4 April, 2016
Background
On November 11, 2015, the Court of Final Appeal (CFA) handed down the judgment which sealed the fate of Yung Kee Holdings Limited (Company), a company registered in the BVI which holds various family companies of the Yung family, including those which operate the famous Yung Kee Restaurant (Restaurant) and the Kee Club in Hong Kong. The judgment which ordered the winding up of the Company became effective on December 17, 2015, when the two branches of the Yung family failed to agree on the Company shares buyout scheme by one of the branches. This outcome would probably have made the deceased family patriarch, Mr. Kam Shui Fai (Kam Senior), turn in his grave.
The Family Business Ownership and Operation
It was reported that Kam Senior founded the Restaurant, which became famous for its traditional Cantonese cuisine including roast goose and roast pork, in the 1940s. Kam Senior had always wanted his elder son (Kam Kwan Sing), the Petitioner/Appellant in these proceedings, and his second son (Kam Kwan Lai), the first Respondent in these proceedings, to work together in the family business. According to the Courts’ findings, since the 1970s, the elder son had been responsible for the day-to-day operations of the Restaurant, while the second son has been responsible for building maintenance of the properties (including the building where the Restaurant is located), the corporate and investment sides of the business.
Since the 1990s, the majority shareholding of the family companies was owned by a unit trust (Long Yau Unit Trust) with Long Yau Limited (Long Yau) acting as trustee. The sole shareholder of Long Yau was the Company and the initial shareholder of the Company was the wife of Kam Senior. It has not been denied that the arrangement was put in place in order to bring the shares of the family companies outside of Hong Kong for the purpose of minimizing estate duty exposure.
In 2009, after the demise of Kam Senior and the abolition of estate duty in Hong Kong, the unit trust was terminated. The Judge at the Court of First Instance (the trial judge) commented that no “particular explanation” was offered by any of the witnesses (including the family members and the financial advisor to Kam Senior) as to why the assets in the unit trust were being distributed in the way they were, but the result was that Long Yau became the legal and beneficial owner of the shares in the family companies while the Company became the ultimate holding company. Ownership of the shares in the Company became as follows:
- 35 percent being beneficially owned by the elder son/brother;
- 45 percent being beneficially owned by the second son/brother, after 10 percent of the shareholding was transferred to him from the third brother (who passed away in 2007);
- 10 percent being beneficially owned by the wife of Kam Senior, the mother; and
- 10 percent being beneficially owned by the sister.
The personal ownership allowed the family members to exercise their individual rights as shareholders, and eventually, a “divergence” within the family ensued. In May 2009, the mother decided to pass her shareholding to the elder brother to equalize his rights with the second brother. The sister then passed the voting rights attached to her shares to the second brother, believing him to be a better businessman.
It was reported that the second brother then used his majority voting rights (55 percent) to change the constitution of the Company. Without calling a shareholders’ meeting, he changed the quorum requirement for the Company’s board meetings from all appointed directors (which was originally himself and the elder brother) to just half of the number of directors appointed. He also appointed his son Carrel as an additional director of the Company. Further steps were then taken to ensure that his family had control of Long Yau and the company which operates the Restaurant, by the appointment of Carrel as the additional director of these companies.
The elder brother complained that he was not consulted on these nor any other business decisions, such as increasing the remuneration for Carrel, or allowing Carrel and his sister to use properties owned by the family. He alleged that his access to the group’s financial information was denied and his control over the Restaurant was “usurped”. In 2010, the elder brother brought action for: (1) an order for the buyout of his shares in the Company under s168A of the Companies Ordinance (Ordinance) on the basis that the affairs of the Company were carried out in an unfairly prejudicial manner, or in the alternative; and (2) the winding up of the Company on “just and equitable” ground under s327(3)(c) of the Ordinance.
Jurisdiction and Company Law Matters
It is not the purpose of this article to go into the details of the company law and jurisdictional arguments which are important aspects of the Courts’ decisions. Suffice it to say that the Courts at all levels decided that s168A has no application on the basis that the Company has not established any “place of business” in Hong Kong. For the purpose of that provision, the place where the Company discussed its affairs and held its board meetings does not constitute its place of business. This may seem surprising to private wealth advisors who are used to the concept that the place where companies hold their board meetings to decide on strategic matters is often highly relevant in determining the tax residency of such companies.
As for the jurisdiction to wind up the Company, although rejected by the lower Courts, the CFA decided that the Company did not need to have a place of business in Hong Kong in order for a winding up order (under s 327(3)(c)) to be granted. All that was required was for the Company to show a “sufficient connection” with Hong Kong. This was established by the presence of its shareholders in Hong Kong, as well as by the assets in Hong Kong which may be made available to the Company’s liquidators for the benefit of its shareholders. The fact that the family companies’ assets in Hong Kong are held via its subsidiary (Long Yau, a BVI company), rather than directly by the Company, does not matter.
The Conduct of the Business and Unfair Prejudice
Having decided that it had jurisdiction, the CFA also looked at whether the conduct of the family business amounted to unfair prejudice against the elder brother.
The CFA acknowledged that there may be situations when the exercise of the strict legal rights of shareholders may be subject to equitable constraints, if there is sufficient unfairness or breaches of good faith between them. This may happen particularly if the company is a “quasi partnership” type of business. In the present case, it was found to be a “common understanding that each brother was entitled to participate in the business and had to be properly consulted”. It was therefore reasonable for the elder brother to expect that his views and position within the group would be respected.
By unilaterally reconstituting the boards of the various companies and then making various business decisions benefiting his family members, the second brother was found to have made a “pre-emptive strike” on the elder brother and to have “dictated” matters to him. The trial judge also found Carrel to be “gratuitously rude” to his uncle on various occasions. These actions were inconsistent with the “maintenance of trust and confidence that had existed in the past” and without “due regard to the personal nature of the relationship involved.” Accordingly, the second brother could not have insisted on his strict legal rights as a shareholder, and unfair prejudice was established justifying the grant of an order to wind up the Company.
It should be noted that CFA’s finding on unfairness centers on the failure to respect the elder brother’s right to be consulted. The elder brother’s right to participate in the business does not mean that he should have had a power of veto, nor that there must have been unanimity in every decision regarding the running of the family business.
Lessons Learned for Wealth and Succession Planning
The first observation is that the dispute leading to the legal action only started when the shareholding of the Company came into the individual ownership of the family members in 2009. If the ownership of the Company shares had been held by a discretionary trust for the benefit of an open class of beneficiaries, consisting of children and issue of the family, the winding up of the Company might have been avoided.
Trust ownership could prevent the fragmentation of the shareholding and the potential divergence resulting from individual ownership. The trustee of this family trust is preferably an institutional trustee to ensure continuity and also independence from any particular branch of the family. Kam Senior could also have made it known to the trustee and also the family members of his dreams and visions (via letters of wishes and also in the deed of addition of the assets to the trust) that several elements of the family business, in particular the Restaurant and the building where it is located, are to be preserved as strategic holdings of the trust, to generate economic benefits for the family for generations.
Purely sorting out the “ownership system” in the “three circle model” of family business via a trust ownership would not have helped to facilitate the brothers working together, though, and this is where a properly structured family governance system may come into play. We should be reminded that the findings of the CFA on “unfair prejudice” were centered on the violation of the elder brother’s right to be consulted. Facilitating fair process and proper communication among the family members is what a family governance mechanism ought to be able to achieve.
A family governance mechanism usually consists of the establishment of a family council and a family assembly, and the entering into by the family members of a “family constitution,” the operation of which would interface with the trust structure to provide for checks and balances. It is beyond the scope of this article to examine the content of a family constitution, but typically this will include a mission statement, a set of family principles for doing business together, composition and function of the family council/ family assembly, criteria for participation in the family business, etc. To enable the constitution to have “teeth,” it would usually be specified that any failure by any family member to observe its terms may result in his/her losing an entitlement to the family wealth.
If, through the process of devising the family constitution (which should involve Kam Senior and all adult family members), it was apparent that the brothers still wanted to work together as joint owners of the family business, then the mechanism could have been put in place to better define their roles, separate their powers, and facilitate communication.
The second brother might have been given the role as head of the “business system,” since it was reported that the majority of the family members viewed him to be a better businessman. He could have been designated as the “Investment Advisor” in the family trust, having the voting powers attached to the shares and the right to decide on the directorship of the family companies (but without the right to sell the strategic family companies).
At the same time, the elder brother could have been designated as the head of the “family system” and become chairman of the family council (with casting and/or additional votes). The family council would have oversight of the family businesses, and could also be given the right to replace the “Investment Advisor” in the family trust. In this way, the second brother would have had to report to and consult with the elder brother (and also other family members) on important business decisions, such as the engagement and promotion of any family members in the business. The elder brother may also have been designated as the initial “Protector” of the family trust who could have given recommendations to the trustee, including whether to withhold trust distributions to family members for failing to comply with the terms or spirit of the family constitution. This might have ensured that all family members would stay in line and continue to respect each other.
The dynamics, values and concerns are no doubt different in every family and there is no set rules as to how a family constitution should be drawn up, or how it should interface with the operation of the family trust. However, the message brought home by the Yung Kee Holdings case is that trust ownership of the family business coupled with a well-designed family governance mechanism warrant due consideration. Such arrangement could effectively remove the family business and fortune from the strict and impersonal corporate regulatory regime, facilitate communication and respect between the family members, and bring about the harmony and continuity desired by founders of most family businesses.
For further information, please contact:
Mabel Lui, Partner, Winston & Strawn
mabel.lui@winston.com
