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Introduction
Minority shareholders and directors of a company and family office often face various challenges. They may have little to no control over day-to-day management and when they suspect mismanagement, or may face substantial difficulties obtaining books and records to investigate their suspicion.
This article highlights the relevant considerations by reference to the recent case of Morning Ray Investment Co Ltd v Jinhui International Enterprise Ltd [2022] HKCFI 926 against the backdrop of another earlier case of Yung Siu Wa v Raffles Family Office Limited and Others [2018] HKCFI 2620.
Distinguishing directors’ and shareholders’ right to inspect
While there is an overlap between directors’ and shareholders’ right to inspect company documents, such rights are legally distinct and are founded on different premises.
Directors’ extensive right to inspect
A director’s right to inspect is well-established and extensive, under both the common law and statute.
Under common law, directors’ right to inspect company documents is integral to their duties. Directors may inspect and take copies of any documents belonging to the company, such as board minutes, financial and company records, and corporate information, without needing any justification. With the exception that the director is acting with improper purpose, for example to abuse confidence and to injure the company materially, any perceived vindictiveness or previous inaction is irrelevant.
The Companies Ordinance (Cap 622) (” CO “) also prescribes specific statutory rights of inspection to directors.
Shareholders may apply for inspection on showing both good faith and proper purpose
Contrastingly, shareholders do not have an inherent right to inspect company books and records. To gain access to company books and records, either five members or such number of member(s) holding 2.5% of the voting shares can apply for inspection under s 740 of the CO (” s 740 “).
Such an application will need to justify that it is made in good faith and for proper purpose. To establish good faith, the shareholder must have acted honestly in making the application. The predominant motive must not be idle curiosity, for harassment or blackmail, a wish to obtain information to benefit the company’s competitors, or any other improper motive that amounts to an abuse of process. As for “proper purpose”, the Court will consider whether the application was made for a proper purpose i.e. whether the applicant can show a sufficiently reasonable case “to investigate a genuine and credible belief [of] corporate mismanagement”. It is sufficient that the shareholder’s purpose is “germane to shareholder’s economic interest”, without proving a personal or proprietary interest in the matter.
Morning Ray – not exercising the directors’ right to inspect may prejudice an application under s 740
In Morning Ray, the plaintiff was a minority shareholder of the defendant company and had a representative director on the board of the defendant. The defendant was a holding company and the sole asset of which was a majority shareholding in a company listed on the Shenzhen Stock Exchange. The plaintiff alleged mismanagement of the defendant by the other two shareholders, including (i) the advancement of unauthorised loans to those shareholders, (ii) impropriety in dealing with dividends and proceeds of sale of company asset, and (iii) failure to produce audited financial statements. In order to investigate the complaints, the plaintiff sought disclosure of nearly all company documents for the past 9 years.
The Court rejected the application as the plaintiff failed to discharge the burden to the Court’s satisfaction to allow the inspection.
The central issue in Morning Ray was whether the application was for a proper purpose. The plaintiff neither explained why it had not included directors’ right to inspect in its application, nor demonstrated that its representative director had even made a meaningful attempt to exercise such right. The Court rejected the application based on such failures, in recognition of the division of responsibility under the CO and generally accepted principles of corporate governance. Under that framework, directors are responsible for monitoring the performance of a company and should take actions proactively. More practically, the Court felt it is more economical and direct to pursue a director’s application which is “far more straightforward” and also to include a shareholder’s application as the alternative cause of action.
In these circumstances, the Court found that it was not for a proper purpose to allow the plaintiff to avail itself of s 740 of the CO. The Court went further to opine that if the plaintiff had no representative director, the Court would have found that the plaintiff had established a proper purpose and the application was made in good faith.
In reaching this conclusion, the Court relied on Lehman & Co Management Limited v Effiscient Limited & Anor [2011] 4 HKLRD 237 (CFI); [2011] 5 HKLRD 668 (CA), in which the application for inspection arose in an unfair prejudice proceeding between Lehman & Co. Management Limited (” Lehman Management “) and Effiscient Limited (” Effiscient “), the two equal shareholders of LehmanBrown Ltd (” LehmanBrown “). LehmanBrown was part of the business venture by Lehman Management and Effiscient to provide professional services in China. However, the relationship between the two shareholders irretrievably broke down in 2008. Lehman Management complained of unilateral decision-making made by a nominee director of Effiscient, overpayment of salaries and failure to provide financial information. Effiscient in turn protested of mismanagement and misappropriation of LehmanBrown’s assets by Lehman Management. Lehman Management had been represented on the board of LehmanBrown until after commencement of the unfair prejudice proceeding. Lehman Management applied to inspect the books and records of LehmanBrown under s 152 FA of the old CO (the predecessor provision of s 740).
In dismissing the application, the CFI held that the assertion of proper purpose and good faith must be tested against the proper context of the application, the context being whether Lehman Management could have other recourse to protect its right. In that case, Lehman Management’s nominee director did not exercise its right to inspect when it was entitled to do so. Since an order of inspection in favour of a shareholder was likely an exception, if the shareholder had but failed to utilise other options or remedies open to him to protect his right, it could not be said that such an order was necessary. The CA dismissed Lehman Management’s appeal and affirmed the CFI’s view that a failure of a shareholder’s representative director to exercise the right to inspect was relevant in assessing if good faith or proper purpose had been shown.
Yung Siu Wa – directors subject to inevitable removal may lose their right to inspect
That being said, seeking to exercise the directors’ right to inspect is not without risks. Morning Ray noted that it is common for a director’s request for access to be countered by his removal, thereby stripping him of the right to inspect as demonstrated by Yung Siu Wa v Raffles Family Office Limited and Others [2018] HKCFI 2620.
The plaintiff in Yung Siu Wa was a minority shareholder and director of the first defendant company, a renowned multi-family office and independent asset manager. The first defendant wholly-owned the second to sixth defendant companies, of which the plaintiff was also a director. Two of the other three directors of the first defendant, who together owned the majority shareholding in the first defendant, proposed to repay a loan due to a company owned by them. The plaintiff considered the loan dubious and repeatedly requested to inspect company documents as a director, which were ignored by the defendants. In the meantime, the defendants sought to convene general meetings to remove the plaintiff as a director. This prompted the plaintiff to apply to court for an order of inspection in his capacity as a director.
The Court dismissed the application and held that it was not for a proper purpose of discharging directors’ duties. The Court found that, given the majority shareholding held by the opposing camp of directors in the first defendant, it was virtually certain that the plaintiff would be removed as a director of the defendants. The inference drawn from an application for inspection by a director against that context was that it was not for discharging directors’ duties, but was made predominantly to gain an advantage in anticipated proceedings, thus an improper purpose.
As suggested in Morning Ray, had the plaintiff also invoked s 740 as a shareholder in the alternate, it might improve the prospects of the application.
Key takeaways from Morning Ray and Yung Siu Wa
Morning Ray and Yung Siu Wa provided the following guidance to minority shareholders/directors contemplating to exercise their rights to inspect.
The sequence in which the rights should be exercised
The court will consider the availability of other recourse when assessing the merit of an s 740 application. To increase the chance of success, minority shareholders who are directors or have representative directors on the boards should first invoke their directors’ right to inspect.
When initial attempts to exercise the directors’ right to inspect are rejected and removal is anticipated, minority shareholders should consider formulating the application to court for inspection as primarily sought as directors (or representative directors) with an alternative application by the shareholders.
The scope of the requested documents
Finally, a director is more likely to be granted access to a wider scope of company documents than a shareholder, in line with the distinct purpose served by the respective right to inspect. A director can seek inspection of company documents that can reasonably assist him to carry out his director’s duties. On the contrary, a shareholder has to satisfy the court that the requested documents are necessary and relevant to the complaint or concern at hand.
In Morning Ray, the Court commented in passing that the plaintiff’s request was unnecessarily wide and that the request, if granted, would have been limited to the financial records of the company and documents relating to the alleged mismanagement.
Electing the appropriate timing and manner in which to exercise the right to inspect is crucial and this involves delicate strategic planning. Minority shareholders and directors should carefully strategise with their legal advisors.
