The recent decision of the High Court in Ninotre Investment Ltd v L & A International Holdings Ltd(1) is a further example of the court's statutory power to grant a qualifying shareholder access to and inspection of company records.(2) Section 740 of the Companies Ordinance (Cap 622) has become an established mechanism for aggrieved shareholders, with legitimate complaints in their capacity as shareholders, to obtain access to and inspection of company records.
The defendant is listed on the Growth Enterprise Market (the second bourse in Hong Kong). Its stated area of business, according to a 2016 annual report, is broadly:
- production and design; and
- the apparel retail industry.
In April 2016 the defendant acquired a 47.63% stake in a Delaware company, apparently specialising in online gaming software and platforms, for a consideration of approximately HK$596,700,000. In particular, the target was said to have developed a new online computer game.
As the court noted, "the investment quickly proved to be a mistake".(3) The new online game was suspended pending attempts to use it on mobile devices. This led to the investment not providing the anticipated returns on royalties or licensing. It appears that significant impairment losses had to be provided for in the financial statements for the year ending 31 March 2017 and the six months ending 30 September 2017.
The first plaintiff, Ninotre Investment Ltd, was a shareholder and investor in the defendant company. The second plaintiff (an individual) was also an investor and shareholder. They raised concerns that the decision of the board to approve the acquisition of the target had been negligent and resulted in considerable loss, while the defendant's board of directors had made a substantial investment in an area in respect of which it allegedly had no experience.
The plaintiffs applied for an order allowing inspection of documents, pursuant to Section 740, to investigate how the acquisition of the target had come about and whether the directors had observed their duties to the company. The plaintiffs asserted that a fall in the defendant company's share value of approximately 90% within weeks of the completion was connected to the acquisition.
In this case, the first plaintiff at one point owned more than the 2.5% threshold of shares in the defendant company – required under Section 740(6)(a) to be a qualifying shareholder. However, "as a result of dilution and sale of some of its holdings", the first plaintiff's interest subsequently dropped below 2.5%.(4) The second plaintiff then acquired further shares with the purpose of meeting the 2.5% threshold so that the application could be made.
In analysing the key considerations for an application pursuant to Section 740, the court referred to previous established legal principles.(5) To found jurisdiction under Section 740, the application must be made:
- on behalf of five or more shareholders or members representing 2.5% in value of voting rights;
- in good faith; and
- with respect to inspection for a proper purpose.
The court appears to have had little difficulty concluding that an investigation into the circumstances of the acquisition, given the losses and drop in share value, was a 'proper purpose' and that the application was in good faith.
It was noted that the "only issue which requires consideration" was whether acquiring shares with the specific purpose of meeting the threshold would somehow diminish the strength of the plaintiffs' application.(6)
In the court's deliberations, the first question to ask was whether the Section 740(6) qualifying shareholder threshold was satisfied. If that element were met and the application made for a proper purpose, then it did not matter that the first plaintiff was the driver of the application – nor was it bad faith on the part of the second plaintiff to acquire shares for the specific purpose of bringing an application. The court caveated this by noting that there may be instances where the acquisition of shares after the event is relevant to the court's assessment, but this would turn on the facts of the case.
The court therefore allowed the application, with necessary amendments to the terms of the order sought and permission for the parties to return to court for further guidance if need be.
The court appears to have dealt with the issue surrounding the qualifying threshold deftly. Tying back considerations on the threshold to the proper purpose gives clarity and highlights that it is the key element of Section 740. In this regard, if there are suspicions that an application is improper or not for genuine reasons, it would most likely be dealt with as part of the consideration of the purpose of the application and not the nature or method of acquiring the shares to meet the threshold. Linking these two issues together, therefore, and making one subordinate to the other draws the focus on the key element of proper purpose.
The outcome in the case is also encouraging with regard to minority shareholder protection and corporate governance generally. Had the decision been that the qualifying shareholder threshold is more rigid (ie, that the 2.5% should be sustained throughout a certain period or obtained before the event which formed the basis of the purpose of the Section 740 application), it may have had unintended and unfortunate consequences. Companies seeking to resist Section 740 applications might have then been tempted to take action to dilute the shareholdings of aggrieved shareholders. As a key driver of Section 740 is minority shareholder protection, it would seem odd if those close to the threshold ended up in a more precarious position than those easily satisfying the threshold.
For further information on this topic please contact David Smyth or Kingsley Krawczyk at RPC by telephone (+852 2216 7000) or email ([email protected] or [email protected]). The RPC website can be accessed at www.rpc.co.uk.
Endnotes
(1) [2018] HKCFI 2555, 14 November 2018. At the time of writing, no appeal has been lodged.
(2) For further reference please see "Shareholder 'activism' by access to company records", "Note to shareholders: avoid 'fishing'" and "Shareholder access to company records and documents".
(3) Supra note 1, at paragraph 5.
(4) Supra note 1, at paragraph 10.
(5) Artan Investments Ltd v The Bank of East Asia Ltd, HCMP 125/2015, 5 June 2015. Supra note 2. Also see Re China Oriental Group Co Ltd [2018] HKCFI 2066 (an unsuccessful application) and Re Raffles Family Office Ltd [2018] HKCFI 2620 (a director's application for inspection and copies of various company records, pursuant to Section 375 of the Companies Ordinance, and inspection under common law principles).
(6) Supra note 1, at paragraph 10.
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