive in respect of the accounts receivable into a designated bank account. D Ltd may withdraw money from the designated account for ordinary business use. It has been revealed that the charge was not registered with the Companies Registry within the required time limit. REQUIRED: Explain whether the charge created is a fixed charge or floating charge in law. Advise Bank A of the legal consequences under the Companies Ordinance of the failure to register a charge, and discuss what can be done to protect the bank s interests under the charge. 6. It is possible in law for a company to create a security consisting of a fixed charge over all its present and future accounts receivable. The starting point of any discussion of the legal differences between a fixed and floating charge is Re Yorkshire Woolcombers Association Ltd [1903] 2 Ch 284. The court stated that a floating charge should have the following three characteristics: (1) if it is a charge on a class of assets of a company present and future; (2) if that class is one which, in the ordinary course of the business of the company, would be changing from time to time; and (3) it is contemplated by the charge that, until some further step is taken by or on behalf of the chargee, the company may carry on its business in the ordinary way as far as concerns the particular class of assets. The Privy Council in Agnew v Commissioners of Inland Revenue [2001] 2 AC 710 explained that the first two characteristics, although typical of a floating charge, are not distinctive of it they are not necessarily inconsistent with a fixed charge. It is the third characteristic which is the hallmark of a floating charge and distinguishes it from a fixed charge. It follows that how a charge should be categorised depends upon the nature of the rights over the charged asset that have been granted to the chargee or reserved to the chargor. The label that the parties have given to the charge is not conclusive of the legal nature of the charge. It is clear that the essential value of a book debt as a security lies in the money that can be obtained from the debtor in payment. In Re Brightlife Ltd [1987] Ch 200, there was a debenture expressed to grant a "first specific charge" of the chargor's accounts receivable. The loan contract did not allow the chargor to dispose of or charge the uncollected accounts receivable but left the chargor free to collect the debts, pay the money into its bank account and draw in the ordinary course of business. Despite the description as a "first specific charge", the charge was held to be a floating charge. As mentioned above, the Privy Council in Agnew held that the critical feature which can distinguish a floating charge from a fixed charge is the chargor's ability to control and manage the charged assets and withdraw them from the security freely and without the chargee's consent: "[a] restriction on disposition [of accounts receivable] which nevertheless allows collection and free use of the proceeds is inconsistent with the fixed nature of the charge; it allows the debt and its proceeds to be withdrawn from the security by the act of the company in collecting it". In this case, by the loan contract Bank A gives a high degree of freedom to D Ltd to use the proceeds from the collection of accounts receivable. Therefore, the charge should be regarded as a floating charge. The consequences of a failure to register a charge are serious. Under section 80(1), a charge (fixed or floating) is void against the liquidator and any creditor of the company unless the particulars of the charge are delivered to the Companies Registry for registration within five weeks after the date of its creation. If a charge becomes void due to non-registration, the loan thereby shall immediately become payable. Since it is the duty of a company to send to the Page 13 of 14

14 Companies Registry for registration, D Ltd and its directors who are responsible for the failure to register the charge are liable to a fine (section 81(3)). Bank A can make an application to the court for an order authoring the registration of the charge out of time. The court, on being satisfied that the omission to register a charge within the stipulated time was accidental, or due to inadvertence or to some other sufficient cause, or is not of a nature to prejudice the position of creditors or shareholders of the company, or that on other grounds it is just and equitable to grant relief, may order that the time for registration be extended (section 86(1)). Perhaps to the dismay of D Ltd and its directors, the grant of the court order to extend time for registration does not have the effect of relieving them of their liability under section 81 (section 86(2)). -End- Page 14 of 14