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Focus: Asia Finance - When a little bit of knowledge can be dangerous – the 'indoor management rule'

13 January 2010

In brief: The long-established common law 'indoor management rule' protects outsiders in their dealings with companies and allows them to assume that a company's internal management requirements have been complied with. A recent Hong Kong Court of Final Appeal decision has examined the circumstances in which a lender would be put on notice of possible internal procedural irregularities in the borrower's approval process, thereby limiting the lender's ability to rely on the indoor management rule. Partner Matthew Barnard (view CV) and Senior Associate Justin Chin report.

How does it affect you?

Lenders need to be mindful:

  • that if they are aware of apparent irregularities in a borrower's internal procedures that relate to the approval of the borrowing transaction, they may not be able to rely on the indoor management rule; and
  • that their lawyers' knowledge (in their capacity as agent of the lenders) of a borrower's internal management requirements and any departures from those requirements can be considered to be their knowledge, and thereby put the lender on notice of the need to make further inquiries as to whether the borrower has followed all its internal approval procedures and whether they have been complied with.

The case

Active Base LTD v Roderick John Sutton and Others FACV14/2009 arose from the liquidation of Moulin Global Eyecare Holdings (Moulin), a company formerly listed on the Hong Kong Stock Exchange and controlled by the Ma family.

In late 2004, Moulin entered into an agreement to acquire a 56 per cent interest in Eye Care Centres of America, Inc. for US$450 million. In the last week of February 2005, Mr Ma Bo Kee, the chairman of Moulin, approached a director of Active Base LTD (Active), for a HK$50 million loan to be lent to either Moulin or personally to Mr Ma Bo Kee (the loan). It was indicated to Active that the loan would be used to assist Moulin in its acquisition of Eye Care Centres of America, Inc.

On late 23 February 2005, it was decided that the loan would be extended to Moulin rather than Mr Ma Bo Kee. On the same evening, solicitors for Active, who were responsible for the drafting of the loan documents, were informed that the Moulin board meeting approving the loan would be held the next day. At Moulin's request, solicitors for Active were then instructed to draft the board minutes for Moulin and to only include directors who were related to Mr Ma Bo Kee as 'present' for the meeting. This pattern of attendance was also previously indicated to an Active director and both the Active director and Active's solicitors were aware that the Hong Kong Listing Rules required a listed company to have at least three independent non-executive directors on its board. The solicitors for Active were not instructed to prepare any notice of the meeting of Moulin directors.

On 24 February 2005, representatives of Moulin and Active attended to the execution of the loan documents. At the signing, the treasurer of Moulin (also a relative of Mr Ma Bo Kee) told the Active director present that the Moulin board meeting had been held. The loan document and the debenture securing the loan were signed by two directors of Moulin (the chairman and the CEO, both being Ma family members) and, on 25 February 2005, the loan was advanced to Moulin.

It was later established that Moulin had been insolvent since 31 December 2004 and had defaulted on a number of other loans. A creditor's petition was presented against Moulin on 21 June 2005, followed by the appointment of provisional liquidators on 23 June 2005 and the making of a winding-up order on 5 June 2006. In April 2008, liquidators estimated that Moulin creditors were likely to receive about HK$2.36 billion less than what they were owed.

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The decision

Moulin appeared to have validly approved the loan by passing a resolution at a board meeting. The lower courts concluded that the loan was not approved by Moulin because its internal by-laws had not been complied ie the requirements of Moulin's article of association which required notice of the board meeting to be given to all directors.

Active did not challenge the lower court's findings but instead asserted that it could rely on the indoor management rule established in Royal British Bank v Turquand (1856) 6 El & Bl 327. The indoor management rule permits an outsider dealing with a company, having satisfied himself that the proposed transaction is not in its nature inconsistent with the articles of association, to assume that the officers of the company have observed and complied with the provisions of the company's articles of association. However, an outsider cannot rely on the rule if he has notice of an irregularity or has been put on inquiry of that irregularity.

The Hong Kong Court of Final Appeal took into consideration the following facts.

  • Solicitors for Active were asked to draft minutes showing the participation of only the Ma family directors even before the availability and terms of the loan were known.
  • The business to be transacted at the Moulin board meeting was far from ordinary. It was to approve: (i) the taking by a publicly listed company of a substantial loan to help finance a major acquisition; and (ii) the creation of a floating charge over all its undertaking in order to secure that loan.
  • The chairman of Moulin wanted the loan to be personal to him, which was difficult to understand having regard to the corporate purpose for which the money was required.
  • Ma family security was being provided even though the loan was to a listed company.

Justice Litton in his judgement stated:

The inference would seem irresistible that the staff members handling the matter for [Active] had intended at the outset to exclude the non-Ma family members of the board from any knowledge of the transaction.

  

In an unanimous decision, the five judges of the Court of Final Appeal ruled that Active had been put on inquiry of the irregularity arising from the failure to give notice of the board meting to all directors and that Active could not rely on the indoor management rule.

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Comments

The question of when an outsider is put on inquiry of irregularities is a difficult one that involves a balance between conflicting interests. Courts will often consider the need to protect and promote business convenience on the one hand, and on the other hand the facilitation of fraud as a consequence of an over-extensive application of the indoor management rule.

This case demonstrates that notice or knowledge of irregularities of a company's internal procedure will substantially limit a party's ability to rely on the indoor management rule. It is possible that the court would have concluded differently had the Active director and solicitors of Active not come across the knowledge of the intended attendance pattern of the Moulin directors meeting. Involving the lender's lawyers in the borrower's approval process carries risks if the required internal procedures are not strictly complied with.

As a matter of general principle, lenders have no duty to look into the management of a corporate borrower or consider its interest as a borrower. However, once they (or their lawyers) are aware of anything unusual, it may be very much in a lender's interest to make further inquiry.

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