BUSINESS

ASSOCIATIONS
(TUTORIAL)
PANGYUE CHENG
FACULTY OF LAW
THE UNIVERSITY OF HONG KONG
 T4
CAPITAL MAINTENANCE &
DIRECTORS
QUESTION 1

The Company presently has an issued share capital of HK$5,000,000 divided into
100 shares. The present market value of the total shares is HK$15,000,000, the
same amount as the “shareholders’ funds” (i.e. paid up share capital and reserves)
in the most recent audited accounts of the Company.
Since the last round of injection of funds, Lucy has been increasingly in
disagreement with Bianca over the management of the Company. In particular,
Lucy always exercised her vote against major board decisions resulting in the
Company’s operations coming to a standstill. To resolve the issue, Bianca
proposes to buy out Lucy’s entire shareholding in the Company and Lucy is
happy to be bought out but is only willing to sell her shares at market price. 2
QUESTION 1

Share value
What is the initial subscription price per share?
 Initial subscription price per share=issued shared capital ÷ number of shares
(HK$50,000 per share)
What is the current market value per share? 15,000,000/100

 Current market value per share= total market value ÷ number of shares (HK$
150,000 per share)
What is the total value of Lucy’s 25 shares?
3
 Lucy’s shares (25 shares) = HK$3.75 million
QUESTION 1

Unfortunately, Bianca does not have sufficient funds to purchase Lucy’s

shares and needs to borrow from her banker for one-third of the purchase
price. Bianca’s banker is only prepared to lend her that amount if the
Company were to guarantee repayment of the loan. Sophie, in principle, is
not against the idea as she would also like to see Lucy leave the Company.

4
QUESTION 1

Financing the Buyout

How much will Bianca borrow from the bank?
 1/3× HK$3.75 million = HK$1.25 million
If the bank will only lend on the condition that the company guarantees the loan, does this
arrangement raise any company law concerns?
 Provision of guarantee is a form of financial assistance (S274(1) CO).The proposed
giving of guarantee by the Company for the loan to Bianca would amount to the
Company giving financial assistance for the purpose of the acquisition of its own
shares which is prohibited under s 275(1) CO. 5
QUESTION 1

What’s the consequences of an unauthorised giving of financial assistance for acquisition of

own shares?
Is the guarantee valid?
 Criminal offence (s275(4) CO)
 The validity of the contract is not affected (s276 CO)
Are there any exceptions to the company providing financial assistance?
 Principal Purpose Exception(s278 CO)
 If the principal purpose is not to give the financial assistance for the purchase of shares; or
 If the giving of the financial assistance is only an incidental part of some larger purpose; and
 In both cases, the assistance is given in good faith in the interests of the company 6
QUESTION 1

Could it be said that the larger purpose of the provision of financial assistance is to prevent the
Company’s operations from coming to a standstill?
 Following Brady v Brady, the “purpose” of the transaction must be distinguished from
its commercial motive. Although the transaction aims to resolve a deadlock, its legal
purpose is to facilitate Bianca’s acquisition of shares, and thus the principal purpose
exception is unlikely to apply.
 A “larger purpose” must be a separate and wider transaction of which the financial
assistance is only incidental, not merely a more important or desirable objective.
7
QUESTION 1

How can the company lawfully whitewash the financial assistance?

 1. approving the financial assistance when less than 5% of shareholder’s funds is used
(s283 CO)
 2. approving the financial assistance by unanimous consent (s284 CO)
 3. approving the financial assistance by ordinary resolution (s285 CO)

8
QUESTION 1

“Whitewash” procedures
1. Method 1: less than 5% of shareholder’s funds (s283 CO)
What must the directors approve and confirm before the company can give financial assistance?
 Board resolution
 Company should give the assistance
 Giving of assistance is in the best interests of the company
 Terms of conditions of the assistance are fair and reasonable to the company
 Solvency statement by directors who voted in favour of resolution
Can the company whitewash the transaction in this way?
 The amount of proposed financial assistance (HK$1.25m) is more than 5% (HK$750,000) of 9
shareholders’ funds so this would not work
QUESTION 1
“Whitewash” procedures
2. Method 2: unanimous consent (s284 CO)
What are the requirements for both the directors and the members?
 Board resolution
 Company should give the assistance
 Giving of assistance is in the best interests of the company
 Terms of conditions of the assistance are fair and reasonable to the company
 Solvency statement by directors who voted in favour of resolution
 Written resolution of all members
Can the company whitewash the transaction in this way?
 Bianca is likely to approve and so is Lucy (as she would like to exit) and this would depend 10

on whether Sophie would approve the guarantee

QUESTION 1
“Whitewash” procedures
3. Method 3: ordinary resolution (s285 CO)
What are the requirements for both the directors and the members?
 Board resolution
 Company should give the assistance
 Giving of assistance is in the best interests of the company and is of benefit to those
members not receiving the assistance
 Terms of conditions of the assistance are fair and reasonable to the company and to those
members not receiving the assistance
 Solvency statement by directors who voted in favour of resolution
11

 Ordinary resolution by members

QUESTION 1
For the third method, if Bianca and Lucy vote in favor, the ordinary resolution will pass.
However, what can Sophie do if she dissents?
 As Sophie holds more than 5% of the total voting rights, she may apply to the court for a
restraining order under s286 CO on the grounds that:
 (a) the giving of the assistance is neither
 (i) in the best interests of the company; nor
 (ii) of benefit to those members of the company not receiving the assistance. i.e. herself; or

 (b) the terms and conditions under which the assistance is to be given are not fair and
reasonable to
 (i) the company; and
12

 (ii) those members not receiving the assistance, i.e. herself.

QUESTION 2(A)
Belinda – 55%
Peter– 35%
Freddie (Belinda’s brother) – 10%
All the three shareholders also serve as directors of the Company. The Company has
adopted the Model Articles without amendment, and the shareholders did not enter
into any shareholders’ agreement.
In recent years, Belinda and Peter had a significant disagreement regarding the
Company’s business strategies. There were rumours that Peter was planning to start his
own business elsewhere but Belinda did not have any [Link] times, Peter did not
turn up for work or attend directors’ meetings. Despite Belinda’s requests, Peter
refused to resign from his directorship.
Belinda would like to appoint her daughter, Susan, to replace Peter as a director and she13
comes to you for advice as to how this could be effected.
QUESTION 2(A)

Removal of a director
How can a company remove a director?
 Under s462 CO, the Company may remove a director by ordinary resolution at a
general meeting (not by written resolution) despite anything in Company’s articles
and any agreement between the Company and Peter.
 Belinda and Freddie together hold 65% of the voting rights in the Company. At a
general meeting, Belinda and Freddie would be able to pass an ordinary resolution to
remove Peter.

14
QUESTION 2(A)

Appointment of a Director
By what manner may a director be appointed?
 The removal of Peter creates a casual vacancy which can be filled in the following
manners:
 By members ordinary resolution: Belinda and Freddie may by ordinary resolution appoint
Susan (Model Article 22(1)(a)), in which case, she can hold office for an unlimited period
of time (Model Article 22(2)); or
 By the board: the Board now consisting of Belinda and Freddie (Board quorum is 2
directors under Model Article 11(2)) can appoint Susan under Model Article 22(1)(b) but
this would mean Susan can only hold office until the next annual general meeting (Model
15
Article 22(4)(a))
QUESTION 2(B)
Belinda – 55%
Nick – 35%
Freddie – 10%
Belinda was the one who called the shots in the daily operation of business.
Before founding the Company, Belinda already solely owned a company, Artisan Cooking
Studio Limited (“ACS”), which operates a culinary academy that offers workshops and
training sessions.A few years ago, Belinda met Flora, who loved baking, at a public charity
event, and they have been friends ever since. Flora owns a company called Sweet Bakery
Limited (“Sweet Bakery”), which specializes in making cakes and pastries. Belinda decided to
collaborate with Flora’s company by providing on-site cake-making workshops for client
functions and private events for a fee. The fees received from Sweet Bakery accounted for
30% of Belinda’s company’s annual revenue. 16
QUESTION 2(B)
Flora later asked Belinda if the Company would be interested in acquiring Sweet Bakery. Even
though Belinda knew that Sweet Bakery was loss-making, she saw great potentials in the
business. She agreed with Flora to have the Company acquire Sweet Bakery (“Acquisition”) for
a consideration of HK$2 million, which amount doubled the then net asset value of Sweet
Bakery.
A board meeting of the Company was held to approve the Acquisition. While Susan knew about
her mother’s interest in baking, she was not aware that her mother owned ACS or of ACS’
connection with Sweet Bakery at the time of the meeting. Belinda only stated in the meeting
that it was her belief that the business of Sweet Bakery had great potentials which would
benefit the Company in the long run and the fact that it was loss-making should be temporary.
Susan was skeptical of the Acquisition and believed that a more cautionary approach would be
more appropriate. However, Susan just went along with Belinda’s idea without saying anything,
and voted with Belinda to approve the Acquisition and to authorise Belinda to handle all the
matters relating to it. No general meeting of the Company was held in respect of the 17

Acquisition.
QUESTION 2(B)

Belinda, on behalf of the Company, entered into a simple share sale and purchase
agreement with Flora shortly after the board meeting. The agreement did not contain
any warranties regarding the financial position of Sweet Bakery.
Sweet Bakery turned out to be very unprofitable which negatively impacted on the
Company’s financial position. Nick has now become aware of the Acquisition and
discovered Belinda’s prior business connection with Sweet Bakery.
Nick comes to you for advice on possible claims against Belinda and Susan in
respect of the Company’s recent operations.

18
QUESTION 2(B)

What claims may be brought against Belinda and Susan?

1. Breach of duty to act in good faith in the interests of the company
2. Exercise of power for an improper purpose
3. Breach of duty to avoid conflict of interests
4. Breach of statutory duty of care
19
QUESTION 2(B)

1. Breach of duty to act in good faith in the interests of the company

How do courts determine whether directors have acted in good faith?
Since the Board has considered whether the acquisition will be in the interests of the
Company, the subjective standard will apply, i.e., what the directors believe in good faith
to be in the interests of the company, which means in the interest of the shareholders
as a whole (Hutton v West Cork Railway), and not the objective standard in Charterbridge
case (what an intelligent and honest man in the position of a director could have
reasonably believed that the transactions were for the benefit of the company).
20
QUESTION 2(B)
1. Breach of duty to act in good faith in the interests of the company
Even applying the subjective standard, can the acquisition be justified as being in the interests of the
Company?
 It is a substantial acquisition well beyond its market value and in a business that neither the Company
nor its directors have any substantive experience in. Belinda at the Board meeting admitted that Sweet
Bakery was not yet profitable.
 For Belinda: a director owes a duty to consider the relevant factors and exclude from consideration
irrelevant ones. It may be questioned whether Belinda caused the Company to proceed with the
acquisition due to her own personal interest.
 For Susan: a director should exercise independent judgment (Law Wai Duen v Boldwin Construction Co
Ltd) and cannot absolve herself entirely from responsibility in relation to the management of the
company and defer to the other directors. Susan approved the acquisition despite her skepticism and 21
her belief that a more cautious approach should have been taken.
QUESTION 2(B)

2. Exercise of power for an improper purpose

Did the Board exercise its contracting power for an improper purpose?
Apply a four-stage test:
1) Identify the power whose exercise is in question
2) Identify the proper purpose for which the power was granted to the directors
 To be determined by looking at the articles and business activities of the company
3) Identify the ‘primary’ or ‘substantial’ purpose for which the power is exercised
 Question of fact
4) Decide whether that purpose is proper or improper 22

 Difficult to prove the power had been exercised for improper purpose in the present case
QUESTION 2(B)

3. Breach of duty to avoid conflict of interests

Has Belinda breached her duty to avoid conflicts of interest under common law?
 Belinda may have breach her duty to avoid conflict of interests by failing to make disclosure
to shareholders and to seek their approval at common law (as no general meeting was held
in respect of the Acquisition)
What is the test for determining whether there is a conflict of interest?
 A real sensible possibility of conflict (objective test)
What’s the consequences of non-disclosure?
 Contract voidable by company against a party which has notice of director’s breach of duty
 Was Flora aware of Belinda’s breach of duty?
 Secret profits (if any) to be accounted for by directors: Belinda must account to the 23
Company for any profits she makes as a result of the Acquisition.
QUESTION 2(B)

3. Breach of duty to avoid conflict of interests

Is there any statutory duty requiring disclosure here?
 Belinda may have breached her statutory duty under s 536 CO (which is supplementary to
the common law disclosure rule) to disclose her interest to her co-director, Susan. Duty
arises when:
 director’s (direct or indirect) interest in the transaction/arrangement/contract is material;
 contract of significance to the company’s business
What does ‘interest’ mean? Is Belinda’s interest (in the acquisition of Sweet Bakery) material?
 ‘Interest’ includes both direct and indirect interest
24
 A significant portion of ACS’ profits came from the arrangements with Sweet Bakery –
potentially the same or more profits after the acquisition?
QUESTION 2(B)

3. Breach of duty to avoid conflict of interests

Is the transaction significant to the company’s business?
 The acquisition is arguably significant, as the purchase price of HK$2 million
represents a substantial proportion of the Company’s net asset value of HK$10
million.
 Belinda has a duty to disclose to Susan the nature and extent of her interest which
she did not.
What’s the consequence of non-compliance?
 Non-compliance constitutes a criminal offence under s542 CO.
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QUESTION 2(B)
4. Breach of statutory duty of care
Which statutory provision sets out the duty of care?
 S465 CO
 Standard of care expected of director: objective + subjective standard
 Should Belinda be held to a higher standard of care given her experience in investment banking?
Sweet Bakery was not profitable — what should a reasonable director do in this situation?
 But the Company paid a premium in acquiring Sweet Bakery.
 Is this a significant transaction for the Company?
 A significant acquisition for the Company but it seemed they did not carry out adequate 26
due diligence (Rontex Int’l Holding Ltd)
QUESTION 2(B)

4. Breach of statutory duty of care

Has Susan breached her duty of care?
 Did not exercise independent judgement (Law Wai Duen)
Has Belinda breached her duty of care?
 Negligent in handling the legal documentation for the Acquisition by not requiring
Flora to give financial warranties especially when Sweet Bakery was a loss-making
company (D’Jan of London Ltd, Copp v D’Jan)

27
QUESTION 2(B)
Can Belinda and Susan be solved from liabilities or obtain any relief from their misconduct?
 Belinda and Susan did not obtain prior authorisation from the members for the
acquisition.
 They may seek to obtain ratification of their breaches.
Can they successfully obtain ratification by the members?
 Under s 473 CO, the votes of a member who is the director in breach of duty are
discounted. Belinda’s votes should therefore be discounted. Only Nick’s and Freddie's
vote would count for ratification.
Can they successfully obtain relief from the court?
 Unlikely, because:
 There was misconduct
 They did not honestly and reasonably 28

 They ought to fairly to be excused in view of all the circumstances