Company Failed In Its Action Against Director And His Son Who Set Up A Rivalry Business. Why?

Introduction

Imagine this: An employee director, who owns 50% of a business, and his employee-son secretly set up a rival business. Not only this, they abused their positions to misuse the company's confidential information, poached employees and solicited customers while they were still on the company's payroll. What can the company do?

This was the plaintiff's case in Sea Dragon Food Limited v Tung Chung Wah and others HCA 564/2019 HKCFI 4187.

Factual background

The plaintiff, Sea Dragon Food Limited ("Company"), was in the business of production of secondary food products such as fish balls, siumai and other dim sums, for sale to local restaurants and food stalls. Yuen Tak Sung ("Yuen") and the 1st defendant, Tung Chung Wah ("Father"), equally owned and directed the Company.

The dispute centred on the actions of the Father and his son, Tung Ka Yuen ("Son"), the 2nd defendant. The Company employed the Son as a manager under an oral contract from September 2015 until his resignation on 27 July 2018. The Son was the sole director and shareholder of the 3rd defendant, Yuen Hoi (HK) Food Production Limited ("Competitor"), a rival company incorporated on 2 May 2018 that also ran a business of production of secondary food products to local food stores. It was not disputed that the Competitor was in competition with that of the Company.

The Company alleged that the following key events took place in July 2018:

• On 24 July 2018, the Son allegedly met individually with four Company's employees ("4 Employees") and asked if they would follow him and join the Competitor. The 4 Employees later left the Company's employment.
• On 25 and 26 July 2018, the Father attempted to issue a notice stating that the Company would cease operation and the Competitor would take over. This notice was not circulated. Later, another notice was issued to the customers stating the Company would "gloriously cease business".
• On 27 July 2018, the Son resigned and terminated his employment.
• On 28 July 2018, Yuen issued yet another notice asserting the Company would continue its business.

Upon leave granted by the Court of First Instance ("CFI") to Yuen, the Company brought a statutory derivative action against the Father, the Son and the Competitor.

Legal issues and the CFI's findings

In relation to the Father and the Son, the Company claimed against them for breaches of fiduciary and fidelity duties for setting up and running the Competitor in competition with the Company's business, misuse of confidential information, wrongful solicitation of the 4 Employees and customers.

The CFI considered various issues including, among other things, the following:

1. Whether the Father and the Son owed fiduciary duties to the Company including director's duties of the Father and fiduciary duties owned by them as employees? ("Issue 1")
2. Whether there was any breach of implied terms of employment by the Father and the Son including duties of good faith, fidelity, confidentiality, and non-solicitation? ("Issue 2")
3. Whether the Father and the Son misappropriated and misused the Company's confidential information and trade secrets? ("Issue 3")
4. Whether the Father and the Son had wrongfully solicited the 4 Employees and customers? ("Issue 4")

Issue 1

A company director owes fiduciary duties and duties under Companies Ordinance to the company.

On the other hand, it is a well-established principle that an employment relationship does not, by itself, give rise to a fiduciary duty owed by the employee to the employer. Fiduciary duties arise only when the employee has undertaken specific contractual obligations that place him in a situation where he must act solely in the interests of the employer (a single-minded duty of loyalty). This relationship must be consistent with, and conform to, the contractual terms. The CFI affirmed this position.

The CFI found the Father owed fiduciary and director's duties as the Company's director but the Company's claims failed on proof. There was no credible evidence that the Father participated in the Competitor's business or personally benefited from it.

The CFI found the Company failed to plead the material facts necessary to establish such a fiduciary relationship with the Son. Simply pleading the Son was a "manager" was insufficient, as the court looks to substance over form, requiring details on his seniority, managerial responsibility, decision-making autonomy, and independence. Therefore, the claim that the Son breached fiduciary duties by failing to inform the Company of the Competitor's setup was not open to the Company.

Issue 2

The Company argued that the Father and the Son breached their duties of fidelity and duties by setting up the Competitor in competition with the Company.

Duties of good faith and fidelity, which are implied in all employment contracts, prohibit an employee from competing with the employer during the course of employment. However, such duties impose no inhibition on competing after employment terminates. An employee retains the freedom to prepare for future competitive activities while still employed, provided he does not engage in actual competitive activity such as competitive tendering or trading.

The CFI ruled that the Company was unable to advance its claims against the Father or the Son for the establishment of the Competitor due to defective pleadings. For instance, the Company's pleaded case against the Father, whilst it was pleaded there was an employment agreement between the Company and the Father, it was silent as to when it was concluded and whether it was made orally or in writing. There was no plea of any express terms of the Father's employment agreement.

In any event, the Son's conduct before his resignation on 27 July 2018 involved undertaking "preparatory steps" (such as planning and arrangement, which the Son claimed was done during spare time). The evidence failed to show any actual competitive activities by the Son prior to his resignation, thus the Company failed to establish any breach of duty.

Issue 3

The Company claimed the Father and the Son misappropriated and misused the Company's confidential information, including customer lists, supplier lists, financial data, and product pricing information.

The CFI recognized an implied term that a director (the Father) and an employee (the Son) must not use any trade secret or confidential information learned during their tenure. To qualify as a trade secret, the information must be confidential, difficult to isolate, capable of causing significant harm if disclosed, and the owner must limit its dissemination.

The Company failed to prove that the information in issue qualified as a trade secret. The Company could not even produce the alleged customer lists or supplier lists for the CFI to examine. The information complained of such as customer or supplier contact details were readily available in the public domain (for example, on the internet or food guides) and therefore not trade secrets. Furthermore, the Company's evidence that the Father misappropriated files via a USB stick was deemed "unsafe" hearsay, as the Company's witness (Yuen) did not have clear visibility of what was taken.

Issue 4

The Company alleged the Father and the Son wrongfully solicited the 4 Employees and the Company's customers.

Again, the CFI dismissed these claims due to inadequate pleadings and a lack of credible evidence.

Regarding the 4 Employees, the Company failed to plead any duty not to solicit employees. Furthermore, the Son's witnesses (including two of the 4 Employees) testified that they decided to join the Competitor after the Company announced the cessation of its business, undermining the Company's claim of wrongful solicitation while the Son was employed.

Regarding the customers, the Company relied heavily on hearsay evidence from Yuen, who was often repeating what others (like an unidentified boss of a customer) told him. The CFI refused to attach weight to this hearsay evidence, especially given inconsistencies between the Company's witnesses.

Conclusion

The CFI dismissed all claims brought by the Company.

Takeaways

In Sea Dragon, the Company's claims for breach of fiduciary duties, breach of duty of fidelity, misuse of confidential information, wrongful solicitation of employees and customers, and passing off were all rejected by the CFI on the basis that the Company failed to properly plead the requisite duties and material facts, lack of proof, and inadmissible evidence.

Sea Dragon serves as a sharp reminder for litigants in employment (and related) litigation:

1. Pleading rules require claims and relevant facts to be clearly pleaded in the statement of claim.
2. Evidence must be credible, non-hearsay, properly tested by cross-examination, and supported by contemporaneous documents.
3. A director owes his company fiduciary duties and duties under Companies Ordinance.
4. Employees do not generally owe fiduciary duties except where specific circumstances and material facts establish such duties.
5. Duties of good faith and fidelity may be implied in employment contracts but must be pleaded and supported by facts.
6. Trade secrets confidentiality requires showing the nature of information, confidentiality, and potential harm if disclosed.
7. Solicitation claims require pleading and proof of duties not to solicit employees or customers.
8. Passing off requires proof of goodwill, misrepresentation and damage.

Employment (and related) litigation is often no straightforward and can be complex. As always, if in doubt, it is advisable to seek legal advice.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.