Hong Kong Court of Final Appeal decides on directors' duties and conflict of interest amid sushi and noodles

The Hong Kong Court of Final Appeal (CFA) has, in Poon Ka Man Jason & Ors v Cheng Wai Tao & Others, brought some closure to the long running dispute between siblings Jason and Daisy Poon and Ricky Cheng as business partners who owned the Ajisen Group of restaurants and ventured into the sushi business through the chain of Itamae restaurants.  The dispute began over ten years ago when Ricky Cheng (Ricky) began to operate and expand the Itamae chain and Itacho group of restaurants on his own even though the partners had agreed to develop a chain of Japanese-style sushi restaurants as an extension of the Ajisen business.  The CFA held, by a 3-2 majority, that Ricky was in breach of his fiduciary duties as a director of Smart Wave Ltd ("Smart Wave") in setting up additional Itamae and Itacho restaurants in competition, as a result of which business opportunities and profits were diverted to benefit Ricky's personal interests.

Importantly, the CFA examined the scope of a director's positive duty of loyalty to act in the best interests of the company and the 'no-conflict rule', which provides that a fiduciary may not put himself in a position where his own interest and duties to the company conflict.  The CFA also examined how to determine the scope of fiduciary duties and whether the scope can be modified.  

This is a key decision for directors, particularly in the context of large or group businesses and in a place like Hong Kong where it is common for individuals to hold directorships (often in addition to being a shareholder) in a number of businesses, some of which may be in direct or indirect competition with each other.  The clarity around the scope of fiduciary duties and how to modify it where necessary will be of benefit to parties who juggle business and personal interests through their multiple roles as directors and shareholders.

Background

Jason and Ricky were, amongst others, business partners in a chain of Japanese noodle restaurants trading as Ajisen Ramen. Each restaurant was held by a separate corporate entity and each partner held shares in each entity.

In 2004, the parties decided to go into the sushi restaurant business, using a similar arrangement to that of Ajisen Ramen. The first restaurant was opened by Smart Wave under the trading name Itamae Sushi in August 2004. Following the opening of this restaurant, Ricky opened three more restaurants under the Itamae brand with himself as sole shareholder (and sole director) of each entity.  A dispute arose between the parties regarding Ricky's conduct in opening and operating separate entities without involving the other parties.

This dispute was intended to be resolved via a shareholders' agreement (known as the Hero Elegant Agreement) between Ricky and a corporate entity owned by Jason (and another) to hold the Itamae Sushi restaurants under a new corporate entity called "Hero Elegant Limited" (which did not include Smart Wave), with subsequent Itamae Sushi restaurants to be operated by subsidiaries of Hero Elegant Limited.  However, Ricky continued to open further Itamae Sushi restaurants with himself as sole shareholder of each entity. In addition, he opened sushi restaurants as a shareholder under the name Itacho.  Jason and Daisy's company, Fine Elite Group Limited, subsequently sued for breach of the Hero Elegant Agreement. This claim was dismissed by the judge at first instance as it was held that Fine Elite Group Limited had been in repudiatory breach of this Agreement. There was no appeal against this judgment.

As an alternative to the breach of contract claim, Jason commenced a derivative action on behalf of all shareholders in Smart Wave (except Ricky) claiming that Ricky breached his fiduciary duties as sole director of Smart Wave by opening further restaurants under separate corporate entities.

Court of First Instance and Court of Appeal decisions

The judge, at the Court of First Instance (CFI) dismissed the derivative action brought by Smart Wave in relation to the Itamae restaurants on the basis that the Ajisen shareholders had agreed that the chain of Ajisen restaurants would be established through the means of different corporate vehicles where one company would operate one restaurant.  The parties continued to operate on the same understanding and, accordingly, Smart Wave was of a 'limited nature' i.e., it was only a single-purpose company with interests in and concerns over one single Itamae restaurant only. It was held that the shareholders had never intended Smart Wave to have the exclusive right to carry on the business of the Itamae chain of restaurants.  The CFI did, however, order Ricky to pay damages in respect of the Itacho restaurants. Ricky was held to be in breach of his fiduciary duty by operating a business in direct competition with Itamae under the name of Itacho. Smart Wave appealed that part of the decision which concerned the Itamae chain of restaurants.

The Court of Appeal (CA) reversed the CFI judgment, allowed Smart Wave's appeal and held that Ricky was in breach of his fiduciary duties as a director of Smart Wave by operating and expanding both the Itamae and Itacho group of restaurants.  CA held that there was no evidence which suggested that the other shareholders of Smart Wave knew or intended Smart Wave not to have an exclusive right to operate the other Itamae restaurants.  As a sole director, it was Ricky's responsibility and duty to act in the best interests of Smart Wave and, by operating a competing sushi business, he diverted business opportunities and profits away from Smart Wave towards his personal benefit.  Ricky was held liable to account for all the profits he made in the sushi businesses he expanded up until Smart Wave ceased to operate in 2010.

Court of Final Appeal decision

Leave to the Court of Final Appeal was granted.   The main question before the CFA was: whether, in the events that occurred, Ricky's conduct in expanding and operating the sushi business (through Itacho and other Itamae restaurants) was out of the scope of the fiduciary duties Ricky owed to Smart Wave. In other words, whether the no-conflict rule applies to a director of a company in a chain business where the agreed business model was to have one company for one agreed operation.  Further, even if he was in conflict, whether Smart Wave (being a company of 'limited nature' operating only one restaurant, as held by the CFI), by agreement or assent from all its shareholders, could be taken to have agreed that Ricky could expand and operate other Itamae restaurants on his own.

The majority dismissed the appeal and held that Ricky was in breach of his fiduciary duties to Smart Wave.  Smart Wave, although of a limited nature as a single-purpose company , was 'the first of what was to become a chain of restaurants [and] had an interest in the establishment and operation of the chain as it developed.'  Accordingly, the set up of additional companies by Ricky which ran sushi restaurants under the names Itamae and Itacho in competition with Smart Wave diverted business opportunities and profits away from Smart Wave to the detriment of the company. 

In addition, the majority affirmed the so-called ratification principle, holding that the scope of fiduciary duties can be modified where, for example, a director would like to act in competition or for his own interest as long as there is unanimous assent of the shareholders of that company.  Although this principle was affirmed, the majority held that, in this case, the understanding that Smart Wave would only operate one restaurant was inextricably interrelated with the expectation and agreement that Jason, Daisy and Ricky would be substantial shareholders in each company that operated an Itamae sushi restaurant following Smart Wave. Moreover, there was no evidence that the shareholders of Smart Wave agreed to authorise Ricky to set up and operate other such companies on his own. Accordingly, the ratification principle did not apply in this case.

Comments

The law on the scope of a director's duties and the application of the no conflict rule may appear relatively straightforward, but the complexity that is involved to navigate this in practice is evident by this saga, which took over 10 years to achieve closure.  The judgment highlights the potential difficulties attendant on the fairly common practice in a commercial hub like Hong Kong of individuals often holding multiple directorships and shareholdings.  This decision will hopefully cause such individuals carefully to consider the various directorships they hold, particularly where they hold positions in companies which may be in competition.   Directors should be particularly aware of the scope of duties they owe as a result of their fiduciary relationship with the company.

Where there is doubt as to the duties owed or the scope of such duties, directors should ensure that any modification of such scope is clear and, where possible, assented to by all the shareholders of the company. Such modification need not be formally set out, although directors may wish to record such consent in order to ensure contemporary evidence is available, should the question of scope ever be in dispute.

If you wish to discuss, please contact Gareth Thomas, Julian Copeman, Dominic Geiser or Priya Aswani of our Dispute Resolution team.