He v. Zhong

2020 BCSC 1867 He v. Zhong

IN THE SUPREME COURT OF BRITISH COLUMBIA Citation: He v. Zhong, 2020 BCSC 1867 Date: 20201130 Docket: S207834 Registry: Vancouver Between: Siheng He and Pentagon Industrial Limited Petitioners And Ze Wen Zhong, Grandlake Investments Corp. Respondents Before: The Honourable Madam Justice Francis Reasons for Judgment Counsel for the Petitioners: J. Jiang Counsel for the Respondents: S.M. MacKenzie Place and Date of Trial/Hearing: New Westminster, B.C. November 6, 2020 Place and Date of Judgment: Vancouver, B.C. November 30, 2020 [1] Siheng He and Pentagon Industrial Limited ("Pentagon") apply for leave to commence a derivative action in the name of the respondent Grandlake Investments Corp. ("Grandlake") against Ze Wen Zhong pursuant to ss. 232 and 233 of the B.C. Business Corporations Act, S.B.C. 2002, c. 57 [Act]. [2] The petitioners and Mr. Zhong are shareholders in Grandlake, a company incorporated for the purposes of developing a property in South Vancouver. The petitioners say that Mr. Zhong misappropriated $8.4 million from Grandlake and they wish to sue on Grandlake's behalf for return of those funds. [3] For the reasons that follow, I have found that the petitioners have failed to meet the requirements of s. 233 of the Act and their petition must be dismissed. Factual Background [4] In 2016, Grandlake acquired three lots on the southeast corner of Granville Street and

Park Drive in Vancouver (the "Land") for the purposes of a townhouse development (the "Project"). The Land was purchased with loans supplied by Yi Huang, Mr. Zhong, and Rong Li International Trading ("Rong Li"), a company controlled by Mr. Zhong, as well as a $4,289,525 loan secured by a mortgage from Canadian Western Bank (the "CWB Mortgage"). [5] The original shareholders of Grandlake were Mr. Zhong and Mr. Huang. In 2017, Mr. Huang expressed an interest in selling his Grandlake shares. Mr. Zhong commenced discussions with Ms. He about investing in the Project and possibly purchasing Mr. Huang's shares. [6] In September 2017, Ms. He, through her company Pentagon, invested $2,502,500 in Grandlake in exchange for 25 Class A Common Shares of Grandlake and a shareholder's loan in the amount of $2,230,804. [7] The parties disagree about what Mr. Zhong told Ms. He about the CWB Mortgage at the time her company invested in Grandlake. Ms. He claims that Mr. Zhong told her that the loan secured by the CWB Mortgage was his personal debt, obtained to fund his share of the capital contribution to Grandlake when the Land was purchased. Mr. Zhong claims that, while he told Ms. He that he was a personal guarantor of the CWB Mortgage, he never told Ms. He that the CWB Mortgage was his personal liability. [8] Since September 2017, 1132878 B.C. Ltd. ("878") a company controlled by Mr. Zhong,

has owned 75% of the shares in Grandlake and Pentagon has owned 25% of the shares in Grandlake. [9] In mid-2019, Grandlake was experiencing financial difficulties. The company had not been able to presell enough units to obtain the construction financing it required to complete the Project. [10] On August 23, 2019, the shareholders of Grandlake had a meeting. The primary topic discussed at that meeting was a concern expressed by Ms. He and her husband about the pace of the Project and the consequent delay in recovering the funds they had invested. A number of options were discussed at this meeting for allaying Ms. He's concerns, including sale of the Project, Mr. Zhong buying out Pentagon's interest in Grandlake, and a guaranteed return on investment for Pentagon from Grandlake. [11] In October 2019, unbeknownst to the petitioners, Grandlake obtained two new mortgages, securing loans with a total value of $8.4 million (the "2019 Mortgage Funds"). These loans were approximately equivalent to the assessed value of the Land. [12] According to Mr. Zhong, the 2019 Mortgage Funds were used to pay out the CWB Mortgage and to repay Project expenses that had been and would be paid by Rong Li pursuant to a loan agreement between Grandlake and Rong Li. [13] Ms. He makes a number of allegations about the use of the 2019 Mortgage Funds, some of which are not consistent with one another: a)

She deposes that Mr. Zhong has admitted to using the 2019 Mortgage Funds for his personal benefit and not for the benefit of Grandlake or the Project. b) She deposes that Mr. Zhong used part of the 2019 Mortgage Funds to pay out shareholder's loans to his credit or the credit of 878. c) She deposes that the balance of the 2019 Mortgage Funds, after payment of the CWB Mortgage, was used to fund three other property development projects in which Mr. Zhong has an interest. [14] The Grandlake shareholders had another meeting on May 15, 2020. The minutes, which are signed by Mr. Zhong, state: At the meeting, Zewen Zhong explained that although the loan agreement for 8,400,000 was signed in the name of Grandlake, it was actually his personal debt, and he was personally responsible for the principal of the loan, corresponding interest, and other potential risks arising therefrom, which would have nothing to do with Grandlake and other shareholders. To clarify relevant responsibilities, Zewen Zhong agreed to sign a written letter of guarantee to Grandlake and other shareholders. The letter of guarantee will be signed after it is drafted by the lawyer. [15] Mr. Zhong admits that he signed the minutes of the May 15, 2020 shareholders' meeting, although he notes that they were drafted by Ms. He's husband. He now takes issue with the statements excerpted above. In his affidavit, he

states: I did not state that the [2019 Mortgage Funds] were my personal debt. I did confirm that I was a personal guarantor for the [2019 Mortgage Funds]. I requested item 6 be inserted into the minutes as I wanted to ensure that whatever documents were produced as a result of the meeting were factually and legally accurate. [16] The minutes are translated from Chinese and unfortunately the translation of item 6 is not particularly clear. It says: Specific agreements and contracts are subject to texts drafted by the lawyers representing two sides upon confirmation of the legal basis and factual basis. [17] Counsel for Mr. Zhong submits that I should interpret item 6 to mean that Mr. Zhong committed to nothing at the May 15, 2020 shareholders' meeting, and that everything that was discussed was subject to further negotiation upon consultation with legal counsel. He says Mr. Zhong's signature on the minutes should be construed as nothing more than his acknowledgment that he was in attendance at the meeting. [18] The records Mr. Zhong has attached to his affidavit support his evidence that he did not use the 2019 Mortgage Funds for his personal benefit. [19] There is no dispute that, from the $8.4 million of 2019 Mortgage Funds, over $4.2 million was used to discharge the CWB Mortgage. The financial records of Grandlake show that by September 2020, Grandlake had incurred $3.2

million in capitalized expenditures, all related to developing the Project. Most of these expenses had initially been paid by Rong Li, pursuant to its loan agreement with Grandlake. The remainder of the 2019 Mortgage Funds, after payment of the CWB Mortgage, appear to have gone to Rong Li for the outstanding balance of its loan to Grandlake. [20] Grandlake appears to have overpaid Rong Li by $856,644; the December 31, 2019 balance sheet for Grandlake shows $856,644 owing to Grandlake from Rong Li. The petitioners submit that this is evidence that Mr. Zhong has used the 2019 Mortgage Funds to benefit Rong Li, rather than Grandlake. However, Mr. Zhong has deposed that Rong Li continues to pay all Project-related expenses for Grandlake. In the period from January 2020 to September 2020, Rong Li has paid $529,879.43 in expenses on behalf of Grandlake. Mr. Zhong submits that by the end of 2020, the December 31, 2019 balance of $856,644 held by Rong Li will be significantly depleted, and will continue to be reduced as Rong Li pays ongoing Project-related expenses. [21] Mr. Zhong continues to maintain that, while he is a personal guarantor of the 2019 mortgages, he has never represented that the 2019 mortgages were his personal debt. While it is perplexing that he would have signed minutes suggesting that the 2019 Mortgage Funds were used personally by him, the records of Grandlake

support his position. The 2019 Mortgage Funds were clearly used to pay off the CWB Mortgage and to pay Rong Li for the Project-related expenses it had incurred, and would incur, on behalf of Grandlake. Proposed Derivative Action [22] The petitioners have included a draft notice of civil claim as a schedule to their petition. They propose to plead the following causes of action: a) breach of fiduciary duty by Mr. Zhang with respect to the 2019 Mortgage Funds; b) conversion of the 2019 Mortgage Funds to Mr. Zhang's own benefit; and c) unjust enrichment of Mr. Zhang giving rise to a constructive trust remedy. Legal Authorities [23] Under s. 232 of the Act, a shareholder or director may apply to court for leave to bring a proceeding in a company's name to enforce a right, duty, or obligation owed to the company or to obtain damages for a breach. [24] Pursuant to s. 233, the court may grant leave if four conditions apply: a) the complainant has made reasonable efforts to cause the directors of the company to prosecute or defend the legal proceeding, b) notice of the application for leave has been given to the company and to any other person the court may order, c) the complainant is acting in good faith, and d) it appears to the court that it is in the best interests of the company for the legal proceeding to be prosecuted or defended. [25] The dispute in this case is whether the

conditions set out in subsections (a), (c) and (d) have been met. Has the petitioner made reasonable efforts to cause the directors of the company to pursue action? [26] The respondents argue that the petitioners have failed to meet the first branch of the test for a derivative action. They argue that no demand was ever made of Mr. Zhong to pursue a claim on behalf of Grandlake with respect to his use of the 2019 Mortgage Funds. [27] The petitioners argue that it would be absurd to require that they demand Mr. Zhong sue himself before they can bring a derivative action petition. Obviously Mr. Zhong would not act on such a demand, so they reasonably declined to take this step. [28] While there may have been no point in making a demand on Mr. Zhong, it remains a statutory requirement that the petitioners do so before commencing a claim. The petitioners rely on dicta from the Court of Appeal in Holdyk v. Adolph, 2012 BCCA 37, to support the proposition that, where a demand would be fruitless, it is not necessary for a demand under s. 233(1)(a) be made. I cannot agree that Holdyk stands for this proposition. In Holdyk, the Court of Appeal simply remarked that s. 233(1)(a) was not raised by the respondents and that the respondents would have been unlikely to approve a prosecution of a claim against themselves. The Court of Appeal does not say that s. 233(1)(a) doesn't apply in cases

in which the proceeding in question would involve a director suing themselves. [29] Section 233(1)(a) remains a statutory condition even if there is no point in a petitioner making a demand of a director to sue themselves: Pok v. 474078 B.C. Ltd., 1997 CanLII 1603 (B.C.S.C.) at para. 23. [30] A letter from the applicant's solicitor demanding that Mr. Zhong take action against himself would constitute the reasonable efforts required under s. 233(1)(a): Gill v. Kalgidhar Darbar Sahib Society, 2018 BCSC 813 at para.

39. The petitioners failed to take this fairly basic step in order to meet the requirements of s. 233(1)(a). [31] No explanation has been proffered by the petitioners as to why they did not simply write a demand letter. They have not met the requirements of s. 233(1)(a). Are the petitioners acting in good faith? [32] Key elements of the good faith analysis were recently re-stated by our Court of Appeal in 2538520 Ontario Ltd. v. Eastern Platinum Limited, 2020 BCCA 313 at paras. 29-33 [Eastern]: · Good faith will not be presumed even when a derivative action is determined to be in the best interests of the company. · The onus is on the applicant to provide evidence proving this question of fact. · The applicant must show that the primary purpose for bringing the derivative action is to benefit the company. · Factors to be considered in determining good faith include the applicant's belief in the merits of the proposed claim, existing disputes between the parties, and alleged ulterior motives. [33] The interests of the applicant and the interests of the company may align, and the fact that the applicant may benefit from a successful derivative action is not an indicator of bad faith: 550934 British Columbia Ltd. v. A.R. Thompson Group, 2012 BCSC 1332, at para. 50 [A.R. Thompson]. [34] The petitioners argue that they meet the test for good faith because they have brought a

meritorious claim that will, if successful, enrich the company in the amount of $8.4 million. The respondents argue that the history of the relationship between the parties demonstrates that the petitioners are not acting in good faith in bringing this application. [35] The minutes of the shareholders' meeting suggest that the primary preoccupation of the petitioners has, until the commencement of this petition, been to improve the terms of their investment in Grandlake and give them security that they previously did not have. At the August 2019 shareholders' meeting, Ms. He and her husband complained about the delays in the project and its impact on their capital needs for other projects. After Mr. Zhong caused Grandlake to encumber the Land with $8.4 million in secured loans in October 2019, Ms. He was understandably even more concerned about her ability to extract her capital from the Project. The May 15, 2020 shareholders' meeting resulted in Mr. Zhong's tentative agreement to give Ms. He a guaranteed rate of return on her investment. The notion of Mr. Zhong repaying the company for the 2019 Mortgage Funds does not appear to have ever been discussed. [36] The actions of the parties subsequent to the last shareholders' meeting also support the respondent's version of events. Within seven days of the May 15, 2020 shareholders' meeting, counsel for the petitioners had sent a

draft agreement and draft promissory note to counsel for the respondents. The proposed agreement would have the petitioners receive a guaranteed investment return from Grandlake, and the draft promissory note would have Mr. Zhong acknowledging that the 2019 Mortgage Funds were his personal liability. In response to these draft documents, on June 10, 2020, Mr. Zhong's counsel sent a draft shareholders' agreement to counsel for the petitioners. The draft shareholders' agreement contemplated an investment return for Pentagon, but did not acknowledge that the 2019 Mortgage Funds were Mr. Zhong's personal debt. [37] Counsel for the petitioners did not respond to the draft shareholders' agreement provided by Mr. Zhong's counsel and on August 6, 2020, this petition was commenced. [38] There is no evidence prior to the filing of this petition that the petitioners have ever been concerned with Grandlake recouping funds Mr. Zhong allegedly appropriated from the company. Rather, their sole preoccupation has been protecting the capital they have invested in Grandlake and securing a rate of return. [39] Good faith is a question of fact to be determined on all the evidence. In this case, the evidence does not support a finding of good faith. I find that the most reasonable explanation for the petitioners' decision to commence the petition is that they seek to use the litigation as leverage

in their ongoing negotiations for a guaranteed return on their investment in Grandlake. There is simply no other reasonable explanation for why the petitioners, in the midst of negotiating a shareholders' agreement with Mr. Zhong to secure their interest in the company, would bring a petition seeking leave for the company to sue Mr. Zhong for $8.4 million. Is this legal proceeding in the best interests of the company? [40] As noted in Eastern at paras. 34-35, a consideration of the best interests of the company includes a consideration of the merits of the proposed action and whether the action has a reasonable prospect of success or is bound to fail. The onus is on the applicant to provide some evidence that the proposed action has a reasonable prospect of success: Eastern at para. 36. [41] The court should not attempt to resolve conflicting versions of the facts in the leave application. The sole purpose of considering the respondent's version of the facts is to test the reasonableness on its face of the applicant's version: A.R. Thompson, at paras. 60-61. Nevertheless, the court should do more than "skim the surface" of the pleadings: Eastern at para. 37. [42] The court must also consider "whether the potential relief sought in the action makes it worthwhile to the company to undertake the costs and inconvenience of pursuing it": Eastern at para. 38. [43] It would appear on

its face that an action to recover misappropriated funds for the benefit of Grandlake must be in the best interests of the company. The company stands to gain $8.4 million if the action is successful. However, the analysis of the company's best interests is not this simple. I also must be satisfied that the action is not frivolous or bound to fail. On this basis, I cannot find that the action is in the best interests of the company. [44] In his responding evidence, Mr. Zhong has accounted for the entirety of the $8.4 million 2019 Mortgage Funds. A portion of the funds went to pay off the CWB Mortgage, and the remainder was paid to Rong Li to cover outstanding and upcoming Project-related expenses. [45] As to Ms. He's allegation that the CWB Mortgage was a personal debt of Mr. Zhong, I cannot find this to be the case, irrespective of what Mr. Zhong may have told Ms. He in 2017. The loan from CWB was to Grandlake, not Mr. Zhong, and it was secured with a mortgage on the Land which is owned by Grandlake. Mr. Zhong's personal guarantee of this loan does not alleviate Grandlake of liability to pay out a loan under which it is the primary debtor. It may be that Ms. He misunderstood Mr. Zhong when he told her that he was a personal guarantor of the CWB loan, but any misunderstanding would have been cleared up by Ms. He searching title, which would have revealed that, as a matter of

law, Grandlake was primarily responsible for this indebtedness. [46] Further, Ms. He's assertion that Mr. Zhong required the loan secured by the CWB Mortgage to meet his capital contribution obligation to Grandlake is inconsistent with the records of Grandlake and the manner in which other capital contributions have been recorded. Mr. Huang and Pentagon each made capital contributions to Grandlake and in exchange received shares plus a shareholder's loan account balance equivalent to, or close to, their capital contribution. If Mr. Zhong took out the CWB Mortgage for the purpose of making his personal capital contribution, he would be personally liable for the CWB mortgage, but he would also have a shareholder's loan balance equivalent to the amount of the CWB Mortgage. The fact that the funds under the CWB Mortgage were recorded as a "bank loan" to the company and not recorded as a capital infusion from Mr. Zhong with a corresponding shareholder's loan balance undermines Ms. He's characterization of this loan. [47] Ms. He has no reasonable prospect of success in her claim that the CWB Mortgage was a personal debt of Mr. Zhong and that therefore the payment of the CWB Mortgage from the 2019 Mortgage Funds was a misappropriation of company funds. [48] With respect to the remainder of the 2019 Mortgage Funds, Ms. He makes two allegations: (1) that it was used to pay out a

shareholder's loan to Mr. Zhong or 878, and (2) that it was used to fund his other development projects. These factual allegations are speculative, lacking in any evidentiary basis, and entirely inconsistent with the financial statements of Grandlake, which account for the entirety of the 2019 Mortgage Funds. [49] In the circumstances, I find the claim that the petitioners seek to bring is bound to fail. As such, it is not in the best interests of the company pursuant to Eastern. [50] An additional reason why the claim is not in the best interests of the company is that a pending lawsuit of this nature is likely to detrimentally effect the marketing of the Project. Mr. Zhong has deposed that there is an immediate opportunity to finally advance the Project to the construction phase, but the existence of this litigation has prevented Grandlake from entering into presale contracts and is likely to bring the Project to a halt. I cannot find in these circumstances that the litigation proposed by the petitioners, even if it did have some merit, is in the best interests of the company. Conclusion [51] The application is dismissed, with costs. "Francis J."