This paper is a response to the First Phase Companies Ordinance Rewrite Consultation Paper Question 7 whether we should abolish the common law derivative action (the CDA) currently retained by sec. 168BC (4) in the amended Companies Ordinance (2004).
This paper firstly briefly introduces the current co-existence of the common law derivative action and the statutory derivative action (the SDA) and figure out potential problems which lead us to think about whether we should abolish the CDA.
The main part of this paper discusses five arguable aspects from both the con sides and the pro sides of whether abolishing the CDA. This paper discusses the CCASS system which disables many shareholders to use the SDA; the rights of minority shareholders of offshore companies who cannot use the SDA; the international context regarding the CDA in many other common law jurisdictions; the potential confusions and complications with and without the co-existence and some pitfalls of the CDA which are minor and can be ignored.
On the discussion of the above five aspects, the authors find that the CDA overrides the SDA in respect of each issue at the current time in Hong Kong, therefore this paper reaches a conclusion that Hong Kong should preserve the CDA at the current stage.
Upon the disagreement of the abolishment of the CDA, the authors also provide some further recommendations to help improve the current situations regarding the co-existence of the CDA and the SDA.
TABLE OF CONTENTS
Table of Contents3
1. Introduction5 1.1 The Facts of Foss v Harbottle Case5 1.2 The Rules of Foss v Harbottle Case5 1.3 The Common Law Derivative Action6 1.4 The Drawbacks of the Common Law Derivative Action7 1.5 Introduction of SDA into Companies Ordinance7 1.6 Problems of the Co-existence of the CDA and the SDA8
2. Five Aspects Regarding the Co-existence of CDA and SDA9 2.1 The CCASS System9 2.2 Members of Offshore Companies11 2.3 The International Context of Derivative Action13 2.4 Confusions and Complications Arisen without CDA15 2.4.1 General Discussion16 2.4.2 The MDA May Not Continue to Work17 2.5 Other Drawbacks of the CDA Can be Ignored at the Current Stage18
3. Hong Kong Should Preserve the CDA19
4. Further Recommendations20 4.1 Slight Amend sec. 16820 4.1.1 Extend the Scope of Qualified Plaintiff of the SDA20 4.1.2 Only Keep the CDA for Shareholders of Offshore Companies20 4.2 Require Offshore Companies to Accept Hong Kong Statue20 4.3 Similar Legal System in the Region20
Before we discuss whether we should abolish or preserve the common law derivative action in Hong Kong, we would like to briefly introduce the background of the leading case (Foss v Harbottle) which established the principles of the common law derivative action as well as the pitfalls of it. Then we will mention the statutory derivative action which was the statutory regime introduced to deal with these pitfalls of the common law derivative action. At last we present the problems faced by the co-existence of these two derivative actions which lead to this paper’s main topic whether we should abolish or preserve the common law derivative action.
1.1 The Facts of Foss v Harbottle Case
Victorian Park Company was set up to develop parks and gardens. Harbottle was one of the eight promoters of this company. Foss was one shareholder, who brought a law suit alleging that the promoters sold a land to the company at a very high price. But Harbottle argued that Foss, the plaintiff, could not represent the Company to sue the promoters.
1.2 The Rules of Foss v Harbottle Case
The judges in Foss v Harbottle held that the courts should not interfere in the internal management of companies. Because the company is a separate legal entity, if something wrong is done to the company, only the company itself can sue and that is the so called Proper Plaintiff Rule.
The effect of this rule is to eliminate vexatious litigation by troublesome minority shareholders. However, the rule was also criticized by many researchers. If the directors of the company do something wrong, they will of course not have the incentive to make the company bring law suits against themselves. Therefore the minority shareholders cannot have the rights to get the wrongdoers to pay remedies to the company and it is to some extent unfair.
Due to this reason, later, four exceptions to the rule were established to try to solve this problem. It is held that the Proper Plaintiff Rule will not apply if the relevant transaction • λis ultra vires or illegal;
• λrequires the sanction of a special majority; • λinfringes the personal rights of a shareholder; or • λamounts to a fraud on the minority.
1.3 The Common Law Derivative Action
The exceptions to the Proper Plaintiff Rule in Foss v Harbottle allow the minority shareholders under some limited conditions to sue on behalf of the company. The common law derivative action (the CDA) is applied based on these exceptions. There are two basic requirements for applying the CDA: • The alleged wrong or breach of duty cannot be ratified by a simple majority of the members; • The alleged wrongdoers are in control of the company, so that the company cannot sue by itself.
1.4 The Drawbacks of the Common Law Derivative Action
Although the exceptions to rules in Foss v Harbottle open a door for the shareholders to take derivative actions, there are still some drawbacks in the CDA which make it not so effective to protect the rights of the minority shareholders.
Just like the Australian Senate Standing Committee stated in its Report: Despite a recent tendency towards relaxation, the narrow rules of standing make it difficult for a shareholder to take legal action.
There are some obstacles that confront shareholders in bringing litigation in CDA. These obstacles include: • λThere are some defects in exceptions to the rule in Foss v Harbottle; • λThe expense of litigation is very high;
• λIt is very difficult for shareholders to obtain information from the company. These drawbacks will be discussed more detailed in later part of this paper.
1.5 Introduction of SDA into Companies Ordinance
Because the CDA have the above pitfalls and cannot adequately protect the rights of the minority shareholders, the SDA was introduced in many common law jurisdictions. For example, SDA was introduced to Singapore and New Zealand in 1993 and Australia in 2001.
In Hong Kong, SDA was also written into Companies Ordinance in 2005. Unlike CDA, the court will consider the good faith of the shareholders and the best interests of the company instead of those exceptions to the rule in Foss v Harbottle. In addition, the ratification by a general meeting will not stop the derivative proceedings which mean the hurdle to apply the SDA is relatively lower than that of the CDA. 1.6 Problems of the Co-existence of the CDA and the SDA
Many jurisdictions abolished the CDA after introducing the SDA, for example, Australia, Canada, New Zealand and the UK. But Hong Kong currently preserves the CDA. The co-existence of the CDA and the SDA may cause some problems such as confusions and complications and this was concerned by the Court of Final Appeal in Waddington case in 2008. This directly leads to the Question 7 in the Consultation Paper. In the following session the authors will discuss the potential problems caused by the co-existence and rationally prove that indeed these potential problems should not be the reasons to deprive the shareholders of the rights to apply the CDA in Hong Kong because these potential problems are overridden by the benefits brought by the CDA.
2. Five Aspects Regarding the Co-existence of CDA and SDA
In this part the authors will focus on five aspects regarding whether or not abolishing the CDA. In each aspect the authors will compare and analyze both the reasons to abolish and preserve the CDA and rationally prove that the CDA should not be abolished in respect of all the five aspects.
2.1 The CCASS System
Under Section 168BC (Members may bring or intervene in proceedings) (1) of Companies Ordinance, it states clearly that only members of a company can bring a SDA on behalf of company. However, there is no clear requirement whether the plaintiff has to be a member in order to bring a CDA, and the judge is granted discretion to decide. Therefore those shareholders who are not members can still bring a lawsuit on behalf of the company under the CDA.
Hong Kong at the current stage still uses the CCASS system for the stock exchange under which the vast majority of shares owned by the public are not held by themselves, but actually held in nominee account which means those shareholders indeed are not registered to be the members of a company even they invest their money and buy shares of that company.
Therefore they are not qualified to apply the SDA under sec.168BC (1). Moreover the nominees who are often huge financial institutions and are custodians of huge numbers of shares from a lot of shareholders may not have the incentive to bring the lawsuit for some minority shareholders. Further even one shareholder wants to suit the directors on behalf of the company other directors may not want to do this therefore the nominee may not be authorized to take derivative actions just because one shareholder’s requirement.
Then the shareholder may have to withdraw the shares and again deposit them into the CCASS System which is very troublesome in practice and is a waste of money and time. The lag of time is a major concern because it is a great obstacle for the shareholders to take timely action. What is even worse, it is often the case that when the shareholders have the incentive to take such actions the company is already in a difficult financial position and the SFC may block the transaction and register of the shares of the company. Hence the shareholders once withdraw the shares he or she may not be able to deposit them again since the block set up by the SFC.
Therefore it is almost very unlikely for a minority shareholder who is not a member of the company to take the statutory derivative action against the directors under the current version of amended Companies Ordinance (2004) and the practical CCASS System.
However as stated above the CDA does not strictly require that only members can be qualified to apply. Therefore CDA is a much more feasible proceeding for Hong Kong shareholders than the SDA and actually CDA is almost the only feasible way for the minority shareholders of the listed company to take action (Non-listed companies and private companies do not use the CCASS System to exchange shares). Indeed we observe that from July 15, 2005 when the SDA came into effect most cases applying the SDA are related to private companies which support the opinion the CDA is still very important for shareholders of listed companies.
Upon the above discussion the authors reach the conclusion that since the shares of the listed companies are exchanged using the CCASS System and the current SDA is only applicable to members, Hong Kong now should still preserve the CDA.
2.2 Members of Offshore Companies
As will be discussed later in this paper, one of the most important reasons to keep CDA is that it protects the Hong Kong shareholders of companies which are registered outside Hong Kong but have no places of business in Hong Kong in essence offshore companies. However, many people think this is not an effective protection because the procedure is too complicated that it is highly unlikely for small shareholders to take such an action. The right to perform CDA is theoretically feasible but is highly unlikely in reality. Following flow chart shows simply how a shareholder of an oversea company could take action: [pic]
First he should go to the Hong Kong court, ideally, get the order. Then the order will be taken to register at a court in Singapore. If that court allows enforcing the Hong Kong order, then they issue another order to enforce it on the company. This might not be the end of the story; the remedy is given to the company, so it is subject to the company’s management’s decision whether to distribute it to the shareholders or not. Again this decision will be made by those directors who are sued in the case and they may not be willing to do so. Therefore this CDA is unlikely to be taken by small shareholders to spend huge cost in exchange of the remedy or no remedy at all.
However this cannot constitute the reason to simply abolish the CDA. The CDA is difficult to apply however it is the only way for those shareholders of the offshore companies to protect their rights. To illustrate this section 2 of the Companies Ordinance is reproduced here “Specified Corporation” means a Hong Kong company or a non-Hong Kong company. (Added 30 of 2004 s.2) and s168 BC (1) only allows the members of specified corporations to take SDA.
As mentioned above, there are a large number of companies (Around 80% according to the HKEX) incorporated outside Hong Kong but with Hong Kong shareholders. It can be inferred that amongst those huge number of companies many have no place of business in Hong Kong, which are neither Hong Kong companies nor non-Hong Kong companies within the definition of "specified corporation". Therefore these offshore companies do not qualify under sec.2 hence sec.168 BC (1) cannot apply. Analyzing sec.2 and sec. 168 it is established that shareholders of offshore companies can only apply the CDA because the CDA does not have similar restrictions.
The CDA is the only way to help minority shareholders in overseas company therefore Hong Kong should preserve the CDA.
The authors recognize that the CDA has high huddle to prove, high costs to incur and complex procedure to apply. However shareholders of offshore companies can only use CDA and we should not deprive the right to use CDA just because that it is complex to use. That is not the purpose of legislation and the spirit of law to develop a fair society.
After all, complexity to get the remedies is much better than no way to get the remedies. The CDA can preserve the ability of the members of foreign companies to bring a derivative action in Hong Kong. The rights of these Hong Kong shareholders of such offshore companies to bring a CDA as one more option to defend their own interest may be deprived once CDA is abolished, thus CDA cannot be enforceable in the courts of Hong Kong in any events which is not fair to them.
Moreover the existence of CDA also provides a deterrent force to proposed offenders such as offshore companies’ directors seeking for self-interest. 2.3 The International Context of Derivative Action
The judgment given by Ribeiro PJ in the Waddington case might be the most direct fuse for this issue (para. 32): "The co-existence of both the statutory and common law regimes is unusual in an international context and is a source of confusion and complication. It would appear to be appropriate for the statutory regime to replace the common law derivative action altogether. This question deserves to be addressed by the Administration and the Legislature as soon as possible." He addressed that the co-existence is unusual and might raise confusion. This concern is further addressed in the consultation paper. The discussion here then will start with these points in 2.3 as well as 2.4 and expand to the inherent weaknesses with CDA in 2.5.
As is mentioned by Ribeiro and the consultation paper, it is unusual in an international context for both the SDA and the CDA to co-exist. So that practices in other jurisdictions where common law applies are reviewed as a reference. Actually, in contrast to Hong Kong, many jurisdictions replaced the CDA after the introduction of SDA.  [pic]
Take New Zealand as an example, in its s 165(6) Company Act 1993, it regulates: Except as provided in this section (this section refers to section 165 which deals with statutory derivative action), a shareholder is not entitled to bring or intervene in any proceedings in the name of, or on behalf of, a company or a related company. Apparently, the CDA is excluded.
However the authors further notice that all above countries are representative ones in terms of developed western countries. The fact that many common law jurisdictions abolish CDA cannot prove the reasonableness of the abolition. This just represents what the situation is in western countries but not represent what we should do in Hong Kong. We should notice that HK has very different economic and political environment as those western jurisdictions and cannot just copy what they do. Thus people cannot suppose this of great value of reference for Hong Kong.
Therefore Singapore and Malaysia may be of much more value when considering whether or not abolishing the CDA after introducing the SDA. These three common law jurisdictions have many similarities. All these three are in the Southeast Asia whose economy took off during 1970s and then the structure of the society changed and attention are more focused on developing financial centre and attract more foreign direct investment. Foreign companies are welcomed to be listed in the stock exchanges and local residents get involved in these financial transactions.
The economy in these three jurisdictions is now facing similar pressure and the protection of minority shareholders’ is of great importance in order to make the public confident in the financial markets and the economy. Similar stock exchanges, similar financial positions and similar fiscal policies make it valuable to consider what Singapore and Malaysia does in terms of the derivative action when consider the legislation in Hong Kong.
Both Singapore and Malaysia preserves CDA after introduction of SDA.
Take Singapore as an example it adopted the SDA in its Companies Bills sec. 216 A and sec. 216 B in 1993 however it still keeps the CDA and only regards the SDA as an addition to the CDA to make the sets of derivative actions complete.
Different jurisdictions should consider their own specific situations and only refer to other jurisdictions of the same economy and political situations to establish or revise for the most effective legal system. Regarding to Singapore and Malaysia, as well as the unique situations of Hong Kong to build an international financial centre, the CDA should be preserved at this stage to make sure each investor can be granted sufficient right to protect their investment and make sure that Hong Kong has healthy financial markets and regulated companies’ behaviors.
2.4 Confusions and Complications Arisen without CDA
The second claim made by the CFA in Waddington case is that the co-existence of the SDA and the CDA is a source of confusions and complications. The as was addressed in the Consultation Paper in 2003, the CDA and the SDA differ not only in terms of form, but also in substantive issues. Under SDA, a member could, with leave of court, take the company to the court. According to s168BC (3), grant of leave requires: the action appears prima facie in the interest of the company; a serious question to be tried; the company is actually not acting; and there is a written notice.
On the other hand, under CDA, the exceptions to the Foss rule must be proved. Where ultra vires acts, special resolution, infringement of rights, fraud on minority must be proved and satisfied. In addition, the effects of ratification by the board of directors also differ. The most confused part might be that the company is the plaintiff under SDA whilst a defendant under CDA.
Some scholar mentioned in his work that: The retention of common law may even create the uncertainty and confusion as to what constitutes the lex fori.
Recall that in New Zealand, the CDA is abolished. B.Matthew argued that one of the intentions is to avoid confusion which was raised in an early Canadian case Rogers v Bank of Montreal.: To avoid the uncertainty of whether a derivative action may be brought under the oppression remedy as well as via the statutory leave procedure, and whether the statutory leave requirement acts to the exclusion of actions under one of the exceptions to Foss v Harbottle.
However the authors do not regard the above confusions will be sufficient reasons to abolish the CDA. The following are the arguments of some general discussions.
2.4.1 General Discussions
The co-existence arrangement of the CDA and the SDA has been in place for about 5 years since July 2005, it has not caused any major legal problems. It has never been a source of confusion and complication.
Besides, Section 168BC (4) states that the SDA provisions “shall not affect any common law right of a member of a specified corporation to bring proceedings on behalf of the specified corporation”. In other words, unlike the law in other jurisdictions which abolishes the CDA, the Bill allows the co-existence of the CDA and SDA. This has been done because Hong Kong is unique in the sense that there are a large number of companies incorporated outside Hong Kong, but with Hong Kong shareholders. And there are also safeguards in the Company Ordinance to prevent duplicative CDA and SDA under section 168BE and section 168BC (5) which are reproduced as following.
Section 168BE: Where leave has been granted to a member of a specified corporation under section 168BC(3) and the member, in the exercise of any common law right, subsequently brings proceedings on behalf of the specified corporation in respect of the same cause or matter, or subsequently intervenes in the proceedings in question to which the specified corporation is a party, the court may— (a) order to be struck out or amended any pleading or the indorsement of any writ in the proceedings brought under the common law, or the intervention under the common law, or anything in such pleading or indorsement; and (b) order the proceedings brought under the common law, or the intervention under the common law, to be stayed or dismissed or judgment to be entered accordingly.
Section 168BC (5): The court may dismiss an application for leave under subsection (3) if the applicant has, in the exercise of any common law right.
This shows that in 2004 when amending the Companies Ordinance, the legislator had expressed concern over this problem and tried to avoid confusion.
Thirdly, no such confusions regarding which derivative action to use will actually arises because members of private and non listed companies will of course choose the SDA since it is much more convenient and those shareholders of listed companies and offshore companies will of course choose the CDA since they cannot use the SDA therefore we do not see much possibility of confusions arising because of the co-existence.
Therefore we should preserve the CDA.
2.4.2 The MDA Currently we can take multiple derivative actions (MDA) only under CDA as affirmed by the decision made by Court of Final Appeal in Waddington Ltd v Thomas Chan Chun Hoo. Waddington case introduced a very important way for minority shareholders of the associate to sue the directors of the specific corporation however that case is based on CDA. Although in response to the comments made by the Court of Final Appeal in that case, the extension of SDA to cover MDA has been considered by Standing Committee on Company Law Reform (SCCLR) recently, it has not been really passed yet now.
Once we abolish CDA which is the legal basis of MDA Waddington will not longer apply and MDA may come to an end. Therefore that will become a source of confusions as people may wonder whether MDA can be used without the CDA. Therefore the rights of concerned person have to be safeguarded before the legislation of MDA. It is therefore safer to preserve CDA at this stage to protect the rights under the MDA and avoid confusions.
2.5 Other Drawbacks of the CDA Can be Ignored at the Current Stage
Now comes the inherent weaknesses and drawbacks with CDA which can actually be ignored.
First, the Foss rule is complicated and instable. Someone even call the Foss rule the deepest mystery of company law. – The rule is obscure and outdated. Much of the cases were decided years ago and it’s hard to reconcile all those decided cases. – As Parlie Choo mentioned in his work what exactly amounted to a fraud on the minority has been conflicting and difficult.  – The importance and extent of ratification was unclear
– And also, the court seems unwilling to get involved with the internal management of companies.  Some exemptions are actually hard to be satisfied constitute the second weakness of CDA. Exemptions must be proved under CDA, failing to do so the plaintiff failed the trial. Fraud on minority might be the most representative one. The court will collect shareholders’ opinions as to decide whether fraud exists. In cases where the wrongdoer is also the controlling shareholder, this is extremely difficult to prove. So injustice exists when the wrongdoer got the majority control. The problem is most severe with listed public companies. Thus, CDA easily fails to protect the small shareholders effectively which means it fails the initial purpose of derivative action.
Last but not least, in most cases, the costs of the proceedings must be borne by the individual or minority shareholder who commences the action. As we recall from previous, the degree of evidence differs under each scenario. And we make the assumption that the more evidence to be collected the higher cost. Under SDA, the hurdle is actually low and the company may take over the case as well as the cost. However under CDA, the exceptions are very strict requirements and the shareholder is responsible for the case from the beginning to the end. As Dr Y.C. Choong said, under CDA cost can be crippling as they have to show that he has the locus standi (the right) to sue in a preliminary hearing.
However as we say above those people can choose the SDA for easy legal proceedings but those people who cannot use the SDA have to use the CDA. And we should not deprive their rights just because that the CDA is relatively complex. Therefore these issues can be regarded as minor issues and should be ignored at the current stage since the Companies Ordinance has not been perfect.
3. Preserve the Common Law Derivative Action in Hong Kong On the balance of the above five issues the authors think that we should preserve the CDA in Hong Kong at the current stage. 4. Further Recommendations 4.1 Slight amend the Companies Ordinance
4.1.1 Option1 Abolish the CDA for specified corporations since the shareholders of those companies can use the SDA. Keep the CDA for offshore companies. Furthermore the MDA should be recognized by the Companies Ordinance and base it on the SDA.
4.1.1 Option2 Extend the SDA to overseas companies and abolish the CDA. "any person who, to the satisfaction of the court, has an interest in the relief claimed in the proceedings, whether legal or equitable". Furthermore the MDA should be recognized by the Companies Ordinance and base it on the SDA.
4.2 Regulate the offshore companies Hong Kong may amend the Listing Rules to require the offshore companies to sign to accept the regulation of Hong Kong Statue therefore the minority shareholders may be able to sue under the SDA. However even that is the situation the directors may not have the assets in Hong Kong and remedy is still hard to get in practice. Therefore we have the third suggestion which is a similar legal system in the Region
4.3 Similar law system in the Region Once the law in different jurisdictions becomes much more similar offshore companies are of course regulated and minority shareholders’ rights are well protected because similar legal system in the Region can enhance the cooperation between Hong Kong and neighbor jurisdictions in terms of executing the statue and order granted by the court. Or maybe even better the similar legal system will make Hong Kong court judgments have binding effect on the offshore companies and then in practice the remedy can be got much easily than the current CDA model.
In this paper we response to the Question 7 of the consultation paper and our answer is we should preserve the CDA currently.
We consider five aspects and rationally prove that the CDA should be preserved in respect of each aspect.
Although the authors prefer to preserve the CDA, further suggestions are also provided for future improvement of some current practical weaknesses in terms of derivative action in Hong Kong.
References The statutory derivative action: now showing near you, Paul von Nessen S.H. Goo Chee Keong Low, 2008, Journal of Business Law
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