This is "a classic lesson to all those who are enthusiastic in setting up their own start-up operations, in particular in the information and technology sector". So commented the Honourable Mr Justice Lok presiding over the Intellectual Property List of the Hong Kong Court of First Instance in Emagist Entertainment Ltd v Nether Games (Hong Kong) Ltd  HKCFI 899.
On the face of it, the dispute was a source code copyright infringement case. However, the parties' claims and counterclaims then revealed multiple issues relating to (amongst others) the mode of operation of the business, employment of staff, investment in the company, accounting disputes and the sharing of profits. Ultimately, the Court awarded approximately US$456,000 against the defendants (creators of the game), reflecting losses suffered by Emagist (the game’s copyright owner).
The decision sheds much light on the considerations a start-up should address at the outset of their venture.
Disputes arose amongst the originators of an online role playing game “Ninja Saga” when Emagist Entertainment Ltd (Emagist) found that the defendants had migrated source code from the game elsewhere, after their business relationship turned sour.
Emagist was in the business of developing and publishing online games. Through its officer Mr Lee, Emagist enlisted the help of the defendants in conceiving, developing and publishing the game on various platforms in 2009-2012, which brought Emagist substantial profits. The defendants were also brought in to help introduce capital investment and funding to help the business grow.
It was Emagist's case that unbeknownst to them, the defendants migrated the game's source code and modified server settings to Nether Games (Hong Kong) Limited, so that the game was running elsewhere outside the control and knowledge of Emagist. Emagist also claimed that certain documents including employment contracts and non-disclosure agreements had gone missing.
Emagist obtained an interim injunction restraining the defendants from continuing the alleged copyright infringement. Emagist also claimed that due to the interruption caused by the "migration" of the source code, the game had lost its popularity and, in turn, revenue estimated at millions of Hong Kong dollars.
The case continued with the defendants defending the copyright infringement claim alleging ownership in the source code, and alleging that the defendants were entitled to copy the code as it belonged to both Emagist and the defendants as they were business partners in a partnership and/or co-authors of the works.
The case also involved arguments as to whether Emagist was in fact a partnership, and various claims over purportedly wrongful sharing or distribution of alleged partnership assets.
The court's judgment frames the disputes into distinct issues start-ups should think about (e.g. the structure of their operation) and what happens when the business becomes a success or a failure.
Business partners or employees?
One main issue in this dispute was the legal relationship between the parties. This was a pivotal threshold question. If the court held that the parties had been in a partnership, the court was likely to find there was shared ownership of the copyright, as well as in the profits and losses deriving from the game. Conversely, if the defendants were held to be Emagist's employees, more likely than not copyright would have belonged to Emagist as the employer.
Ultimately, the Court decided that there was no partnership, taking into account:
- The defendants did not enquire as to how much of the partnership/ joint venture they were entitled. This supported Emagist's case that any reward of shares should be considered part of the employees' incentive scheme which was to be made at the sole discretion of their employer Emagist.
- The defendants did not request distribution of profits when the game became successful. Instead, Emagist decided upon and made monthly payments which were in substance monthly salaries paid to the defendants.
- While sharing of losses is not necessary for a partnership to exist, Emagist (and not the defendants) bore the initial expenses of the game business.
- The defendants sought instructions and/or permission for sick leave or absence from Emagist. It was “one thing for a junior and inexperienced partner to rely on a more experienced partner to make decisions for the partnership” but it was “another for a person to work like an employee”, for example seeking permission to be absent from work.
Ownership of assets
Whilst there was no dispute that the defendants had written the source code and database materials, the court found that the copyright in these works belonged to Emagist and not the defendants:
- The employer is the first owner of any copyright in employee works made in the course of the employee's employment under the Copyright Ordinance (Cap. 528). Even if the defendants were working as consultants or independent contractors, a notion which the court rejected, the works would be commissioned works with copyright belonging to Emagist.
- When investors subsequently joined the game business, the defendants should have known that the investors would also purchase the copyright in the game, being the most important and valuable asset of the business. The defendants however did not demand participation in this transaction. The defendants' inaction or indifference was an implied acknowledgement that the copyright of the game belonged to Emagist.
- One of the defendants signed a non-disclosure agreement with Emagist relating to the use of confidential information. This was in conflict with the proposition that the defendants owned the copyright in the game.
The court also commented that the investor should have demanded written documents, such as agreements between Emagist and the original authors of computer codes, music and other drawings associated with the game, to confirm that Emagist was the owner of the copyright in the game, which was the most important asset of the business at the time. These were basic documents. If the investor had demanded proper due diligence documents, which should have been the case, the differences between the parties might have been resolved much earlier without the need for legal proceedings.
Business funds misused?
The defendants complained about certain of Mr Lee's withdrawals and/or his alleged misappropriation of funds belonging to Emagist. However, as the defendants were only employees and not partners in the business, they did not have standing to make such a claim. These claims were dismissed.
The judgment also noted the following points against the defendants:
- the alleged expenses were recorded openly in ledgers and financial statements and yet no complaints were made contemporaneously – the delay in subsequently making these complaints made it difficult for detailed particulars of the expenses to be given at trial.
- a proper derivative action should be commenced in matters such as this, but was not in this case. For such a derivative action, other business stakeholders (such as the investor in this case) should be involved in any related investigation.
This case illustrates how one can be a victim of one’s own success.
As the judge noted, it is just part of human nature that different persons may have different expectations as to the business operation and their rewards and liabilities. With this in mind, we recommend that start-ups should at least document the following matters at the start of their venture:
- What type of corporate vehicle and governance structure will the business run on? Equal or unequal ownership? Percentage of shares ?
- Who owns the business’s assets and bears its liabilities?
- How should roles, responsibilities and duties be defined?
- How will intellectual property, trade secrets and confidential information be protected?
- What are the profit sharing and loss bearing arrangements? Who gets the rewards for the work ?
- How will any disputes be handled?
- What is the exit plan?
Start-ups should consider seeking legal advice at the outset and also keep a proper paper trail documenting shareholder rights, constitutional and employment documents, distribution of profits, minutes of meetings etc. These may come in handy when disputes arise, and hopefully will help determine how much profit to share when the start-up has become a success. Here, even the meeting relied on by the defendants for their claim that the business was a partnership was undocumented.
These considerations become ever more acute in circumstances where parties are entering into joint ventures and partnerships, either at the outset or further down the line, as is increasingly the case with technology ventures.
For more on how businesses can prevail when technology fails, see our Litigation Landscape report:
Authored by Eugene Low, James Kwan, Byron Phillips, Charmaine Kwong, Nigel Sharman.