Paula Lishman Limited v. Erom Roche Inc., docket T-1265-93

     T-1265-93

B E T W E E N:

     PAULA LISHMAN LIMITED,

     PAULA LISHMAN

     Plaintiffs

     - and -

     EROM ROCHE INC.

     H. & I FUR TRADING INC.

     HARRY IWATA c.o.b. H & I FUR TRADING INC.

     R. B. MANAGEMENT GROUP INC.

         Defendants

     REASONS FOR ORDER

ROTHSTEIN, J.:

     This is a reference pursuant to judgment in this matter dated May 8, 1996. The plaintiffs have elected an accounting of profits made by the defendants by reason of their infringement of the plaintiffs' patent.

     The parties have agreed that the reference should deal with the fiscal year of Erom Roche Inc. ending August 31, 1995 (the first year) and the period September 1, 1995 to April 30, 1996 (the second year). The parties have agreed that as a starting point, the gross profit of Erom Roche Inc. for the first year is $298,464 and for the second year a loss of $82,222 was incurred.

RESOLUTION OF DISPUTED ISSUES

     1. R & D expenses. This item involves, amongst other things, whether R & D costs were properly included in the accounts of Erom Roche Inc. This question pertains, at least in part, to a period prior to the two years which are the subject of this reference. For this reason, no adjustments will be made with respect to R & D expenses. In particular, R & D depreciation expense for the two periods will be allowed as deductible expenses. However, there will be no write down of the undepreciated R & D costs as of April 30, 1996. These matters will be dealt with at a later date if there is no agreement between the parties.

     2.      Salary of Harry Iwata. The salary was $2,000 per month. There is a question as to whether the salary should be increased to a more reasonable level. Erom Roche Inc. has paid a number of personal expenses for Mr. Iwata and rather than adjusting the salary, the personal expenses for Mr. Iwata will be treated as remuneration to him and when aggregated, a determination will be made as to whether the aggregated amounts constitute reasonable remuneration.

     3.      Costs attributable to United States operations. The defendant consents to add back to the profit of Erom Roche Inc. for the second year, the sum of $1,469 being airfares attributable to the United States operations. The plaintiffs have sought to add back a portion of salary expense that is alleged to be attributable to United States operations. However, it is not clear that the salary expense incurred could have been avoided had there been no United States operations. For this reason salary expense will not be adjusted.

     4.      Interest, travelling and gift expenses relating to Yoshiko Iwata. These items are to be treated as part of Mr. Iwata's remuneration. They are not expenses of Erom Roche Inc. incurred in the infringing operation.

     5.      Cleaning expenses. The defendants claim cleaning expenses for the Iwata home as Sachiko Iwata, Mr. Iwata's wife, did certain work with respect to the infringing operation there. Having regard to the documentary evidence pertaining to this expense, I am not satisfied that what are alleged to be cleaning expenses were incurred for the Erom Roche Inc. business. These appear to be personal expenses pertaining to cleaning or other household matters for the Iwata home. This amount will be attributed to Mr. Iwata's remuneration.

     6.      Legal fees. Following Teledyne Industries Inc. et al. v. Lido Industrial Products Limited (1982), 68 CPR (2d) 204 at 214, legal fees are not a proper expense attributable to the infringing operation. The sum of $10,693 for the first year and $45,032 for the second year will be added back to the gross profit of Erom Roche Inc.

     7.      Vehicle expenses. The vehicle expenses paid by Erom Roche Inc. for the personal vehicles of Mr. and Mrs. Iwata are to be treated as twenty-five percent business and seventy-five percent personal, based upon the evidence as to use of the vehicles. The business portion is deductible as an expense of Erom Roche Inc. and the personal portion is to be treated as remuneration to Mr. Iwata.

     8.      Sales Promotion. I am not satisfied that the items under sales promotion amounting to $21,614 in the first year are expenses attributable to the infringing operation. There was inconsistency between Mr. Iwata's evidence at discovery and at the reference pertaining to the largest item, which was a watch. I am satisfied that these are personal expenses and should be attributed to Mr. Iwata's remuneration.

     9.      Reasonableness of Mr. Iwata's salary. When amounts to be attributed to Mr. Iwata's remuneration are added to his salary, the total amounts to $82,240 for the first year and $33,294 for the second year. Both parties agreed that these were reasonable amounts.

     However counsel for the plaintiffs argued that a repayment of Mr. Iwata's shareholder's loan should be taken into account in determining overall reasonableness. In the first year, according to the plaintiffs, Mr. Iwata was repaid $312,509 and in the second year $132,954 (counsel for the defendants says that the amounts paid on Mr. Iwata's shareholder's loan were, for the first year $294,226 and for the second year $78,648. Counsel have agreed that they will resolve these figures by agreement). Counsel for the plaintiffs says that when aggregated with Mr. Iwata's remuneration, the totals of $394,749 for the first year and $167,248 for the second year are unreasonable.

     Counsel for the defendants says that repayment of the shareholder's loan is not relevant to the reasonableness of Mr. Iwata's salary as the repayment of the loan. I agree. While perhaps relevant for other purposes, the loan repayment is not relevant in determining the reasonableness of Mr. Iwata's remuneration. The amount treated as remuneration to Mr. Iwata does not bring his total remuneration to an unreasonable range and will therefore be allowed as an expense of Erom Roche Inc. pertaining to the infringing operation as if the amounts were Mr. Iwata's salary.

     10.      Atelier Sachiko Inc. The plaintiffs seek to add back to the profits of Erom Roche Inc., subcontract expenses paid to Atelier Sachiko Inc., a company belonging to Mr. Iwata's wife. The defendants say that this company was incorporated in order to perform certain work previously performed by Erom Roche Inc. in the production of fur garments. It is said that the company was incorporated in order to split income between Mr. & Mrs. Iwata, to save workers' compensation expenses and to recognize that Mrs. Iwata's salary from Erom Roche Inc. was unduly low.

     The setting up of Atelier Sachiko Inc. resulted in Mrs. Iwata transferring her ten percent interest in Erom Roche Inc. to Mr. Iwata. The subcontract arrangement was entered into on August 31, 1995 but was made retroactive to January 1, 1994. In addition to the subcontract work that Atelier Sachiko Inc. was to do, it was also to receive a seven percent commission on all Canadian sales of garments by Erom Roche Inc. This arrangement was entered into during the course of this litigation and only a little more than four months before the trial began.

     While I cannot be certain that there were not other benefits from setting up the company, the effect of its establishment was to reduce the profits of Erom Roche Inc. which, of course, was a convenient way for the defendants to limit the exposure to liability of Erom Roche Inc. in the event of an unsuccessful outcome at trial.

     There is significant difficulty with the numbers pertaining to the subcontract expense. The subcontract expense increases significantly month by month from September 1995 until March 1996 when it begins to decrease. There is no explanation for this increase. The sales of Erom Roche Inc., which would seem to be one indication of the requirement for the services of Atelier Sachiko Inc., were not increasing in the same manner. Nor is there evidence before me as to the relationship between the subcontract and the share transfer, although they were to be part of one transaction.

     The retroactivity of the compensation agreement to January 1994 creates further doubt about the bona fides of the transaction. Also, there is no apparent reason why Erom Roche Inc. would agree to an increase in its cost of seven percent of Canadian sales simply to pay this sum to Atelier Sachiko Inc. if it had been able to make the sales without such expense.

     Finally, the evidence in this case indicates a devious attempt by Mr. Iwata originally to obtain the plaintiffs' garments for sale in Japan, then to ascertain the plaintiffs' method of manufacture and nature of its products so that they could be copied and finally, after having been caught out in the original infringing operation, attempting to change its methodology while producing essentially the same garments as the plaintiffs. It is obvious that Mr. Iwata is a sophisticated businessman who has little difficulty taking whatever steps he considers necessary to enhance his own position at the expense of others. While, when Atelier Sachiko Inc. was established, there was no certainty that the plaintiffs would be successful at trial, I infer that Mr. Iwata had every reason to ensure that if the result of the trial was unfavourable, he would benefit from insulating Erom Roche Inc. from having to pay a judgment by reducing that company's profit.

     In the circumstances, I conclude that Atelier Sachiko Inc. was established as a means of reducing Erom Roche Inc.'s profit. I would therefore add back to Erom Roche's profit the amounts paid by Erom Roche Inc. to Atelier Sachiko Inc. that constituted remuneration to Yashiko Iwata or any of the Iwata children over and above the rate of remuneration they were receiving prior to the establishment of Atelier Sachiko Inc. The parties indicate that for the first year this amounted to $56,750 and for the second year $33,875. I would also add back to Erom Roche Inc.'s profit the seven percent commission paid to Atelier Sachiko Inc. which for the first year amounted to $45,500 and for the second year $9,447.

     The plaintiffs claim that an additional sum of $5,250 for pattern expenses should be added back to Erom Roche Inc.'s profit. This amount, which appeared in the books at one point, could not be reconciled in the final set of accounts from which the accounting is drawn. However, I am not satisfied that there is a double counting of this item and I would not add it back to the Erom Roche Inc. profit.

     11. Ogawa Fashion Planning Corporation. Ogawa Fashion Planning Corporation is Erom Roche Inc.'s sales agency in Japan. It is owned by Mr. Iwata's mother-in-law and other relatives. Erom Roche Inc. was to pay commission to Ogawa for sales arranged by Ogawa. The rate of commission was originally seven percent but there is a suggestion in the evidence that this may have been increased to nine percent as of September 1, 1995.

     The amounts payable to Ogawa for the first year at seven percent were U.S $223,490 and for the second year at nine percent U.S. $102,447. The plaintiffs say that like Atelier Sachiko Inc., this commission arrangement was simply a way to strip profits from Erom Roche Inc. The plaintiffs contend that there is no need for Erom Roche Inc. to have a sales agent in Japan and cite evidence such as gifts given by Erom Roche Inc. directly to customers that suggest that Erom Roche Inc. was making its own sales and that there may not be a rationale for the commission arrangement with Ogawa.

     On the other hand, there is an August 1993 agreement between Erom Roche Inc. and Ogawa Fashion Planning Corporation providing for a seven percent commission on sales made by Ogawa. It appears that some payments were made to Ogawa amounting in total to U.S. $174,742, the last payment being made in February 1996. The balance currently outstanding is U.S. $151,195 and there is no evidence of demand for payment of this sum although it is clearly past due.

     I have some doubt that Ogawa Fashion Planning Corporation is a bona fide sales agent for Erom Roche Inc. However, cash payments were actually made to that company and it appears there was a formal agency agreement signed in 1993. While this action had been commenced at the time, the plaintiffs were in the process of commencing and expanding their business of selling fur garments in Japan at the time.

     I cannot, on a balance of probabilities, conclude that the Ogawa commission arrangement was a sham with its sole or primary purpose that of reducing the profits of Erom Roche Inc.

     However, the evidence of the increase in commission from seven percent to nine percent for the second year is weak and indeed is contradicted by a 1996 statement from Ogawa itself which calculates commission at seven percent. In the result, I would allow as a deductible expense commission expense to Ogawa calculated at seven percent for both the first and second years. I would add back to the profit of Erom Roche Inc. the difference in commission expense between seven percent and nine percent for the second year.

LIABILITY OF HARRY IWATA AND R.B. MANAGEMENT GROUP INC.

     In the judgment dated May 8, 1996, paragraphs 6 and 7 provided in part:

6.      THIS COURT ORDERS AND ADJUDGES that a post-trial reference be conducted before this Court at Toronto to inquire into and to either assess the damages suffered by the Plaintiffs or, as the Plaintiffs may elect, to take an account of the profits made by the Defendants, or any of them, by reason of their infringement of Canadian Patent 1,107,487...

7.      THIS COURT ORDERS AND ADJUDGES that the Defendants pay to the Plaintiffs such sums as may be found due to the Plaintiffs as profits or damages and costs of the action to date forthwith after the conclusion of the reference.

     In the Amended Joint Statement of Issues submitted by the parties, the issue of liability is stated as follows:

5.      To what extent are the Defendants separately or jointly liable to the Plaintiffs for the profits earned? The Plaintiffs claim that all Defendants are severally and jointly liable for all profits owing to the Plaintiffs. The Defendants claim that each Defendant is liable to pay his or its own Differential Profits.

     While the judgment of May 8, 1996 finds the defendants liable, it does not allocate liability between each defendant named in the action, specifically Erom Roche, Mr. Iwata and R.B. Management. The issue was thus left open as to whether liability should be determined on a separate basis for each defendant or on the basis of joint and several liability.

     The plaintiffs say that Harry Iwata and R.B. Management Group Inc. should be held to be jointly and severally liable for the amounts owing to the plaintiffs as a result of this accounting of profits of Erom Roche Inc. In particular, it is said that Mr. Iwata withdrew over $400,000 in repayment of shareholder's loans, and caused Erom Roche Inc. to pay legal fees for R.B. Management Group Inc. in the sum of $18,000 in the relevant period. Because of these payments the plaintiffs are concerned that Erom Roche does not have sufficient assets to pay the amount awarded, and this is the reason for holding Mr. Iwata and R.B. Management Group Inc. liable.

     The plaintiffs argue that there are several ways in which joint and several liability can be imposed on Mr. Iwata and R.B. Management Group Inc. in the context of this accounting. These really boil down to two approaches: one is "lifting the corporate veil", and the other is constituting Erom Roche a constructive trustee for the plaintiffs and making Mr. Iwata personally liable as a stranger to the trust who has precipitated or assisted in breach of the trust.

     Counsel for the defendants argues that "lifting the corporate veil" or the trust approach is inappropriate in this case because liability should be determined for each defendant on a separate basis, such that each defendant is liable to pay his or its own differential profits.

     Specifically with respect to the liability of Mr. Iwata, counsel for the defendant argues that in the realm of patent law the test concerning the personal liability of a principal shareholder for the infringing acts of a company was laid out by the Federal Court of Appeal in Mentmore Manufacturing v. National Merchandise (1979), 40 C.P.R. 164. I agree with counsel for the defendants that the proper test is the one set out in Mentmore.

     In Mentmore, the defendant company was held to have infringed a patent relating to a retracting mechanism of a ball-point pen. The infringing company was small and closely held, with only two directors who were personally involved in the direction of manufacturing. The issue on appeal was whether the directors should be held personally liable for the infringement. In constructing the test, Le Dain J. noted the general principles concerning personal liability at 171 -172:

What is involved here is a very difficult question of policy. On the one hand, there is the principle that an incorporated company is separate and distinct in law from its shareholders, directors and officers... On the other hand, there is the principle that everyone should answer for his tortious acts. The balancing of these two considerations in the field of patent infringement is particularly difficult.... It would render the offices of director or principal officer unduly hazardous if the degree of direction normally required in the management of a corporation's manufacturing and selling activity could by itself make the director or officer personally liable for infringement by his company.

         . . .

It is the necessary implication of this approach, I think, that not only will the particular direction or authorization required for personal liability not be inferred merely from the fact of close control of a corporation but it will not be inferred from the general direction which those in such control must necessarily impart to its affairs.

     Le Dain J. went on to address the issue of when directors could be held personally liable (at 172):

What, however, is the kind of participation in the acts of the company that should give rise to personal liability? It is an elusive question. It would appear to be that degree and kind of personal involvement by which the director or officer makes the tortious act his own. It is obviously a question of fact to be decided on the circumstances of each case.

     He concluded at page 174:

I do not think that we should go so far as to hold that the director or officer must know or have reason to know that the acts which he directs or procures constitute infringement. That would be to impose a condition of liability that does not exist for patent infringement generally. [...] there must be circumstances from which it is reasonable to conclude that the purpose of the director or officer was not the direction of the manufacturing and selling activity of the company in the ordinary course of his relationship to it but the deliberate, wilful and knowing pursuit of a course of conduct that was likely to constitute infringement or reflected an indifference to the risk of it... Room must be left for a broad appreciation of the circumstances of each case to determine whether as a matter of policy they call for personal liability.

     It would, therefore, be an unusual case where a director would be held liable for infringement.

     In the case at bar, there are a number of factors that have come to light both in the course of the trial and of this accounting that have essentially been outlined above (see item 10 Atelier Sachiko Inc.) They are relevant in considering the test for personal liability prescribed by Mentmore. There has been dishonesty exhibited by Mr. Iwata as a course of conduct with respect to the acquisition of garments from the plaintiffs, the manufacture of garments through Erom Roche Inc. that infringed the plaintiffs' patent and the sale of garments in Japan. There has been a deliberate attempt to strip Erom Roche Inc. of assets to render any judgment obtained by the plaintiffs uncollectible.

     Given the deceptive and deliberately reckless behaviour Mr. Iwata has shown with regard to the plaintiffs and the infringement, it is clear that his conduct cannot be justified as merely directing the manufacturing and selling activity of Erom Roche Ltd. in the ordinary course of his relationship to it as a director. Rather, he engaged in the wilful and knowing pursuit of a scheme that constituted infringement and that reflected an indifference to the risk of it. Therefore, on the principles set out in Mentmore, I find that his participation in the infringing acts of Erom Roche give rise to personal liability on his account.

     I am not satisfied that any of the other defendants are in the same position and would make no order against them.

     In accordance with the agreement of counsel the matter of cost is reserved. Counsel for the plaintiffs shall prepare an order consistent with these reasons, obtain approval as to form and content from counsel for the defendants and submit it to the Court for signature within fourteen days of the date of these reasons.

     Marshall Rothstein

    

     J U D G E

OTTAWA, ONTARIO

FEBRUARY 3, 1997