Derivative Actions for Offshore Companies – Distinguishing Substance from Procedure

Eliot Simpson, Partner, Appleby Hong Kong

In Wong Ming Bun v Wang Ming Fan [2014] 1 HKLRD 1108 the Hong Kong Court of First Instance considered which law governs the question of standing to bring a derivative action.

Mr. Justice Peter Ng, in striking out the claim, decided that the ability to bring a derivative action in relation to a BVI company was a substantive matter of BVI law.

On the facts before the Court, this seems to have been a fairly inevitable conclusion. However, the reasoning raises questions that might arise for argument in other cases. These will be considered after a brief overview of derivative actions.

Derivative Actions at Common Law

A derivative action is one of a number of options open to a minority shareholder who complains about the management of a company, being a procedural mechanism to allow the minority to sue the management in the name of the company.

In order to bring a derivative action, a minority must first get around the rule in Foss v Harbottle (1843) 2 Hare 461, 491–92. That rule states, in short, that where a wrong has been done to a company, prima facie the only proper plaintiff is the company itself and an action by a shareholder claiming relief for the company is not available. There are however, certain exceptions (considered, by way of example, in Edwards v Halliwell [1950] 2 All ER 1064, 1067). The limited circumstances in which a shareholder may bring a derivative action are set out in the sections below.

Exception 1: Illegality or Ultra Vires Actions

An exception arises where those in control of the company (directors or majority shareholders) have caused the company to act in any way that is ultra vires or outside of the company’s legal capacity. Actions may be ultra vires if they are not authorised by the company’s memorandum or articles of association or if they do not comply with the statutory rules or regulations to which the company is subject.

Exception 2: Requirement for Majority

Any action which requires a special or “super” majority cannot be effected by a simple majority. In such a case, the minority shareholders may again bring a derivative action to reverse the illegal action.

Exception 3: Fraud on the Minority

This is widely considered to be the most important exception to the rule in Foss v Harbottle. The shareholder must first show fraud on the minority. Fraud in this sense has a wider scope than fraud at common law and will include acts taken by majority shareholders or directors which cause injury or injustice to the company or the minority shareholder.

Before a shareholder may bring a derivative action on behalf of the company, the shareholder must show: (i) the majority have obtained some benefit; (ii) the benefit has been obtained at the company’s expense or that some loss or detriment has been caused to the company; and (iii) the majority have used their controlling power to prevent an action being brought against them by the company.

Derivative Actions in Hong Kong in Relation to BVI Companies

In his claim, Wong Ming Bun sought to bring a derivative action in the Courts of Hong Kong on behalf of Creative China Limited, a company incorporated under the laws of BVI.

Creative China Limited’s main asset consisted of a substantial shareholding in China Flavors and Fragrances Co. Ltd, a company listed on the Hong Kong Stock Exchange. By his derivative action, the Plaintiff sought to rescind an agreement pursuant to which the shareholdings in the company were altered and to declare void, and cancel, the issue of new shares to the First and Third Defendants.

Three applications concerning the Plaintiff’s claim came before the Court in July 2013 including applications made by the Defendants to strike out of the Plaintiff’s Claim for want of locus standi. It was common ground between the parties that leave of the BVI Court had not been sought before the Plaintiff’s action had been commenced. The Defendants argued successfully that as a result, the Plaintiff did not have locus standi to pursue the case on behalf of the BVI Company.

The Hong Kong Companies Ordinance (Cap. 622) provides in s. 733 for leave to be obtained for derivative actions to be brought before the Hong Kong Courts in relation to both Hong Kong companies and certain companies incorporated elsewhere. It was noted in Wong Ming Bun that the action was not a statutory action under (the then equivalent) s.168BC of Hong Kong’s Companies Ordinance (Cap. 32).

Mr. Justice Peter Ng quoted the following passage from Graeme Johnston, The Conflict of Laws in Hong Kong (2nd ed., 2012), at p. 592:

The ability to bring a derivative action in Hong Kong is a matter for the law of the place of incorporation of the company, though it is also necessary to comply with Hong Kong procedural requirements for the bringing of such actions.

This passage, which was applied by the Court, raises the question of which rules are procedural and which, conversely, are substantive. The Court applied the following passage (concerning the exceptions to the rule in Foss v Harbottle) from the judgment of Lawrence Collins J in Konamaneni v Rolls Royce Industrial Power (India) Ltd [2002] 1 WLR 1269, cited in East Asia Satellite Television (Holdings) Ltd v New Cotai LLC [2011] 3 HKLRD 734:

Although for purely English domestic purposes, the exceptions to the rule have been regarded as a procedural device, I do not consider that in the international context their real nature is procedural.

The Judge therefore looked at what was required under BVI law to bring such an action.

In BVI, statutory provisions on derivative actions have been enacted in ss. 184C to 184F of the BVI Business Companies Act, 2004.

Section 184C(1) of the Act provides that the BVI Court may, on the application of a member of a BVI company, grant leave to bring proceedings in the name and on behalf of that company or to intervene in proceedings to which the company is a party for the purpose of continuing, defending or discontinuing the proceedings on behalf of the company.

The requirement to obtain leave operates as a gateway, to prevent unnecessary or unmeritorious actions from being brought. As such, there are a number of factors set out in s. 184C(2) which will be considered by the BVI Court before leave will be granted, including, for example, whether the derivative action is in the interests of the company, whether the proceedings are likely to succeed and whether an alternative remedy to the derivative claim is available.

Section 184C(6) provides that except as provided by the Act, a member cannot bring or intervene in any proceedings in the name of or on behalf of a company.

In Nigel Gray v Allan Leddra and Pro-Flex Packaging Co. Ltd BVI HC (COM) 79/2011, Mr. Justice Bannister QC in the BVI Commercial Court held that it was an abuse of the process to purport to bring derivative proceedings without the permission of the Court first being obtained and struck out those parts of the claim which were brought derivatively.

Mr. Justice Peter Ng held in Wong Ming Bun that the ability to bring a derivative action in Hong Kong was a matter for the law of the place of incorporation of the company, though it was also necessary to comply with Hong Kong procedural requirements. As the Plaintiff had failed to obtain the necessary leave under BVI law, the applications to strike out the Statement of Claim on the ground of locus standi succeeded.

Mr. Justice Peter Ng doubted whether the Hong Kong court could substitute for the BVI court in granting leave, stating that “no authority has been shown to this Court in support of the proposition that such retrospective leave, even if permissible under BVI law, could be obtained, not from the BVI Court, but from a Hong Kong court….” (Wong Ming Bun, para. 44) As a matter of BVI law, it probably could not, as s. 184C uses the capitalised expression “the Court” which is defined in the Act to mean the (BVI) High Court.

Whilst s. 184C has been described as a codification of the rights of members of a BVI company to bring a derivative action, this description should be treated carefully. There can be no doubt that the requirements of s. 184C are in addition to, and not instead of, the need to establish one of the exceptions to the rule in Foss v Harbottle.

It is also important to note that ss. 184D to 184F give powers to the Court to make further orders during the course of derivative actions. These include, by way of example, the power to make “an order giving directions for the conduct of the proceedings” (s. 184E(b)). One open question that remains is if the Hong Kong court must defer to the BVI court on the issue of leave under s. 184C, must it also defer on issues of the conduct of proceedings under s. 184E?

Derivative Actions in respect of Bermuda and Cayman Islands Companies

In contrast with BVI, the Bermuda Companies Act 1981 does not provide any statutory framework for derivative actions. They may therefore be brought as a matter of common law, applying the principles developed in the English decisions cited above.

It follows that, so far as Bermuda law is concerned, there would be no bar to a member of a Bermuda company bringing a derivative action in the name of a Bermuda company (and without the need to obtain leave or permission from the Bermuda court) in the courts of Hong Kong, or elsewhere. Whether this would be possible under Hong Kong law would presumably depend upon whether the company was caught by the statutory requirement for leave in s. 733 of the Companies Ordinance.

Turning to the Cayman Islands, there are no provisions in the Companies Law on derivative actions.

However, in the Cayman Islands, where a defendant to such an action gives notice of intention to defend, the plaintiff must apply to the court for leave to continue the action and must submit an affidavit verifying the acts on which the claim and the entitlement to sue on behalf of the company are based. This is required under O. 15, r. 12A of the Cayman Islands Grand Court Rules, 1995 (derived from an equivalent rule in the former English Rules of the Supreme Court).

At the hearing of an application for leave, the Cayman Court may, in addition to granting leave for the action to continue, or alternatively dismissing it, adjourn the application for hearing at a later date with such directions as the court may consider expedient.

Under O. 15, r. 12A(12) if there is a material change in circumstances after the Court has given leave to continue the action, a defendant can apply to the Court requiring the Plaintiff to show cause why the Court should not dismiss the action or any claim made in it by way of derivative action.

The Grand Court Rules apply to proceedings brought before the Cayman Islands Grand Court and are broadly procedural in nature, but echoing Lawrence Collins J, is the real nature of the requirement in O. 15, r. 12A (to obtain leave) procedural in the international context? It could no doubt be argued that they should be treated no differently from the BVI provisions. That approach would appear to mean that the Defendant could go back to the Grand Court under O. 15 r. 12A(12) during the course of foreign (Hong Kong) proceedings to re-try the question whether the action should continue in the event of a change of circumstances.

Conclusion

The decision in Wong Ming Bun may be unsurprising in light of the clear terms of s. 184C of the BVI Business Companies Act, 2004 and is consistent with a similar finding in Microsoft Corp v Vadem Ltd, C.A. No. 6940-VCP (Del. Ch. Apr. 27, 2012) (a Delaware decision). There might however still be scope to argue, in a derivative action involving a Cayman company if not a BVI company, that provisions requiring leave are procedural in nature. This does not seem to be at odds with the comments of Lawrence Collins J. His comments, about the substantive nature of the rules on derivative actions, were dealing with the exceptions to the rule in Foss v Harbottle (rather than the requirement for leave).

For BVI companies, the safer course in these sorts of cases is probably to try to obtain leave first in BVI.

For Cayman companies, this may not be possible. Order 15, r. 12A applies to an action begun by writ in which a defendant has given notice of intention to defend. It plainly contemplates this to be an action in the Grand Court. An application for leave might not be possible where the proceeding has been issued in an overseas court.

In all of these cases, it will be appropriate to weigh the pros and cons of issuing the claims in the courts of the jurisdiction of incorporation. That approach would avoid the difficult conflicts of laws issues that arise, although the enforcement of any judgment may take longer if the defendant has no assets in that jurisdiction.

Jurisdictions: