The dispute in the case arose between Tianrui (International) Holding Company Ltd (“Tianrui”), a minority shareholder in China Shanshui Cement Group Ltd (“China Shanshui”), a company incorporated in the Cayman Islands and listed in Hong Kong. Tianrui alleged that the board of directors of China Shanshui (the “Board”) engaged in misconduct, including breaches of fiduciary duties and self-dealing. Tianrui sought to bring proceedings to address the alleged misconduct.

The history of the case involved a “prolonged battle” for ultimate control of China Shanshui whose core business was the production, distribution and supply of cement and other construction materials throughout The People’s Republic of China. Following the allotment of shares to the holders of certain convertible bonds in China Shanshui, Tianrui alleged that the recipients of those allotments were connected to other shareholders who were competing with it for ultimate control of China Shanshui. The allotment of shares in question resulted in Tianrui’s shareholding being materially diluted (following the dilution, Tianrui was no longer able to block the passing of a special resolution as its shareholding dropped below 25%) and Tianrui therefore argued that this amounted to an improper exercise of the Board’s power to issue shares.

China Shanshui’s counter argument was that Tianrui was not entitled to bring its claim directly, on the basis that any claim should be brought as a derivative claim on behalf of China Shanshui against the Board. Under Cayman Islands law, derivative actions are an exception to the general rule that only a company itself can sue to remedy wrongs done to it – often referred to as the rule in Foss v Harbottle.

The Privy Council (the last court of appeal for Cayman Islands legal proceedings) was asked to determine:

1. Whether Tianrui could bring a derivative action: Tianrui needed to show that the alleged misconduct amounted to a “fraud on the minority” and that China Shanshui itself was unable to act because the Board was complicit in the alleged wrongdoing.
2. Fiduciary Duties of Directors: The case scrutinised the Board’s duties to China Shanshui, particularly their obligation to act in its best interests and their duty to avoid conflicts of interest.
3. Corporate Governance Principles: The Privy Council had to balance shareholder remedies with the fundamental principle of corporate autonomy, which dictates that companies should generally control their own business and affairs without interference.

Against the above matters, the Privy Council had to consider many decades of prior jurisprudence on derivative actions. Whilst some of the cited cases provided that a perceived improper dilution of a shareholder’s interest could form the basis of a derivative action, the established case law was either vague, contradictory or silent on the legal basis of a claim being brought by a shareholder directly.

Derivative actions are a unique aspect of corporate law designed to protect shareholders in exceptional circumstances. To succeed in bringing such an action, a claimant must satisfy the following strict criteria:

1. Fraud on the Minority: The claimant must prove that the directors of the company in question engaged in fraudulent or oppressive conduct, harming the company and its shareholders.
2. Control of Wrongdoers: The claimant must show that the wrongdoers in question have effective control of the company, leaving it unable to bring the action itself.

The Court must also consider the overarching principle of corporate personality, ensuring these actions do not undermine the company’s governance structure and fundamental autonomy as a body corporate in its own right.

Tianrui argued that the Board misused their powers for personal gain and failed to act in China Shanshui’s best interests. Specifically, Tianrui alleged that certain decisions taken by the Board unfairly diluted its shareholding (as described above) and improperly favored other shareholders in China Shanshui.

In resisting Tianrui’s submissions, the Board contended that their actions were lawful and had been made in good faith to safeguard China Shanshui’s stability and prospects. The Board further argued that the derivative action that Tianrui was attempting to bring was an inappropriate means for Tianrui to challenge decisions taken by the Board.

In its judgment, the Privy Council sought to strike an appropriate balance between the fundamental and long-established legal principles and more practical matters, and found as follows:

1. Directors to act properly: on the basis that the memorandum and articles of association of a company are a statutory contract between the company in question and its shareholders, it follows that the directors of the company must exercise the powers that are given to them (including the power to issue shares) under those memorandum and articles of association for proper purposes.
2. Fraud and Wrongdoing: The Court agreed that derivative actions require evidence of serious misconduct. The Privy Council held that Tianrui had successfully demonstrated that the alleged conduct could qualify as a “fraud on the minority”, if proven. In particular, it was noted that the dilution of shareholders, particularly where the effect of that dilution removes practical rights from minority shareholders (such as the ability to block a special resolution from being passed), can be an improper exercise of the directors’ ability to issue shares.
3. Control by Wrongdoers: The Privy Council acknowledged that derivative claims are a vital tool which is available to protect shareholders where the alleged wrongdoers dominate the company’s decision-making processes. Tianrui established that those who were allegedly responsible for the misconduct in question retained effective control of China Shansui, thus effectively blocking any other remedy that might be available.
4. Fiduciary Duties: Directors have a duty to act in good faith and to prioritise the company’s best interests over their personal interests or those of their affiliates. The Privy Council emphasised that breaches of this duty are central to shareholder protection. It follows that the ability to bring such a claim is not just the preserve of minority shareholders; if the criteria for bringing such a claim are met, any shareholder (including majority shareholders) could bring a claim.
5. Corporate Governance: The judgment highlighted the need to balance minority shareholder protections with the principle of corporate autonomy. While derivative actions are an essential remedy, the court stressed their use should remain limited to prevent interference with legitimate board decision-making.

The Privy Council ultimately ruled in favor of Tianrui, thus allowing the derivative action that was sought by Tianrui to proceed. It confirmed that the allegations, if proven, would constitute serious breaches of fiduciary duty by the Board and would justify the intervention of the Court.

This decision underscores that derivative actions are not to be taken lightly. The claimant must present clear evidence of wrongdoing and demonstrate that the company itself cannot pursue the claim.

This case offers valuable lessons for shareholders, and directors:

1. For Shareholders: Minority shareholders who are seeking such a remedy must be prepared to meet the high bar that is set in order for such an action to proceed. Those who suspect wrongdoing should carefully and accurately document evidence of alleged wrongdoing contemporaneously in a way that proves both misconduct and the company’s inability to act. Meeting only one of these standards alone will be insufficient to enable such an action to proceed.
2. For Directors: Directors should be mindful of their fiduciary duties, exercise their powers only for a proper purpose and should ensure that their decisions withstand objective, and possibly judicial, scrutiny. Transparent and well-documented decision-making processes can mitigate the risk of challenges to decisions made and/or help to defend against these challenges. Directors of companies would therefore be well advised to do the following.

1. 1. Ensure that full and accurate minutes are kept of all important decision-making processes. Such minutes should be sufficiently detailed and should contain a full and accurate consideration by the directors of the pros and cons of the proposed actions and should outline why the directors consider them to be appropriate and to be in the company’s best interests. Any finding by a Court as to whether there has been wrongdoing and whether a claim can be brought are, necessarily, subjective in each case. In the event of any challenge, these records will be valuable evidence and could ultimately be determinative.
   2. Fully and properly disclose any personal interest(s) in matters which are to be considered by them in the course of their role as director. Whilst this is both a necessary and fundamental principle of good corporate governance and required (usually) by the articles of association of the company, this can also go some way to demonstrating that the directors in question are acting in good faith. Directors should therefore familiarise themselves with the provisions of the articles of association relating to the disclosure of their interests and whether they are permitted to continue to form part of the applicable quorum and/or to vote on the matter, irrespective of such interest. They should also consider that where they are so interested, the fact that they are permitted to count in the quorum and vote on the matter, does not mean that they should do so.

The Privy Council’s judgment in Tianrui v China Shanshui serves as a significant clarification of derivative action principles in the Cayman Islands. By allowing the case to proceed, the Privy Council reinforced the importance of holding directors accountable while ensuring that shareholder remedies do not disrupt proper corporate governance.

This decision also highlights the Cayman Islands’ commitment to maintaining a robust legal framework for resolving corporate disputes, preserving its reputation as a leading jurisdiction for global businesses. Minority shareholders can take comfort in the availability of effective remedies where the require threshold is met, whilst directors are reminded of their fiduciary duties and their obligation to consider the interests of all shareholders when taking decisions.

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This publication is not intended to be a substitute for specific legal advice or a legal opinion. If you require further advice relating to the matters discussed in this Briefing, please contact us. We would be delighted to assist.

E: robert.farrell@loebsmith.com

The term ICO refers to an “initial coin offering”, i.e. a public sale of digital tokens or coins, to which various rights may be attached. Although there is no generally recognized classification, industry experts and some regulators have started referring to several categories of tokens based on the underlying economics, as determined on a case-by-case basis after review of the white paper published by the founder team.

• Payment Tokens or Cryptocurrencies: Modeled after Bitcoin (BTC), some tokens (or coins) have no rights attached giving the holders a claim against the issuer, but they are designed to be limited in quantity, similar to precious metals, so that their value may increase based on their adoption by various users. Their value is also tied to the benefits provided by the blockchain platform they are built on (e.g., security, decentralization, disintermediation, anonymity or pseudo-anonymity). Although Mastercoin is generally regarded as the first ICO, Ethereum (ETH) was more successful in 2014, raising 25,000 BTC from investors in the first two weeks of the public sale and later on developing Ethereum as the largest platform for ICOs.
• Utility Tokens: Most ICOs sell tokens which are designed to provide access to an application or service on a blockchain-based platform. Such tokens may be “burned” upon use, but new tokens can generally be purchased on the same platform. Such tokens are the blockchain version of digital coupons, but with the additional benefit of being tradeable securely and pseudo-anonymously (and benefiting from a potential increase in value if the number of users of the platform increases).
• Asset Tokens: Tokens which give the holder a portion of the profits of the business or other economic rights are considered to be securities in several jurisdictions, i.e. a blockchain version of equity interests, debt instruments, etc.
• Hybrid or Other Tokens: Any combination of the above can generally be considered a hybrid token; this may trigger an overlap of applicable regulations.

In some cases, the same blockchain project generates two or more categories of tokens with different rights attached, which are issued in the different stages of the project. In other cases, investment contracts for future tokens (SAFT, SAFTE, and several other variations) are signed before an issuance, enabling the founder team to develop a working model of the blockchain project before any “public” sale. Finally, some blockchain start-ups do not offer any type of coins or tokens.

The assumption would therefore be that issuing tokens in a certain “category” would trigger regulation, while another “category” may not. Such assumption, however, if not confirmed by review by specialist legal counsel, exposes the issuer to substantial legal and regulatory risks, especially since the regulators’ position, as expressed through “Guidance Notes” or unofficial statements, may change over time.  Also, ICO founder teams are generally based in multiple jurisdictions, and promotion efforts may target investors from various countries. Without realizing it, ICO founder teams may in fact be required to comply with several very different regulatory environments.

As at the date of this publication, there is still no specific regulation in the Cayman Islands addressing ICOs and blockchain technology. However, several of the existing laws and regulations are applicable to blockchain start-up companies and their pre-ICO and ICO operations. Also, a recent series of statements have been made by the Cayman regulatory authority, which generally encourage the blockchain ecosystem development. The Cayman Islands Monetary Authority (“CIMA”) itself has unofficially commented that cryptocurrencies, ICOs and FinTech generally are here to stay and that although the Cayman Islands Securities Investment Business Law (2015 Revision) (SIBL) does not include cryptocurrencies or tokens in its list of securities , CIMA may be issuing further guidance to issuers and promoters as they increasingly look to access “real money” through the offshore funds industry.

As things currently stand, ICO founder teams and promoters looking at the Cayman Islands for incorporation of their company or companies should be aware of the following best practices:

1. Have a Real Project. Setting up a Cayman Islands exempt company for your ICO (the “Company”) is not complicated and it usually only takes a few business days. However, a successful project requires more than a legal entity. Based on your business model and strategy, the legal vehicle which may be best suited for your purposes may also be different: for example, a foundation company instead of a regular exempt company may work best if your purpose is to create a stand-alone blockchain ecosystem, not “owned” by a particular person or group of persons. For more details regarding Cayman Islands foundation companies, see our alert Foundation Companies can now be incorporated in the Cayman Islands. Generally, the founder team should be prepared to answer the following questions:

• • What are the key features of the service/platform to be developed?Which market participants (investors) will the ICO target? Are there any restrictions regarding investors? Are the founders planning to bring in pre-ICO investors on a private placement basis (through SAFT agreements or otherwise)?
  • What is the project timeline (ICO phases, milestones, etc.)?
  • What technologies will be used (new or existing, open source project vs. blockchain patent envisaged, etc.)
  • Which cryptocurrencies will be accepted? Will the ICO have a floor or a cap?
  • Have the funds already been allocated to a specific project? How will surplus funds be handled?
  • Will a token be created in the course of the ICO?
  • Which functionalities are planned for the token? What rights will be attached?
  • At which point, by whom and in which manner will the token be transferred to the investors?
  • How can the token be transferred (compatible wallets, technical standards)?
  • Is the token already functional at the time of transfer? If yes, to what extent?
  • How and where can the token be acquired or sold after the ICO (secondary market platforms)?
  • Will it be possible to use the tokens to buy goods or services or make payments to third parties?
  • Are there plans for the Company to buy back tokens?
  • Which service providers will be involved with the ICO?

2. Have a Real Lawyer. A lot of the information generally available on the web about setting up a company or opening up a bank account in the Cayman Islands is inaccurate. Even going to a real CIMA-regulated corporate service provider may not be sufficient in itself, as they will only be able to help with setting up the company and certain basic compliance issues. It is imperative that founder teams use legal counsels who regularly operate within the ICO space and have detailed, specialist knowledge of the regulatory landscape. As shown by the recent wave of enforcement actions and subpoenas in the United States , regulators will not hesitate to go after ICOs if not properly carried out, and the founder team may be forced to return funds, raise compliance standards or face sanctions.

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Notes

1. EY research: initial coin offerings (ICOs), December 2017, in which Ernst & Young studied 372 ICOs having raised US$3.7b in funds.
2. Such as FINMA, the Swiss regulator – see https://www.finma.ch/en/news/2018/02/20180216-mm-ico-wegleitung/
3. From the Ethereum self-published statistics – see https://blog.ethereum.org/2014/08/08/ether-sale-a-statistical-overview/
4. It has been pointed out by many that although blockchain gives the impression of anonymity, in reality most wallets can be linked to a physical identity and in reality only offer a sort of pseudo-anonymity. For example, KYC/AML obligations apply to all cryptocurrency exchange platforms and buying cryptocurrencies on such exchanges is subject to the user providing government-issued identification.
5. For this reason, it may be considered that all tokens are in reality bought for speculative purposes and therefore all tokens (even utility tokens) should be treated as securities in the US (among other jurisdictions).
6. For example, China and South Korea have banned all ICOs. Other regulators have issued warnings to investors and guidance notes, but reserve the possibility to adopt a specific ICO-related regulation or take action at a later stage.
7. Quote from Ms. Heather Smith, Head of Investments & Securities Division of the Cayman Islands Monetary Authority (CIMA), during the Opalesque 2018 Cayman Roundtable.
8. Schedule 1 of Cayman Islands Securities Investment Business Law (2015 Revision) (SIBL) exclusively refers to shares (including stock of any kind in the share capital of a company, interests in a limited partnership, or units of participation in a unit trust), instruments creating or acknowledging indebtedness such as debentures, debenture stock, loan stock, bonds, certificates of deposit and any other instruments creating or acknowledging indebtedness, instruments giving entitlements to securities, certificates representing certain securities, options, futures and contracts for differences.
9. Quote from Ms. Smith during the Opalesque 2018 Cayman Roundtable, see FN vii above.
10. On 24 August 2017, following a request for information from the Securities and Exchange Commission (SEC), Protostarr cancelled its ICO and refunded its investors. On 4 December 2017, the SEC obtained an emergency asset freeze to halt the ICO of Quebec-based PlexCorps. On 11 December 2017, the SEC ordered Munchee Inc. to cease and desist its ongoing token sale. On 17 January 2018, the Enforcement Section of the Massachusetts Securities Division of the Office of the Secretary of the Commonwealth brought an enforcement action against Caviar, a Cayman Islands company, and its founder. On 30 January 2018, the SEC obtained a court order to halt the ICO of Dallas-based AriseBank for allegedly conducting a fraudulent ICO.

Entities which are regulated by CIMA should provide accurate and timely information to stakeholders, including shareholders (or interestholders in a limited partnership) and regulators. This includes financial reporting, compliance filings, and any material changes that could affect shareholders/interestholders.

The board of directors of a Cayman Islands company (“Board”) may delegate some of its responsibility to others (e.g. the Board of Directors of a Fund delegating management of its assets to a Fund Manager) but is nonetheless required to exercise supervisory oversight and control over those delegated functions and moreover the Board should be accountable for its actions and decisions. This includes setting clear roles and responsibilities, establishing performance metrics, and ensuring that there are mechanisms in place to evaluate the performance of the Board and management.

Depending on the subject matter of the rights and entitlements in question, shareholders (particularly those in the same class) should be treated fairly and/or equitably, with their rights respected and any conflicts of interest managed appropriately.

The Board should be composed of qualified individuals with the appropriate diverse skills, experience, and independence to make informed decisions. Regular assessments of Board performance and training opportunities are encouraged to enhance effectiveness.

Effective risk management frameworks should be in place to identify, assess, and mitigate the internal and external risks that the company faces. This includes financial, operational, legal, and reputational risks.

Companies must comply with the legal and regulatory frameworks applicable in the Cayman Islands, including the Companies Act, the Beneficial Ownership Transparency Act, the Securities
Investment Business Act, the Mutual Funds Act, the Private Funds Act, and relevant guidelines issued by regulatory bodies such as CIMA.

Companies should promote and adhere to high ethical standards and conduct business with integrity. This involves establishing codes of conduct, policies to deal with conflict of interest appropriately, anti-corruption policies, and procedures for reporting unethical behaviour.

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By following these principles consistently, Cayman Islands regulated entities can effectively enhance their corporate governance practices, comply with Cayman Islands legal requirements and thereby avoid fines and penalties, align with best practices globally, and foster trust among their stakeholders.

This publication is not intended to be a substitute for specific legal advice or a legal opinion. For specific advice on Corporate Governance, please contact your usual Loeb Smith attorney or any of the following:

E: gary.smith@loebsmith.com
E: robert.farrell@loebsmith.com
E: elizabeth.kenny@loebsmith.com
E: edmond.fung@loebsmith.com
E: vivian.huang@loebsmith.com
E: faye.huang@loebsmith.com
E: yun.sheng@loebsmith.com