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 COPORATE LAW JUNE 2015 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 Central Hotel Ltd (CHL) is a private company incorporated in Hong Kong with its articles of association substantially based on the Model Articles for private companies limited by shares. The additional clauses in CHL s articles are: i) the quorum for general meeting of the company is four shareholders or proxies who physically attend the meeting; and ii) all directors of the company must be aged between 18 and 60 years of age. CHL also has an object clause in its articles of association which provides that the main business of the company is to operate hotels in Hong Kong. 1. Alan, Becky, Catherine, Davy and Elaine are the five shareholders in CHL. Each of them own 20% of CHL s issued shares. Alan, Becky and Francis are CHL s three executive directors, while Alan is also the chairman of CHL s board of directors and its managing director. Due to different views on many management issues, Alan and Becky have not been on speaking terms for months. In a recent board meeting, Alan proposed expanding the company s business to operate hotels in China; he reported in the meeting that some preliminary agreements have been signed with some hotels in China to form a strategic alliance. However, Becky believed that it was too risky for the company to expand its hotel business to China and was very worried about this prospect. After this dispute on the proposed expansion of the company s business, Becky decided to sell her shares to Catherine and to resign as a director of the company. However, she found that, according to the company s articles of association, the transfer of shares must be approved by the board of directors. Alan and Francis have refused to approve the transfer without giving any reasons. Alan will be 61 years old next month and would like to delete the age restriction for the company s directors. He called a general meeting to achieve this and sent a 2

3 notice of the general meeting to all five shareholders on 1 September The notice proposed the meeting be held at 7:00p.m. on 22 September 2014 at Alan s apartment at Discovery Bay. However, due to an error in the company s records, Davy s letter was sent to the wrong address so that Davy did not receive notice of the meeting. Only Alan, Becky and Elaine attended the meeting and an ordinary resolution was passed to approve the deletion of the age restriction. Although Becky voted against the resolution, she was out-voted by Alan and Elaine. REQUIRED: 1. (a) Advise Becky as to whether she may successfully challenge the meeting and the resolution to delete the age restriction for CHL directors. (15 marks) Ans (a) Candidates are expected to discuss the rules about meetings and section 87(1), i.e. alteration of articles of association. A valid meeting generally requires proper notice be given and the meeting be held with sufficient quorum. In Young v Ladies Imperial Club [1920] 2 KB 523, a member of a club was expelled by a resolution passed by committee. One member of the committee had not been sent a notice of the meeting because she had informed the chairman that she would be unable to attend. It was held that failure to send her notice of the meeting invalidated the proceedings and made the expulsion void. The length of notice required is: - 21 days for AGMs (section 571(1)(a)) - 14 days for EGMs (no EGM under Cap 622) if the company is a limited company (section 571(1)(b)(i)) - 7 days for EGMs (no EGM under Cap 622) if the company is an unlimited 3

4 company (section 571(b)(ii)) Candidates may explain article 39 of the Model Articles provides that: (1) An annual general meeting must be called by notice of at least 21 days in writing. (2) A general meeting other than an annual general meeting must be called by notice of at least 14 days in writing. (3) The notice is exclusive of: (a) the day on which it is served or deemed to be served; and (b) the day for which it is given. Candidates may explain section 87(1) of the new Companies Ordinance (Cap. 622). In our case, only an ordinary resolution was passed. As a result, the alteration of the articles of association was invalid. The general principle that a company can alter its articles of association was confirmed in Allen v Gold Reefs of West Africa Ltd [1900] 1 Ch 656 (CA). In this case, the articles gave the company a lien for debts owed by members to the company on all partly paid shares held by such members. Z was the only holder of fully paid shares although he also held shares which were not fully paid. The company altered its articles to extend the lien to fully paid shares. Z s executors challenged the alteration. It was held that the alteration was bona fide for the benefit of the company as a whole, and the lien applied to all shareholders equally. It made no difference that Z was the only person practically affected at the time. The alteration was valid. The court held that a company must exercise the power to change the articles in accordance with the ordinance but also bona fide in the interest of the company as a whole and not only purely for the purpose of the majority, who can ignore minority shareholders. 4

5 Candidates may state that 14 days notice is required under the new Companies Ordinance. In our case, the notice was sent on 1 September 2014 while the meeting was held on 22 September 2014, i.e. this was 20 days notice only. The notice period is enough under the new Companies Ordinance. Accidental omission to give notice of a meeting to, or the non-receipt of notice of a meeting by, any person entitled to receive notice shall not invalidate the proceedings at the meeting: Article 41 of the Model Articles under the new Companies Ordinance (Cap. 622) In our case, although the notice to Davy was sent to a wrong address due to an error in the company s records, the company may argue that this is an accidental omission and this should not invalidate the meeting. A quorum is the minimum number of persons which must be present for the convention and conduct of a valid meeting. No business shall be transacted at any GM unless a quorum of members is present at the time where the meeting proceeds to business and continues to be present until the conclusion of the meeting. In our case, as the quorum for general meeting of the company is four shareholders while there were only three shareholders at the meeting, the meeting was invalid. 1. (b) Advise Becky as to the proper procedures and her rights/ liabilities if she resigns as a director of the company. Ans (b) Candidates should explain section 464 of the new Companies Ordinance (5 marks) A director of a company may, unless it is otherwise provided in the articles of the company or by any agreement with the company, resign as director at any time (section 464(1)). If a director of a company resigns, the company must deliver a 5

6 notice of the resignation to the Registrar in the manner required by section 645(4) (section 464(2)). If the director resigning has reasonable grounds for believing that the company will not deliver the notice, the director resigning must deliver to the Registrar for registration a notice of the resignation in the specified form (section 464(3)). The notice required to be delivered under section 464(3) must state: (a) whether the director resigning is required by the articles of the company or by any agreement with the company to give notice of resignation to the company; and (b) if notice is so required, whether the notice has been given in accordance with the requirement (section 464(4)). If notice of the resignation of a director of a company is required to be given by the articles of the company or by any agreement with the company, the resignation does not have effect unless the director gives notice in writing of the resignation: (a) in accordance with the requirement; (b) by leaving it at the registered office of the company; or (c) by sending it to the company in hard copy form or in electronic form (section 464(5)). No reason need be given but if the director is also an employee of the company a contractual notice period may need to be given or the director will be in breach of the employment contract. In our case, Becky is an executive director of CHL. It is likely that she has an employment contract with the company. As a result, not only does she need to follow section 464 and send a written notice of resignation to the company, she should also follow the terms of her employment contract in order to terminate the employment contract legally. Otherwise, she may need to pay compensation to 6

7 the company due to a breach of her employment contract. 1. (c) Advise Becky as to whether she may successfully challenge the board of directors refusal to register her transfer of shares. (10 marks) Ans (c) Candidates are expected to discuss rules about directors power to refuse registration of a transfer of shares. Candidates should explain sections 141 and 142 of the Companies Ordinance. Section 141(1) provides that the directors of a company may exercise a power: (a) to allot shares in the company; or (b) to grant rights to subscribe for, or to convert any security into, shares in the company, if the company gives approval in advance by resolution of the company. (2) Approval may be given for a particular exercise of the power or for its exercise generally, and may be unconditional or subject to conditions. (3) Subject to subsections (4) and (5), an approval expires: (a) if the company is required to hold an annual general meeting, on the earlier of: (i) the conclusion of the annual general meeting held next after the approval was given; (ii) the expiry of the period within which the next annual general meeting after the approval was given is required to be held; (b) if the company is not required to hold an annual general meeting because of section 612(1), on the date on which the requirements of that section are satisfied; or (c) if the company is not required to hold an annual general meeting for any other reason, on the date specified in the approval, which must not be more than 12 months after the approval was given. (4) An approval may be revoked or varied at any time by resolution of the 7

8 company. (5) The directors may allot shares or grant rights after an approval has expired if: (a) the shares are allotted, or the rights are granted, under an offer, agreement or option made or granted by the company before the approval expired; and (b) the approval allowed the company to make or grant an offer, agreement or option that would or might require shares to be allotted, or rights to be granted, after the approval had expired. Section 142 of the new Companies Ordinance provides that within one month after an allotment of shares, a limited company must deliver to the Registrar for registration a return of the allotment that complies with subsection (2). (2) A return: (a) must be in the specified form; (b) must include a statement of capital as at the date of the allotment that complies with section 201; (c) must state: (i) the number of shares allotted; (ii) the name and address of each allottee; and (iii) if the company s issued share capital is increased as a result of the allotment, the amount of the increase; (d) for any shares allotted for consideration (whether wholly or partly cash consideration or non-cash consideration): (i) must state the amount paid or regarded as paid on each share and the amount (if any) remaining unpaid or regarded as remaining unpaid on each share; (ii) in the case of an allotment wholly or partly for non-cash consideration under an arrangement made under Division 2 of Part 13, must contain particulars of the order of the court sanctioning the arrangement; and (iii) in any other case of an allotment wholly or partly for non-cash consideration, must contain particulars of the contract for sale, or for services or other consideration in respect of which the shares 8

9 were allotted; and (e) for any shares allotted credited as fully paid up (whether on or without a capitalisation): (i) must state the amount regarded as paid on each share; and (ii) must contain particulars of the resolution authorising the capitalisation or allotment. (3) If a limited company contravenes subsection (1), the company, and every responsible person of the company, commit an offence, and each is liable to a fine at level 4 and, in the case of a continuing offence, to a further fine of $700 for each day during which the offence continues. (4) If a limited company fails to deliver a return that complies with subsection (2) within one month after an allotment of shares, the court may, on application by the company or a responsible person of the company, extend the period for delivery of the return by a period determined by the court. (5) The court may extend a period under subsection (4) only if it is satisfied: (a) that failure to deliver the return was accidental or due to inadvertence; or (b) that it is just and equitable to extend the period. (6) If the court extends the period for delivery of a return, any liability already incurred by the company or a responsible person of the company for an offence under subsection (3) is extinguished and subsection (1) has effec t as if the reference to one month were a reference to the extended period. If the directors refuse to register a new member the buyer can apply to the court which may order rectification of the register (section 633), but the directors can refuse if this refusal is within their discretion and they act bona fide. In Simon Fireman v Gold Rice Bowl Ltd. [1987] HKLR 981, the court stressed that it was not entitled to interfere with a decision with which it merely disagrees. If the articles of the company have given the directors the discretion to refuse to register a transfer and the directors have acted bona fide in what they consider to be the best interests of the company and honestly, the court will not exercise its 9

10 discretion under section 69(1B). In Choy Bing Wing v Max Share Ltd [1993] HKLY 154, the court held that it will not interfere unless the transferee shows that the directors have acted from some improper motive or capriciously. The directors are entitled to the presumption of honesty. In our case, unless Becky can show that Alan and Francis were not in good faith, the court is unlikely to interfere. 1. (d) Advise Alan as to the proper procedures to expand the company s business to operate hotels in China and the validity of the preliminary agreements signed between CHL and some hotels in China under the Companies Ordinance. (10 marks) (Total: 40 marks) Ans (d) Candidates should explain sections 115 and 116 of the new Companies Ordinance (Cap. 622). Section 115(1) provides that a company has the capacity, rights, powers and privileges of a natural person of full age. (2) Without limiting subsection (1), a company: (a) may do any act that it is permitted or required to do by its articles or any Ordinance or rule of law; and (b) has power to acquire, hold and dispose of land. (3) In this section: land includes any estate or interest in land, buildings, messuages and tenements of any nature or kind. Section 116(1) provides that if the objects of a company are stated in its articles, the company must not do any act that it is not authorised to do by its articles. (2) If any power of a company is expressly modified or excluded by its articles, the 10

11 company must not exercise the power contrary to that modification or exclusion. (3) A member of a company may bring proceedings to restrain the company from doing any act in contravention of subsection (1) or (2). (4) Proceedings must not be brought under subsection (3) in respect of any act to be done in fulfilment of a legal obligation arising from a previous act of the company. (5) An act by a company (including a transfer of property to or by the company) is not invalid only because the company does the act in contravention of subsection (1) or (2). In our case, the objects clause of the company provides that the company should operate hotels in Hong Kong while the preliminary agreement to expand the business of the company to China may be ultra vires. However, the preliminary agreements signed were still valid under section 116(5) of the Companies Ordinance, though Alan may be sued for breach of directors duties for the ultra vires transaction. A company may alter its articles by special resolution except an alteration in articles to the maximum number of shares that the company may issue, which may be made by ordinary resolution (sections 87 and 88). Section 89(2) of the new Companies Ordinance (Cap. 622) provides that t he company may, by special resolution of which notice has been given to all the members of the company (including members who are not entitled to such notice under the company s articles), alter the objects by: (a) abandoning or restricting any of the objects; or (b) adopting any new object that could lawfully have been contained: (i) in the case of a company formed and registered under this Ordinance, in the company s articles when the articles were registered; or (ii) in the case of an existing company, in the company s memorandum of association when the memorandum was registered. In this case, although, Becky disagreed with the expansion of the company s 11

12 business to China, so if Alan can get the support from Catherine, Davy and Elaine, he may still pass a special resolution as they own 80% of the issued shares of the company in total, provided that Alan, Catherine, Davy and Elaine all attend the general meeting. However, even if a special resolution to alter the objects clause is passed, Becky may still object to the court as she owns 20% of the issued shares of the company, i.e. more than 5%, as required under section 91. The court will then make a decision. 12

13 SECTION B 2. Percy holds a master of finance degree from a prestigious university and is a very experienced finance professional. He is the managing director of Hong Kong Manufacturing Ltd (HKML). Recently, HKML was due to renew an insurance policy covering all its premises against fire. Without reading any terms of the new insurance policy, Percy simply relied on Nancy, his insurance broker, who completed the insurance policy forms, and he then signed them. Two weeks later, some of HKML s premises were destroyed by fire and it was found that there were mistakes in the forms which allowed the insurance company to repudiate liability for any compensation under the insurance policy. HKML subsequently went into liquidation and Leslie was appointed as HKML s liquidator. REQUIRED: 2. (a) Advise Leslie as to whether Percy was in breach of his director s duties. (14 marks) Ans (a) Candidates are expected to discuss the rule 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 categories: fiduciary duties, and duties of skill and care. Fiduciary duties include the following: (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 s duties of care and skill toward the company are not as onerous as the fiduciary duties. (Below is under Cap 32) In Re City Equitable Fire Insurance Co Ltd. [1925] Ch 407, the court laid down 13

14 three propositions which summarise a director s duty of care. A director need not, in the performance of his duties, exhibit a greater degree of skill than may be reasonably expected from a person of his knowledge and experience. Thus, in an action where it is claimed that a director acted negligently, his conduct is judged against that of the reasonable man with his (the director s) qualification and experience. If the director is qualified as an accountant, lawyer, engineer, or otherwise, his conduct will be judged in comparison with that of the relevant professional, but where the director is unqualified, the standard of competence may be very low. (Below is under Cap 32) A director is not bound to give continuous attention to the affairs of the company. His duties are of an intermittent nature to be performed at periodic board meetings and at meetings of any committee of the board upon which he happens to be placed. He is not, however, bound to attend all such meetings, though he ought to attend whenever in the circumstances he is reasonably able to do so. This duty may need to be reconsidered in the case of directors who are employed by the company. In respect of all duties that may properly left to some other official, having regard to the needs of the business and the articles of the company, a director, in the absence of grounds for suspicion, is justified in trusting that official to perform such duties honestly. In our case, it is likely that Percy was in breach of his duties of skills and care as Percy signed the insurance policy without reading any terms of it. Percy holds a master of finance master from a prestigious university and is very experienced and it is expected that he should meet the standard reasonably expected from his qualification and experience. Candidates should also refer to section 465 of the Companies Ordinance (Cap. 622). A director of a company must exercise reasonable care, skill and diligence (section 465(1)). Reasonable care, skill and diligence mean the care, skill and diligence that would 14

15 be exercised by a reasonably diligent person with: (a) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company; and (b) the general knowledge, skill and experience that the director has (section 465(2)). The duty specified in section 465(1) is owed by a director of a company to the company (section 465(3)). The duty specified in section 465(1) has effect in place of the common law rules and equitable principles as regards the duty to exercise reasonable care, skill and diligence, owed by a director of a company to the company (section 465(4)). Section 465 applies to a shadow director as it applies to a director (section 465(5)). 2. (b) Advise Leslie as to whether there is any ground to disqualify Percy as a director of a company under the Companies (Winding Up & Miscellaneous Provisions) Ordinance (Cap. 32) (6 marks) (Total: 20 marks) Ans (b) Candidates are expected to explain the grounds to disqualify a director under the Companies (Winding Up & Miscellaneous Provisions) Ordinance (Cap. 32) The four major grounds for disqualification are: 1. Conviction of a serious offence in connection with the promotion, formation, management, receivership or liquidation of a company or any other indictable offence which involves the element of fraud or dishonesty: section 168E of Cap Persistent defaults relating to the Companies Ordinance requiring any return, 15

16 account or other document to be delivered to the Registrar: section 168F of Cap Fraud in the course of winding up or in relation to fraudulent trading: section 168G of Cap Unfitness involved in running a company that became insolvent as a result of the conduct of the director: section 168H of Cap. 32. Schedule 15 of Cap. 32 provides matters for determining the unfitness of directors, e.g. breach of fiduciary duty or other duty in relation to the company; misapplication or retention of the company s money or other property; failure to account for the company s money or property; failure to comply with the requirements of the Companies Ordinance with regard to keeping registers and making and filing an annual return. In our case, Leslie may argue that Percy is unfit to be a director due to his breach of director s duties. 16

17 3. In 2010 The First Group Ltd (TFG) set up a new company, The First Textile Ltd (TFTL), to manufacture rayon cloth. This process required a licence from the government. In order to obtain the licence, TFTL was required to appoint two experienced directors with special qualifications. Frankie and Ginna were invited to join TFTL. TFG owns 80% of TFTL s issued shares while Frankie and Ginna each own 10% of TFTL s issued shares. There are five directors in TFTL, including Frankie and Ginna, who are the joint managing directors. The other three directors, who are appointed by TFG, are also TFG s directors. Early this year, the government cancelled the licencing system. As a result, TFG used its majority of votes to transfer all TFTL s business into one of TFG s subsidiaries. TFG also cut off the supplies of raw materials to TFTL. As a result, TFTL could not continue its business as no profits was made and its share value crashed. REQUIRED: 3. (a) Advise Frankie and Ginna as to whether they may successfully launch an unfair prejudice application under the Companies Ordinance. (14 marks) Ans (a) Candidates are expected to discuss section 724 of the Companies Ordinance. Under section 724 of the Companies Ordinance, any member of a company who complains that the affairs of the 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. If the court is satisfied that there is a case of unfair prejudice, in order to bring to an end the matters complained of the court may make an order restraining the commission of any such act or the continuance of such conduct. As shareholders, Frankie and Ginna may argue that the effects of the transfer of TFTL s business to one of TFG s subsidiaries and cutting off the supplies of raw materials to TFTL, which are affairs of the company, were prejudicial to the shareholders interests. The existence of corporate affairs causing prejudice to shareholders interests, by 17

18 themselves, is not sufficient to activate the court s jurisdiction under section 724 because such affairs may not be unfair. In other words, prejudicial acts may not necessarily be unfair. As the court in Re Taiwa Land Investment Ltd [1981] HKLR 197 pointed out: It seems clear that elements of both unfairness and prejudice must co-exist for the section to come into play. Conduct which is intrinsically prejudicial to the interests of a shareholder, without also being unfair, will not be enough; conversely the section cannot be relied upon if the conduct of which complaint is made is merely unfair. It is open to the court to find that serious mismanagement of a company's business constitutes conduct that is unfairly prejudicial to the interests of minority shareholders (Re Macro (Ipswich) Ltd [1994] 2 BCLC 354). But as a general rule, the court will normally be very reluctant to accept that managerial decisions can amount to prejudicial conduct, for two reasons. First, there will be cases where there is genuine disagreement between shareholders and directors as to whether a particular decision is commercially sound. The fact that the parties have taken different views is not of itself a proof of unfairness. Secondly, it is a fact that the company s value will depend on the competence of management. Therefore, short of a breach by a director of his duty of skill and care there is prima facie no unfairness to a shareholder if the quality of the management turns out to be poor (Re Elgindata Ltd [1991] BCLC 959). In Scottish Co-operative Wholesale Society Ltd v Meyer [1959] AC 324, which was similar to our case, the House of Lords held that the conduct of the majority was indeed oppressive, and ordered that the minority shareholders shares be bought at a price that was fair. In our case, Frankie and Ginna may argue that by transferring all TFTL s business to one of TFG s subsidiaries and cutting off the supplies of raw materials to TFTL, the affairs of TFTL were conducted in a manner unfairly prejudicial to the interests of Frankie and Ginna. 3. (b) Assuming that their application is successful, what remedies may the court grant under the Companies Ordinance? (6 marks) 18

19 (Total: 20 marks) Ans (b) Section 725 of the Companies Ordinance provides orders which the court may make: - To regulate the affairs of the company in the future; - To provide for certain shareholders or for the company itself to buy the shares of other shareholders; - To restrain the doing or continuation of some act; - To authorise proceedings to be brought in the name of or on behalf of the company against such persons and on such terms as the court may direct; - To appoint a receiver or manager of the whole or a part of the company s property or business, specify his powers and duties, and fix his remuneration; and - The payment of damages and interest on those damages to any members whose interests have been unfairly prejudiced. In our case, if Frankie and Ginna successfully claim there has been an unfairly prejudicial act, they may ask for one of the above remedies. 19

20 4. The Second Rubbers Ltd (TSRL) is a public but unlisted Hong Kong company. Michael is the company s auditor and this year he has prepared an unqualified audit report. Without reading all the documents carefully, Michael failed to discover that TSRL s directors had falsified entries to overstate the company s accounts receivable. Michael knew that the accounts when certified would be used to raise money and for that purpose supplied 10 certified and serially numbered copies to the company. Mainland Bank relied on one of these copies, given to it on its demand, and lent $5 million to TSRL. TSRL went into liquidation two months later. Mainland Bank sued Michael for the amount of the debt, declaring that a careful audit would have shown TSRL to be insolvent. REQUIRED: 4 (a) Advice Michael as to whether he may be liable for any loss suffered by Mainland Bank. Ans (a) Candidates are expected to discuss the rules about auditors liability. (10 marks) In the absence of a contractual relationship, a third party may assert action in the tort of negligence against the defaulting auditor only if they suffer any loss as a result of an auditors breach of duty. Relevant cases are Hedley Byrne and Co Ltd v Heller and Partners Ltd [1963] 3 WLR 101 and Caparo Industries plc v Dickman [1990] 2 AC 605. Candidates may cite any relevant case to support their argument. Marks should be given to any relevant case cited. Negligent mis-statement under a special relationship leading to economic loss has been established as compensatable. This duty was expanded further from the special relationship to the two-stage test in Anns v Merton London Borough Council [1978] AC 728. In a recent Hong Kong case, Guang Xin Enterprises Ltd. (In liquidation) v Kwan Wong Tan & Fong (A firm) [2002] 2 HKC 613, the Court of First Instance held that 20

21 (at 622D-625B): An auditor was not a business advisor. His position in relation to the shareholders of a limited company arose from the relevant provisions of the Companies Ordinance (Cap 32). His duty was to investigate and form an independent opinion on the adequacy of the company's accounts and to report to the company's members whether in his opinion the company's accounts gave a true and fair view of its financial position. He was not employed by the company to advise on how the company should be run. Still less was it the auditor's duty to advise on whether or not the company should carry on its business. In Yue Xiu Finance Co. v Dermot Agnew (1996) (HK), the court held that the relationship of proximity could be established by showing that the defendants knew that the plaintiffs would rely on the audited reports for a particular purpose and intended that the plaintiffs should rely on the reports for that purpose. By applying the above special relationship test, in this case, it seems that there is a special relationship as Michael knew the accounts when certified would be used to raise money and for that purpose supplied 10 certified copies to the company, which then gave one of those copies to Mainland Bank. As a result, Mainland Bank has the right to sue Michael for his breach of duty as TSRL s auditor. 4. (b) Advice Michael as to his potential liability, and possible defences, under the Companies Ordinance if his audit report is included in a prospectus when TSRL is applying for its listing on the Stock Exchange Hong Kong. (10 marks) (Total: 20 marks) Ans (b) Candidates are expected to discuss section 40 of the Companies (Winding Up & Miscellaneous Provisions) Ordinance. Section 40 of the Companies (Winding Up & Miscellaneous Provisions) Ordinance (Cap. 32) provides that, subject to the provisions of this section, where a 21

22 prospectus invites persons to subscribe for shares in or debentures of a company, the following persons shall be liable to pay compensation to all persons who subscribe for any shares or debentures on the faith of the prospectus for the loss or damage they may have sustained by reason of any untrue statement included therein, that is to say: (a) every person who is a director of the company at the time of the issue of the prospectus; (b) every person who has authorised himself to be named and is named in the prospectus as a director or as having agreed to become a director either immediately or after an interval of time; (c) every person being a promoter of the company; and (d) every person who has authorised the issue of the prospectus. Provided that where under section 38C the consent of a person is required to the issue of a prospectus and he has given that consent, he shall not by reason of his having given it be liable under this subsection as a person who has authorised the issue of the prospectus except in respect of an untrue statement purporting to be made by him as an expert. Section 38C of the Companies (Windin g Up & Miscellaneous Provisions) Ordinance (Cap. 32) provides that: (1) A prospectus inviting persons to subscribe for shares in or debentures of a company and including a statement purporting to be made by an expert shall not be issued unless: (a) he has given and has not, before delivery of a copy of the prospectus for registration, withdrawn his written consent to the issue thereof with the statement included in the form and context in which it is included; and (b) a statement that he has given and has not withdrawn his consent as aforesaid appears in the prospectus. (2) If any prospectus is issued in contravention of this section the company and every person who is knowingly a party to the issue thereof shall be liable to a fine. (3) In this section the expression expert includes engineer, valuer, accountant, and 22

23 any other person whose profession gives authority to a statement made by him. Section 40(3) provides that a person who, apart from this subsection would under section 40(1) be liable, by reason of his having given a consent required of him by section 38C, as a person who has authorised the issue of a prospectus in respect of an untrue statement purporting to be made by him as an expert, shall not be so liable if he proves: (a) that, having given his consent under the said section 38C to the issue of the prospectus, he withdrew it in writing before delivery of a copy of the prospectus for registration; or (b) that, after delivery of a copy of the prospectus for registration and before allotment thereunder, he, on becoming aware of the untrue statement, withdrew his consent in writing and gave reasonable public notice of the withdrawal, and of the reason therefor; or (c) that he was competent to make the statement and that he had reasonable ground to believe and did up to the time of the allotment of the shares or debentures, as the case may be, believe that the statement was true. In our case, if Michael has given his consent to include his audit report in the prospectus, he may be liable under section 40(1) of the Companies (Winding Up & Miscellaneous Provisions) Ordinance (Cap. 32), unless he can rely on one of the defences under section 40(3) of the Companies (Winding Up & Miscellaneous Provisions) Ordinance (Cap. 32), i.e. to withdraw his consent in writing or to prove that he was competent to make the statement and he had reasonable ground to believe and did up to the time of the allotment of shares believe that the statement was true. 23

24 5. Carmen has been the company secretary of Sunny Day Ltd (SDL) since its incorporation in The company s articles of association provide that Carmen was to be appointed as SDL s company secretary for life and she should not be removed from office except for misconduct. However, early this week, Carmen had a serious quarrel with Pamela, the CEO of the company, who then proposed removing Carmen as SDL s company secretary in the forthcoming board of directors meeting. REQUIRED: 5. (a) Explain to Carmen as to the contractual effect of a company s articles of association under the Companies Ordinance. (10 marks) Ans (a) Candidates are expected to explain the contractual effect of a company s articles of association under section 86(1) of the Companies Ordinance. Section 86(1) of the Companies Ordinance gives contractual effect to the memorandum and articles of association to provide that they have the effect of a contract under seal: i) between company and each member; and ii) between a member and each other member. Section 86(2) of the Companies Ordinance (Cap. 32) further provides that, without limiting the generality of the above rule, the articles of a company, when registered, are enforceable by the company against each member and by a member against the company and against each other member. In Hickman v Kent [1915] 1 Ch 881, the articles of association provided that if members had a dispute they should go to arbitration. A member was sued under court proceedings which were suspended by the court on the basis that the articles of association were a contract and so the member must first go to arbitration. In Wood v Odessa Water Works (1889) 42 Ch D 636, the articles of association provided that the company could declare a dividend to be paid to members. The 24

25 company sought to give members a debenture bond in lieu of payment. The court held paid means payment in cash. The proposal was not in cash. Therefore, the proposal was in breach of the articles of association and so a breach of contract. An injunction was issued to prevent the company issuing the bonds. 5. (b) Advise Carmen as to whether Pamela is entitled to remove her as SDL s company secretary. (10 marks) (Total: 20 marks) Ans (b) However, the articles of association do not form any contract between the company and other parties. In Beattie v E & F Beattie Ltd [1938] Ch 708, the company's articles provided for any dispute between the company and one of its members to be settled by arbitration. A director who was also a member sought a stay in legal proceedings brought against him concerning his conduct as a director on the grounds that the matter should be referred to arbitration. It was held that there was no contractual agreement to submit to arbitration a dispute between the company and a member in his capacity as director. The articles are enforceable as a contract only with regard to membership matters. In Eley v Positive Government Life Assurance Co Ltd (1876) 1 Ex D 88, the articles provided that Eley was to be appointed as the company's solicitor, and that he should not be removed from office except for misconduct. Eley was employed as solicitor and he became a member of the company some time after its incorporation. When the directors ceased to employ him and used another solicitor, he sued for breach of contract. It was held that the articles did not create any contract between the company and Eley in his capacity as solicitor. In our case, the articles of association do not form any contract between Carmen and SDL. As a result, Carmen may not be able to rely on the articles of association to prevent her removal unless she can argue that the terms of the articles have been incorporated into her employment contract. In Schindler v Northern Raincoat Co Ltd [1960] 1 WLR 1038, S was the managing 25

26 director and had a 10-year employment contract. A new owner of the company removed S from his position as a director and so he could not be the managing director. It was held that the company was in breach of contract to S. In Re New British Iron Co, ex parte Beckwith [1898] 1 Ch 324, Beckwith was employed as a director, relying for his remuneration on a provision in the articles which said he should be paid 1000 per year. He brought an action against the company for payment of his fees. It was held that the articles did not form a contract between the company and Beckwith in his capacity as director, but he had taken office and worked on the basis of the articles, so the provisions had thus become an implied term of his contract of employment and the company was liable to pay him on this basis. In our case, there is insufficient information as to whether Carmen has a separate employment contract with SDL which may incorporate the terms of the articles of association. If this is the case, Carmen may rely on the above cases to claim compensation for her removal. 26

27 6. The new Companies Ordinance (Cap. 622), which consists of 921 sections and 11 schedules, provides a modernised legal framework for the incorporation and operation of companies in Hong Kong. Part 4 of the Ordinance substantially changes some out-dated rules governing share capital of companies in Hong Kong. REQUIRED: 6. (a) Explain THREE major changes introduced by Part 4 (Share Capital) of the new Companies Ordinance (Cap. 622), e.g. the new mandatory no -par system, concepts that were abolished as a result of this new no-par system, etc. (12 marks) Ans (a) Candidates are expected to explain the changes introduced by Part 4 of the new Companies Ordinance (Cap. 622). It was suggested that the par value does not serve the original purpose of protecting creditors and shareholders, and in fact may even be misleading because the par value does not necessarily give an indication of the real value of the shares. The new Companies Ordinance (Cap. 622) adopts the mandatory system of no-par and abolishes relevant concepts, such as nominal value, share premium, issue shares at a discount and the requirement for authorised share capital. Section 135 of the new Companies Ordinance abolishes the concept of nominal value. Upon the commencement of that section, a company s shares will have no nominal value. With the abolition of nominal value, share premium no longer exists. Provisions based on this concept were modified. Section 37 of Schedule 11 is a legislative deeming provision for the amalgamation of the original existing share capital amount with the amount in the company s share premium account and also capital redemption reserve. 27

28 Other new changes introduced by Part 4 of the new Companies Ordinance include the following: (1) Removing the power of companies to issue share warrants to bearer. (2) Extending the requirement of shareholders consent for allotments of shares to the grants of rights to subscribe for, or to convert securities into, shares. (3) Requiring a company to deliver to the Companies Registry a return or notification, including a statement of capital whenever where there is a change to its capital structure. (4) Clarifying and simplifying the requirements relating to class rights. (5) Simplifying the publication procedures for replacement of lost share certificate of a listed company. Section 139 of the new Companies Ordinance repeals a company s power to issue share warrants to bearer while providing that share warrants issued prior to the commencement of that section would be grandfathered, so that upon the surrender of such existing share warrants, the bearer s name will be registered in the company s register of members. Sections of the new Companies Ordinance extend the requirement of shareholders approval for allotment of shares to the grants of rights to subscribe for, or to convert securities into, shares, in order to enhance protection of minority shareholders against dilution. Section 151(3) and (4) of the new Companies Ordinance require the company to give reasons explaining their refusal to register a transfer of shares upon request and within 28 days after receiving the request, so as to enhance transparency and to ensure that directors should exercise their power properly. Section 201 of the new Companies Ordinance sets out information to be contained in a statement of capital. This new requirement ensures that the public register should contain updated information on a company s share capital structure. 6. (b) Explain the information which a company is required to include in a 28

29 statement of capital under the new Companies Ordinance (Cap. 622). (8 marks) (Total: 20 marks) Ans (b) Candidates are expected to explain section 201 of the Companies Ordinance. Section 201(2) provides that a statement of capital must state: (a) the total number of issued shares in the company; (b) the amount paid up or regarded as paid up and the amount (if any) remaining unpaid or regarded as remaining unpaid on the total number of issued shares in the company; (c) the total amount of the company s issued share capital; and (d) (i) the particulars specified in section 201 (3); (ii) the total number of issued shares in the class; (iii) the amount paid up or regarded as paid up and the amount (if any) remaining unpaid or regarded as remaining unpaid on the total number of issued shares in the class; and (iv) the total amount of issued share capital of the class. The particulars under section 201(3) are: (a) particulars of any voting rights attached to shares in the class, including rights that arise only in certain circumstances; (b) particulars of any rights attached to shares in the class, as respects dividends, to participate in a distribution; (c) particulars of any rights attached to shares in the class, as respects capital, to participate in a distribution (including on a winding up); and (d) whether or not shares in the class are redeemable shares. END 29