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 2013 Suggested Answer 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 1

2 SECTION A 1. The manufacturing business of A Ltd, a private company incorporated in Hong Kong with its articles of association substantially based on Table A (the only new clause is that the quorum for general meeting is 10 shareholders or proxies who physically attend the meeting), has not been performing well in recent years for several reasons. Apart from the influence of the global economic environment, the fact that the company has replaced most of its machines and factory facilities for full automation had caused the company to make huge capital investments. Up to the financial year ended on 31 March this year, A Ltd has recorded an accumulated loss of $30 million. As a result, the company has not declared dividends for three years in a row. The great news for the board of directors is that the company made a profit of $5 million in the immediate past financial year. The board decided to reward its patient shareholders (board members are shareholders too) by declaring all $5 million as dividends. However, given that the company s overall financial strength has not actually recovered, the board has also decided that shareholders will be given a choice to receive cash dividends or a scrip dividend equivalent to the value of the cash dividends. Helen, an executive director and a major shareholder of the company, has suffered financial difficulties because of losses in her personal investments. She asked the chairman whether it would be possible for the company to give her up front the amount of dividends she was entitled to and the salary that she would earn for the rest of 2013; otherwise she would face a bankruptcy order from the court. Considering that Helen has been faithfully serving A Ltd for a decade and that her suggestion would not require A Ltd to bear any extra financial burden, the chairman accepted her request and paid her yesterday, which was one month before the annual general meeting. The day after tomorrow will be the day of the extraordinary general meeting when the decision will be taken on whether to approve an amendment to the company s memorandum of association to increase its authorised capital. The company secretary has just received a call from Philip, a shareholder who lives in Canada, telling her that he is not coming to the EGM due to an emergency. The absence of Philip will cause the EGM to lapse as only nine shareholders have confirmed that they will attend (the other six shareholders, including Philip, live outside Hong Kong). The chairman has insisted that the amendment must be approved within five days from today otherwise the company will not be able to meet the timeline of issuing new shares to potential investors. The chairman asks the company secretary to arrange to appoint a proxy for Philip. 2

3 REQUIRED: 1. (a) Explain whether a company can issue shares to shareholders as dividends. Ans (a) Under section 79A of the Companies Ordinance, a company can make a distribution, in cash or in kind, to its shareholders. While the most common way of making a distribution is by way declaring a cash dividend, it is also common to offer an alternative which will entitle shareholders to a scrip dividend of a value equivalent to a cash dividend. It must be noted a company must be authorised by its articles of association before it can declare scrip dividends. 1. (b) Explain whether the board chairman s dividends proposal is lawful under the Companies Ordinance, and how A Ltd can enable itself to implement the proposal before the AGM. Ans (b) A company cannot make a distribution except out of profits available for this purpose (section 79B(1)). A company's profits available for distribution are its accumulated, realised profits, so far as not previously utilised by distribution or capitalisation, less its accumulated, realised losses, so far as not previously written off in a reduction or reorganisation of capital duly made (section 79B(2)). In this case, although A Ltd has made a profit of $5 million, this amount is not enough to cancel out the accumulated losses in the past years. Therefore the company cannot declare and give cash dividends of $5 million to its shareholders. One way to make it possible for A Ltd to declare cash dividends is to write off some or all of its accumulated losses by way of a reduction of capital. By reason of section 79B, the company will remain unable to pay dividends while substantial accumulated losses exist. To reduce capital by, e.g. setting off the accumulated losses with the credit arising from the capital reduction and cancellation of the share premium account, would bring a company s accounts more nearly into line with its available assets and if the company should return to profit from the operations of the group, bring forward the time when it would be in a position to pay dividends (Re Poly Investments Holdings Ltd [2007] 2 HKLRD 10). But that means that the company has to call an EGM before the forthcoming AGM for the purpose of reduction of capital. The legal position in relation to the declaration of scrip dividends is different because the requirement that dividends be paid out of profit does not apply to a distribution by way of issue of fully or partly paid shares. Since the 3

4 issue of bonus shares to shareholders is not seen as a distribution, section79b is not applicable; therefore the fact there are on record accumulated losses would not prevent A Ltd from paying scrip dividends. 1. (c) Explain whether A Ltd can give Helen her dividends and her salary for the rest of the year before its AGM. Ans (c) Since the dividend distribution must be sanctioned by shareholders in the annual general meeting, it is arguable that Helen, as is the case with other shareholders, is not legally entitled to dividends before the AGM, even though it could reasonably be expected that a majority of shareholders would pass the relevant resolution. On the other hand, Helen is not entitled to salaries before they have been earned. By providing unauthorised dividends and unearned salaries to Helen, A Ltd could be said to have effectively given a loan to Helen. A company must not, directly or indirectly, make a loan or a quasi-loan to its directors. In a case of breach, the company, any director of the company who wilfully authorised or permitted the arrangement to be entered into, and any person who knowingly procured the company to enter into the arrangement, will be liable (section 157J). A company which does not belong to a group which has as a member a listed company may provide a loan or a quasi-loan if it has been approved by shareholders in general meeting (section 157HA(2)). 1. (d) Explain whether it is possible for the shareholders of A Ltd to approve the proposed amendment to the capital clause before the timeline fixed by the chairman. Ans (d) Regulation 71 of Table A requires that the instrument appointing a proxy be deposited at the registered office of the company not less than 48 hours before the time for holding the meeting or adjourned meeting at which the person named in the instrument proposes to vote, or, in the case of a poll, not less than 24 hours before the time appointed for the taking of the poll, and in default the instrument of proxy shall not be treated as valid. In this case, it is impossible for Philip to appoint a proxy to attend the meeting on his behalf And therefore it will be impossible for a quorate AGM to be held. There is a way for A Ltd to pass the required resolutions without calling a general meeting under section 116B. Under this provision, a written resolution which is signed off by all the shareholders entitled to attend and vote at a general meeting will be as a valid as one passed by the shareholders in a general meeting. It is not necessary for the shareholders to sign on the same resolution, provided that the copies they sign contain 4

5 the same resolution. The resolution will take effect when the last shareholder signs it off. Since there are still five days before the deadline for completing the transaction, with the aid of a courier service there should be enough time for all shareholders to pass all the resolutions under section 116B. 5

6 SECTION B 2. Pearl and her allies, five persons in total, hold 11% of the shares in H Ltd, which is a private company. Recently the other five shareholders of H Ltd (who are also the directors of the company) have announced their intention to take over the company by way of a scheme of arrangement at a price of $5,000 per share. Pearl and her allies strongly disapprove of the proposal as they believe the fair value of one share is at least $7,000. Therefore they will vote against the scheme at the meeting to be conducted next month as ordered by the court (the court-ordered meeting). From a reliable inside source Pearl knows that yesterday H Ltd issued one share to Mary, the personal secretary to the chairman. The board also called a special board meeting to approve the registration of Mary as a shareholder on the same day. REQUIRED: 2. (a) Explain to Pearl: (i) Ans (i) Why can the issue of one share to Mary improve the chance of success of the proposed takeover? Where a scheme of arrangement is proposed between the company and its members or any class of them, the court may, on the application in a summary way of the company or member of the company, order a meeting of the members of the company or class of members to be summoned in such manner as the court directs (section 166(1)). If a majority in number representing three-fourths in value of the members or class of members, present and voting either in person or by proxy at the meeting, agree to the proposed scheme of arrangement the arrangement shall, if sanctioned by the court, be binding on the members or class of members and also on the company (section 166(2)). In other words, a scheme of arrangement can be approved by a majority of shareholders (the headcount test) holding at least 75% of the issued shares (the share value test). Pearl should understand that by making Mary a registered shareholder entitled to vote, the directors can make sure that both the headcount test and the share value test can be satisfied. 6

7 2. (ii) What can Pearl do to protect her interests if the scheme is approved at the court-ordered meeting? Ans (ii) According to the Court of Appeal in the Re PCCW Ltd [2009] 3 HKC 292, in exercising its power of sanction the court will see: first that the provisions of the Companies Ordinance have been complied with; second that the shareholders are fairly represented by those who attended the meeting and that the statutory majority are acting bona fide and are not coercing the minority in order to promote interests adverse to those of whom they purport to represent; and third, that the arrangement is such as an intelligent and honest man, a member of the class concerned and acting in respect of his interest, might reasonably approve. At the court hearing, Pearl can argue that Mary, due to her close affiliation with the directors and the peculiar fact that she became a shareholder only shortly before the EGM and that she only holds one share, cannot represent in good faith the views of other shareholders: therefore the court should not approve the scheme. As an alternative, Pearl can also argue that the bid is much less than the true value of the share. An intelligent and honest shareholder in the same situation may not agree to the terms of the scheme of arrangement. 2. (b) Explain whether the board of directors has done any legal wrong in issuing one share to Mary and registering her as a shareholder. Ans (b) By law a director will owe several fiduciary duties to the company. In particular, a director must act in good faith in the interest of the company and exercise his powers for proper purposes. Generally speaking, it could be difficult to challenge the subjective good faith of the directors concerned as they could argue that the addition of Mary as a shareholder could help facilitate the takeover of the company, which they think is in the interests of the company. However, when examining whether the directors had exercised their powers for proper purposes, the court will first identify the possible proper purposes of the power to register a new shareholder and then find out the real purpose motivating the directors exercising that power. If the real purpose is not one of the proper purposes then the court can conclude that the directors have acted for an improper purpose. According to the facts, it would be reasonable to argue that the only reason for issuing one share to Mary and registering her as a shareholder in the hasty manner adopted was to manipulate the headcount test under section 166, which was not in any sense a proper reason for the exercise of a fiduciary power. 7

8 3. Down is a majority shareholder of Down s Ltd (incorporated in Hong Kong with Table A as its articles of association), holding 75% of the shares. Two years ago Down retired from the board of directors and left the running of his company to three executive directors. The only non-executive director is Winnie, Down s daughter. Down understands from Winnie that the board has appointed Peter as the new financial controller and plans to appoint Peter s wife, Jane, as the company secretary. Down knows Peter and Jane personally and has no high regard for them. Down wants the board to terminate Peter s employment and not to appoint Jane. In addition, the board of directors wants the company to change its name from Down s Ltd to Down-with-China! to recognise the company s new business focus and delete Ltd from the proposed name as they think this will be more stylish. REQUIRED: 3. (a) Advise Down whether he can cause the board to follow his orders without causing any implications in legal liability. Ans (a) Although the board of directors is supposed to be the major decision maker of the company, a person may be able to take part in board affairs without being formally appointed as a director. Under company law, a de facto director or shadow director has to bear the legal duties of a formally appointed director (Yukong Line Ltd v Rensburg Investments [1998] 2 BCLC 485). According to the court in Re Hydrodam (Corby) Ltd. [1994] 2 BCLC 180, a de facto director is a person who assumes to act as a director. To make such a person liable as a de facto, it is necessary to prove that he undertook functions in relation to the company which could properly be discharged only by a director. It is not sufficient to show that he was concerned in the management of the company s affairs which can properly be performed by a manager below board level. A shadow director is a person in accordance with whose directions or instructions the directors or a majority of directors are accustomed to act. Since Down did not actually personally intervene in board affairs but apparently tried to influence the other directors as a majority shareholder, he could be regarded as a shadow director if the directors were accustomed to follow his advice. In principle, Down is enabled by Regulation 82 of Table A to instruct the board on the management of the company by passing a relevant special resolution. However, Down should be advised that such instruction cannot invalidate any prior act of the company. Therefore, Down can ask the board 8

9 not to employ Jane, but his instruction cannot invalidate the contract with Peter. Down may consider instructing the company to terminate Peter s contract. 3. (b) Explain whether the company can register Down-with-China! as its new name. Ans (b) A company shall not be registered by a name which is the same as a name appearing in the Registrar's index of company names (section 20(1)). This means that Down-with-China can be adopted as the company name if the same has not been registered by another company. Even if this name has not been registered before, very likely it cannot be used because its use could constitute an offence under section 20(1)(d), which states that a company cannot be registered by a name which, in the opinion of the Chief Executive, is offensive or otherwise contrary to the public interest. To Down s Ltd, the new name makes sense because it indicates the company s new business direction. But, literally speaking, the same name could be seen as provocative and as carrying an anti-china meaning. Down s Ltd should be advised that a breach of section 20(1)(d) cannot be ruled out. Where it is proved to the satisfaction of the Registrar of Companies that the objects of a company registered under the Companies Ordinance as a limited company are restricted to 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 authorise the company to make by special resolution a change in its name consisting of the omission of the word "Limited" (section 21(2)). Since Down s company is commercial by nature, it is certain that the word Limited cannot be dispensed with under section 21. 9

10 4. On 2 May 2012, Davis was appointed as the liquidator of J Ltd by the court on the ground of insolvency upon a petition filed on 2 April When Davis studied the company s documents and records, he found that J Ltd had borrowed $8 million by way of an unsecured loan from G Bank in January On 1 September 2011 J Ltd borrowed another $2 million from G Bank and used all its remaining assets to create a floating charge on all of its borrowings. As at 2 May 2012, the amount due to G Bank was $7 million and the book value of the assets under the floating charge was also estimated to be of the same value. Davis also found that the board of directors of J Ltd had ordered a large amount of expensive materials for production on credit in early March This move further deepened the company s financial trouble. From a business perspective this decision was extremely unsound. REQUIRED: 4. (a) Advise Davis as to whether he may challenge the validity of the floating charge under the Companies Ordinance. Ans (a) Under the effect of section 267, where a company is being wound up, a charge which, when created, was a floating charge on the undertaking or property of the company and which was also created within 12 months of the commencement of the winding up shall, unless it is proved that the company immediately after the creation of the charge was solvent, be invalid, except to the amount of any cash paid to the company at the time of or subsequently to the creation of, and in consideration for, the charge, together with interest on that amount at the rate specified in the charge or at the rate 12% per annum, whichever is the less. However, the facts do not give any indication on the financial status of the company. If the company was solvent at the time the charge was created, then the charge would be beyond the reach of section 267 and valid. If the company was actually insolvent at the material time, the charge would only be valid to the extent of the new benefit received by the company in consideration for the charge. Although the charge was created to cover all of the company s borrowings from G Bank, which were $7 million as at 2 May 2012, the charge was only valid to the extent of $2 million. G Bank can only claim the remaining $5 million as an unsecured creditor. 10

11 4. (b) Advise Davis as to whether the directors of the company are personally liable for the expensive materials they ordered. Ans (b) In relation to the expensive purchase of materials, the directors would be liable under section 275 for fraudulent trading if, at the material time, they caused the company to incur new liabilities or they knew that the company had no reasonable prospect of repaying. Even though the decision to purchase materials was commercially unsound and perhaps it was a decision a reasonably competent director would not have made, Davis must note that the court will not impose a liability under section 275 unless it is proved that the directors did know there was no reasonable chance of repaying those new debts. In other words, what has to be proved is the directors actual dishonesty (Aktieselskabet Dansk Skibsfinansiering (body corporate) v Brothers [2000] 1 HKC 511). In the case of a breach of section 275, a director will be made liable for the debts or liabilities incurred as a result of fraudulent trading. A person who is guilty of fraudulent trading may be disqualified by the court from being a director for a certain period (section 168G). 11

12 5. Ian is an executive director of F Ltd. After the retirement of the former managing director, Ian started to tell some outsiders that he was the new managing director. He even told the suppliers that as the managing director he had the full authority to place orders for F Ltd. The other board members always knew he was bluffing to outsiders, but they did not stop him because Ian was the most senior executive in the company. The company just took delivery and paid as Ian ordered. Yesterday Ian placed a huge order with A Ltd (a usual supplier) claiming himself to be the managing director again. However, this time he forgot to first notify the chairman as he would usually do. At the board meeting this morning, Ian was shocked when the board chairman announced that the company would delete A Ltd from the list of approved suppliers with immediate effect because of a sharp decline in its product quality. REQUIRED: 5. (a) Advise the board chairman whether F Ltd can cancel the order with A Ltd on the ground that Ian was never a managing director of the company. Ans (a) The court in Freeman and Lockyer v Buckhurst Park Properties (Mangal) Ltd [1964] All ER 630 stated the four conditions which must be fulfilled to entitle a contractor to enforce against a company a contract entered into on behalf of the company by an agent who had no actual authority to do so. To constitute apparent or ostensible authority, the following must be shown: (1) that a representation that the agent had authority to enter on behalf of the company into a contract of the kind sought to be endorsed was made to the contractor; (2) that such representation was made by a person or persons who had actual authority to manage the business of the company either generally or in respect of those matters to which the contract relates; (3) that the contractor was induced by such representation to enter into the contract that is, that he in fact relied upon it; and (4) that under its memorandum or articles of association the company was not deprived of the capacity either to enter into a contract of the kind sought to be enforced or to delegate authority to enter into a contract of that kind to the agent. It can be argued that the fact that the company always completed the contracts made by Ian with the knowledge that he purported to act as the managing director was a representation by the company to the usual supplier that Ian was a formally appointed managing director with the power to place orders. There was nothing in the facts suggesting that the supplier did not rely on that representation when accepting Ian s orders. Based on 12

13 this analysis, the board chairman should be advised that the usual supplier can enforce the contract against the company by arguing that at the relevant time Ian had apparent authority to bind the company, even though Ian never occupied the position he claimed to have been in. 5. (b) It has just been made known to the chairman that Ian s appointment as director in fact expired two days before the board meeting. Does this change your advice to the chairman made under part (a)? If so, how? Ans (b) Since the constitution of apparent authority is based on the representation made by the company to a contractor without knowledge of the truth, whether Ian was a director or not would not affect the legal position provided that the company had by a representation made the usual supplier believe that Ian was the managing director when he placed the orders. Based on the reasoning given above, the result will be the same even if Ian was not a director at the material time. 5. (c) The board meeting this morning would be inquorate without counting Ian s attendance. Explain to the chairman whether the meeting and the decisions made in the meeting were void. Ans (c) Under section 157, the acts of a director or manager are valid notwithstanding any defect that may afterwards be discovered in his appointment or qualification. The court in Morris v Kanssen [1946] AC 459 explained that the application of this provision also extends to a case in which the term of office of a director has expired but he nevertheless continues to act as a director. Therefore, the chairman can be assured that Ian s attendance can be counted towards the quorum of the meeting and that the resolutions made therein were also valid. 13

14 6. Andy, Benny, Carmen and Danny are the four directors and shareholders of Friends Ltd, each holding 10,000 shares in the company. Recently, a competitor of the company persuaded Andy to work for it as its managing director. Andy then pretended he was sick and resigned as a director of Friends Ltd. He also solicited some of Friends Ltd s major clients to become clients of his new employer. As a result, Friends Ltd lost many of its major clients. REQUIRED: 6. (a) Advise Friends Ltd as to whether it can successfully take any legal action against Andy. Ans (a) Candidates are expected to explain the rules about breach of directors duties. Directors of companies always owe directors duties to their companies but not to individual shareholders. Directors duties may be classified into two main duties, i.e. fiduciary duty and duty of skill and care. The fiduciary duty of directors can be summarised under three headings: 1) To act in good faith for the benefit of the company 2) To exercise their powers for a proper purpose 3) Not to have a conflict of interest between their private interests and their duties as directors A director must not, without the consent of the company, use corporate property or information for his own profit. Otherwise, he is liable to account for any profit made. IDC v Cooley [1972] 1 WLR 443; Peso Silver Mines Ltd. v Cropper (1966) 58 DLR (2d) 1. In IDC v Cooley (1972) C was the managing director of IDC. The company was a consultant to the gas industry. A gas company made it clear that they had a big project and would not award it to IDC but they would like C to do the work for them personally. C claimed he was sick. He resigned as managing director of IDC and began work on the project. IDC sued him saying he had breached his duty as he came to know of the project as a result of his position as managing director of IDC. Thus, he had to hand over the profit on the project to IDC even though he was no longer a director. The court agreed. 14

15 In Peso Silver v Cropper (1966) C was a director of a mining company. The board decided not to proceed with a project as they thought it was too risky. C thought the board was wrong and told them that he wanted to pursue the project himself. He resigned and did so. The project was a great success. The company then sued him to hand over the profit he had made. The court refused saying that the company had rejected the project, C had been honest and thus he could keep the profit. In our case study, if Andy did not disclose his interest to the company and obtained approval from the company, he would be in breach of his director s duty even if he had left the company. If the court held that Andy were in breach of his director s duties, the company would be entitled to claim compensation for the loss it suffered. 6. (b) Benny and Carmen are good friends of Andy and are unwilling to cause the company to take any legal action against Andy. Danny is very unhappy. Advise Danny as to whether he can take any derivative action under the Companies Ordinance against Andy, and, if yes, the proper procedures under the Companies Ordinance. Ans (b) Candidates are expected to explain the rules about statutory derivative action under section 168BA-BK of the Companies Ordinance. Danny may be able to apply to the court to seek leave to bring a derivative action against Andy pursuant to section 168BC. A derivative action can be brought under Pt IVAA if the proceedings relate to misfeasance: section 168BB. If Andy has breached his fiduciary duties as a director of the company, then this conduct will amount to misfeasance. Leave cannot be granted under section 168BC if the company has itself commenced proceedings against the wrongdoer: section 168BC(3)(b). In addition, before leave is sought, Danny will also need to serve a written notice on the company that he intends to seek leave, in accordance with section 168BD: section 168BC(3)(d). The two crucial factors that the court is required to take into account in deciding whether or not to grant leave are: (a) that it appears to be prima facie in the interest of the company that leave be granted; and (b) that there is a serious question to be tried: section 168BC(3)(a), (b). In relation to the first of these requirements, the courts have held that it is sufficient for the applicant to show that there is an arguable case, and that on the face of it, it appears to be in the interest of the company to bring the action: e.g. Re F & S Express Ltd [2005] 4 HKLRD 743; Re Myway Ltd [2008] 3 HKLRD 614; Re Grand Field Group Holdings Ltd [2009] 3 HKC 81. It is not necessary or appropriate to establish this to a particularly high 15

16 standard and the court should not attempt to resolve the underlying dispute at the stage of the leave application. If Danny s dispute with the other directors only involves a difference in opinion on the commercial merits of the transactions, then it would not be in the interests of the company to commence the action. On the other hand, if the problems raised by Danny indicate a likelihood that Andy has breached his duties, then the court may well be prepared to grant leave. The second requirement is also of a relatively low threshold, and the applicant only needs to provide sufficient information to the court to show that there is at least a probability that the company will succeed in establishing its entitlement to the relief sought at the full trial. Danny should provide information to the court on the factual matters that give rise to his allegations of Andy s breaches of duty. END 16