CHUNG YUEN CHU AND ANOTHER v. COSIMO BORRELLI AND OTHERS

CACV 173/2018

[2019] HKCA 622

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF APPEAL

CIVIL APPEAL NO 173 OF 2018

(ON APPEAL FROM HCMP 2093 of 2017)

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J U D G M E N T

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Hon Lam VP:

1.  I respectfully agree with the judgment of Yuen JA and have nothing to add.

Hon Yuen JA:

2.  This is the plaintiffs’ appeal from a Judgment of Chow J given on 24 April 2018 (“the Judgment”) in which he held on the trial of a preliminary issue that two Deeds of Share Pledges dated 1 April 2015 (“the Pledges”) under which the plaintiffs (“the Pledgors”) mortgaged[1] their shares in the 5^th defendant in favour of the 3^rd defendant and the 4^th defendant respectively (collectively “the Pledgees”) were not irredeemable and thus not void. 

3.  The learned judge also ordered the Pledgors to pay the costs of the trial of the preliminary issue.

Background

4.1  The detailed factual background has been set out in the Judgment[2]. 

4.2  Essentially the Pledgors controlled a group of companies (with the 5^th defendant as the ultimate holding company) which were involved in the research, development and manufacturing of high performance materials.  They wished to attract investment, and two private equity funds (“the Investors”) agreed to invest more than US$60 million.  The aim (expected to be achieved in around two years time[3]) was an initial public offering (“IPO”) of a company in the group called SRO Aramid (Jiangsu) Co Ltd (“the Company”).   

4.3  A complex restructuring scheme was undertaken for the purpose of the investment. A number of documents were executed (“the Transaction Documents”) which included an Investor Rights Agreement (“IRA”) and the Pledges.  In respect of the Transaction Documents, the Pledgors’ position before the judge was that:

“in order to determine the validity of the Pledges, it is not necessary to go into the details of the Transaction Documents, other than the Pledges and the IRA”[4].

Mr Hollander[5] acting for the Pledgors on appeal did not resile from that position. 

4.4  The IRA and the Pledges dated 1 April 2015 were not the first set of documents entered into for the investment.  We were not referred to these earlier documents, save that Mr Hollander emphasized that no money was owing to the Investors by the above date.

The IRA

5.1  The IRA was made between the “Founders” (defined as the Pledgors and the 5^th defendant), the Investors[6] and the Company. 

5.2  It contained (amongst other things) provisions for:

- restrictions on transfers by the Founders of their securities in the group prior to the completion of the IPO[7];

- corporate governance[8];

- profit guarantees[9];

- confidentiality[10] etc.

-    Corporate governance     

6.1  Section 5 is the section on Corporate Governance. 

6.2  At the end of this section, there is the following provision: 

“5.8 Termination. This Section 5 shall terminate upon the completion of an IPO except that the Section 5.2(a)(b)(c), 5.2(f), 5.3(c), 5.6 and 5.7 shall survive until such Investor’s shareholding in the Company is less than 5%”.

6.3  These provisions on corporate governance, surviving after completion of the IPO until an Investor’s shareholding drops below 5% may be summarized below:

- section 5.2(a): number and composition of the board of directors;

- section 5.2(b): removal and replacement of directors;

- section 5.2(c): directors’ access to books and accounts of the group, etc;

- section 5.2 (f): establishment of committees reporting to the board of directors;

- section 5.3(c): quorum of board meetings;

-  section 5.6: provision of audited and unaudited annual reports;

- section 5.7: indemnification of investor directors.

-   Confidentiality obligation

7.  Section 10.1 (which the Appellants emphasized both here and below[11]) sets out a “general obligation” (subject to exceptions set out in Section 10.2) that each party to the IRA should not disclose confidential information[12] to any third party, and the Founders are obliged to procure that each Group Member[13] comply with that obligation as if it were a party thereto.  Section 10.3 provides that no publicity release or public announcement concerning the relationship or involvement of the parties should be made (except as required by law or an authority or the stock exchange).     

-    Termination of the IRA     

8.1  Section 11 is the section on “Term and Termination” of the IRA.

8.2  Section 11.1 provides that the agreement

“shall terminate: (a) with respect to any Shareholder on the date on which such Shareholder no longer holds any Shares of the Company, (b) with respect to all Parties, on the date agreed in writing by all of the Parties, or (c) upon the closing of an IPO, except as provided in Section 5.8 and except for Sections 3.1(b), 9.6 and 9.7 which shall survive the closing of an IPO, and other provisions set forth under Section 11.2 below”. (Emphasis added).

8.3  The provisions in section 11.1(c) above which survive the closing of an IPO may be summarized as follows:

- section 5.8: set out above[14];

- section 3.1(b): the Founders agree not to transfer any securities in the Group Members until the Investors have sold all their shares in the Company;

- section 9.6: the Founders shall procure that each Group Member provides a written report to Investors on environmental performance;

- section 9.7: the Founders shall procure that each Group Member carry out its business in accordance with certain principles, eg providing safe and healthy working conditions for employees, etc.

8.4  Section 11(2) provides that:

“Consequences of Termination. If this Agreement is terminated pursuant to Section 11.1,this Agreement shall become null and void and of no further force and effect, except that the Parties shall continue to be bound by the provisions of this Section 11, Section 1 (Interpretation), Section 10 (Confidentiality and Restrictions on Announcement), Section 13.3 (No Partnership), Section 13.11 (Governing Language) and Section 14 (Governing Law and Dispute Resolution). Nothing in Section 11.1 and this Section 11.2 shall be deemed to release any Party from any liability for any breach of this agreement prior to the effective date of such termination”.

8.5  Mr Hollander submitted that as set out above, there were three categories of obligations which survive (to different extents) the termination of the IRA. He provided a table[15] indicating the three survival periods for the provisions relevant to his submissions.  I have made some minor revisions to the headings of the columns for more clarity.     

The Pledges

9.1  As for the Pledges, the Pledgors entered into them on the same day as the IRA.  As noted above, one Pledge was made in favour of the 3^rd defendant and the other was made in favour of the 4^th defendant.  It has not been suggested that there is any substantive difference[16].

9.2  In the Pledges, the Pledgors pledged their shares in the 5^th defendant to the Pledgees[17] and covenanted[18] with them to fully comply with, as principal and not merely as surety, all of the Secured Obligations, which were defined[19] to mean:

“all present and future obligations and liabilities of the Obligors to the Pledgee under the Transaction Documents (including ... the [IRA])”.

9.3  The term “Obligors” was defined[20] to mean: 

“each of the Pledgors, [the 5^th defendant], [SPV][21] and [the Company] ...”.

9.4  Section 8.1 provided that the Pledgors would not transfer, etc the pledged collateral other than as permitted by the IRA, and under section 8.2, the Pledgors agreed that they would procure the Company to carry on business in the ordinary course and not to dispose of its assets except as permitted by the IRA.

10.  Section 12 provided that the Pledgees may appoint receivers if (amongst other things) the security has become enforceable upon the occurrence of an event of default, defined as a default with respect to any Secured Obligation[22].

-    Termination of the Pledges

11.1  Section 20.2 provided:

“The Pledge shall be terminated upon the satisfactory performance (in the judgment of the Pledgee) by each Obligors [sic] of its respective obligations under the Transaction Documents and the termination thereof[23], or as mutually agreed by the Pledgee and all Pledgors”.

11.2  Section 20.3 provided that the Pledge shall remain in full force and effect after it takes effect till its termination.          

Events leading to litigation

12.1  A year later, according to the Investors, various breaches of the IRA occurred[24].  This was disputed by the Pledgors.  In 2017 the Investors appointed receivers[25] pursuant to Section 12 of the Pledges. 

12.2  The Pledgors challenged the validity of the Pledges, and an order was made on 6 November 2017 in HCMP2093/2017 that there should be determined in a trial of preliminary issues whether the Pledges[26] were null and void, or are otherwise invalid and/or ineffective, on the ground that they either (a) are irredeemable, or (b) contain provisions repugnant to the equity of redemption.

Brief review

13.1  Before considering the issues before the judge, it may be helpful to briefly review the historical development of the equitable right of redemption, and how the courts disposed of “clogs” or “fetters” on it. 

13.2  In a typical mortgage, the mortgagor was obliged under contract to repay the loan on a certain date.  If he failed to do so on the contractual date, then under the common law he would have forfeited his interest in the property. 

13.3  However the court of equity gave him the right to redeem his property – after the expiry of the contractual date for repayment – on repayment of the loan, interest and costs.  This equitable right to redeem (also called the equity of redemption) was regarded as an equitable estate which belonged to the mortgagor.

13.4  Anything which hampered the mortgagor’s right to get back the property in the same state or condition as when he mortgaged it was regarded as a “clog” or “fetter” on his right to redeem, and was struck down by the court of equity.  Thus, in a typical “tied house” case, a provision in the contract of mortgage which stated that even after repayment of the loan, the mortgagor/publican could only sell liquor supplied by the mortgagee/brewery for the remainder of the leasehold term meant that the property after redemption was not in the same condition as when it had been mortgaged.  Accordingly the provision was regarded as a clog on the equity of redemption and was severed from the mortgage[27].

13.5  At the same time, the court of equity applied the same concept against mortgagees who attempted to devise ways of, in effect, doing away with redemption.  For instance, if the contract of mortgage itself sets a redemption date to be at so distant a time as to render the equity of redemption illusory (eg if the mortgaged property is a short term of years and the contract provides that redemption can only occur shortly before its expiry), equity would also intervene to declare that postponement provision to be void[28].

13.6  This brings one to the question whether a particular term agreed between a mortgagor and a mortgagee which imposes an obligation on the mortgagor:

(a) is truly a constituent element of the mortgage – in which case, if it is a clog on the equity of redemption, there are the above ramifications;

or alternatively,

(b) is a severable independent bargain outside the mortgage (even though it may be in the same document), in which case the equitable principles set out above do not apply.

This is how the learned editors of Cousins on the Law of Mortgages[29] put it:

“In Kreglinger’s case[30] the House of Lords refused to admit that a covenant clogged the equity of redemption merely because it was contained in a mortgage deed and by its nature might continue to impose obligations on the mortgagor after redemption. Kreglinger’s case appears to decide that, just as equity looks at the substance of a transaction rather than its form to see if the transaction is really a mortgage and even admits parol evidence to explain the deed, so it will look at the intention of the parties rather than at the form of the documents to see if a collateral covenant was intended to be truly a constituent element of the mortgage or an independent severable bargain linked to a mortgage in a larger business transaction but not constituting a term of the mortgage. In the latter case the collateral covenant does not touch the mortgage relationship and stands entirely outside the equitable principles protecting the right to redeem”. (Emphasis added).

Issues before the judge

14.  At the hearing before the judge, it would appear that Mr Sussex was not contending that there was a clog or fetter on the equitable right to redeem[31].  His submission was that the Pledges in their entirety were irredeemable and void ab initio on the grounds that:

(i) some of the obligations under the IRA are non-monetary and survive its termination, and consequently the Pledges cannot be terminated (“the non-monetary continuing obligations point”);

(ii) the wide scope of the obligations (in particular, the requirement that performance be to the satisfaction of the Pledgees) prevents the Pledgors from exercising the right of redemption (“the performance to satisfaction of pledgees point”).  

The judge’s Judgment

15.  In his Judgment, the judge set out the relevant legal principles in admirably succinct and clear terms at §§20-24.  (On appeal, Mr Hollander has not challenged those principles or the judge’s understanding of them). 

(i)    The non-monetary, continuing obligations point

16.  The judge noted that Mr Sussex did not dispute as a matter of principle that it is valid for a mortgage to secure non-monetary obligations; the challenge was to the “indefinite period” of the obligations[32].  Counsel emphasized:

(1) the obligation relating to confidentiality[33], and

(2) the obligations relating to corporate governance (while the investors held at least 5% of the shares) which survived the termination of the IRA upon the closing of an IPO[34].

17.  The judge quoted two cases to support his holding that a mortgage was not rendered irredeemable even though it secured contingent liabilities over an indefinite period. 

18.  In Richards v The Commercial Bank of Australia [35], Fox J in the Supreme Court of the Australian Capital Territory apparently accepted[36] that in principle it was valid for a mortgage to secure one of the mortgagors’ contingent liabilities under guarantees he had signed for third parties.  However there was no discussion of that issue as it was held that the mortgage document in that case was ambiguous.

19.1  In Re Rudd & Son Ltd[37], two builders had given two mortgages to a bank.  After paying off what was owing to the bank, they asked in 1981 to redeem the mortgages.  The bank refused because it had provided performance bonds in connection with construction works done by the builders for two county councils.  The performance bonds had been counter-indemnified by the builders, and the bank asserted that these constituted contingent liabilities of the builders/mortgagors. 

19.2  As events transpired, in 1982 the county councils did make calls on the bank under the performance bonds, but the issue before the court was whether the bank was entitled to refuse redemption the year before.

19.3  The English Court of Appeal held that the builders/mortgagors could not redeem the mortgages in 1981 while there were contingent liabilities to the bank, without making provision for those liabilities to the satisfaction of the bank.  It was irrelevant that at that time, there was no call made on the performance bonds yet.  After construing the mortgage document to cover contingent liabilities which had not yet crystallised into accrued liabilities at the time when the builders/mortgagors asked to redeem the mortgages, Nicholls J (as he then was) said:

“The consequence of this construction is that the mortgagor may find itself unable to redeem its property for an indefinite period, until it becomes known whether a contingent liability will become a present liability or not. So be it”. (Emphasis added).

20.  Relying on the above cases, the judge held that as a matter of law, a mortgage was not objectionable merely because it secured non-monetary obligations “for an uncertain (and, in that sense, indefinite) period”[38]. 

21.  Pausing there, it would be noted that in Rudd, there was a provision in the mortgage whereby the mortgagor could give notice to terminate the security, thereby crystallizing its obligations under the mortgage.  Further it would appear from the passage in Nicholls J’s judgment emphasized above that there was a time limit within which the county councils could make calls on the bank under the performance bonds.  In other words, when the mortgage was entered into, there was no definite period when the security could be redeemed – but it was certain that at some stage in the future, it could be redeemed. 

22.  On the facts of the present case, the judge noted that Section 20.2 of the Pledges provided that they would be terminated upon the satisfactory performance (in the judgment of the Pledgees) by each Obligor of its respective obligations under the Transaction Documents[39] and the termination thereof. 

23.  On the judge’s construction, the question of satisfactory performance of obligations under the IRA “must be judged as at the date of its termination”.  On that basis he held that on the termination of the IRA, the Pledges would terminate under Section 20.2, and the fact that some obligations under the IRA survived the termination of the IRA did not prevent the termination of the Pledges. Hence there was no issue of irredeemability for a continuing, indefinite period[40].  

(ii)   The performance to satisfaction of pledgees point

24.  In relation to this, the judge held that the Pledgees would not be entitled to exercise their judgment in an unreasonable or arbitrary manner, for the law imposed an implied obligation on them to act honestly and in good faith[41].  Accordingly he held that this point would not render the Pledges irredeemable either.     

25.  As a matter of completeness, the judge also dealt with the alternative argument[42] that some provisions were repugnant to the equity of redemption.

Appeal

26.1  The main ground of appeal was that in respect of issue (i), the judge erred in holding that, as a matter of principle, a mortgage could validly secure obligations which are both non-monetary and indefinitely continuing.  Mr Hollander argued that the judge’s reliance on Rudd was misplaced because in that case not only was the obligation monetary, but there would come a point in time[43] when it would become known if the contingent liability would, or would not, become a present liability.  In other words, the obligation “would continue for an uncertain period (but with certainty that [it] would terminate)”[44].

26.2  Mr Hollander argued that that is not the case here, where there were non-monetary obligations which survive the termination of the IRA, some without any certainty of termination at all, and (contrary to the judge’s construction of Section 20.2) the Pledges do not terminate contemporaneously with the IRA because they secure the satisfactory performance of all obligations in the IRA - including those indefinitely surviving its termination.  Unlike Rudd, these obligations “continue without any certainty that they would terminate”[45].  He submitted that the most notable of these was the confidentiality obligation under Section 10 of the IRA, and that there is no case law which supports the proposition that it is valid for redemption to be dependent upon a non-monetary obligation which is potentially permanent.  The right of redemption would then be rendered illusory or a “mere pretence”[46].

27.  Further, in respect of issue (ii), Mr Hollander submitted that the clause that performance must be “satisfactory in the judgment of the Pledgee” injects an element of subjectivity and quality.  Even if the obligations were performed objectively, the Pledgors would have to show that the Pledgees’ judgment that they had not been performed satisfactorily was Wednesbury unreasonable.   

28.  It was not argued that the Pledges were oppressive or unconscionable.  

Discussion

29.1  The starting point must be Section 20.2 of the Pledges which provides for the termination of the Pledges and the release of the pledged collateral.  Under this clause, the Pledges shall be terminated upon the satisfactory performance (in the judgment of the Pledgees)[47] by each Obligor of its respective obligations under the IRA and the termination thereof.

29.2  In my view, both satisfactory performance by each Obligor of its obligations under the IRA and the termination of the IRA must be achieved for the Pledges to terminate.  With respect to the learned judge, I do not think that clause can be construed to mean that the question of satisfactory performance of the obligations under the IRA must be judged as at the date of its termination.  It is not so expressly provided, and I do not think it can be so implied when there are many obligations of commercial benefit to the Investors which the parties expressly agreed should survive the termination of the IRA e.g. the closing of the IPO terminates the IRA, but the parties agreed that the corporate governance obligations survive and remain binding while the Investors still hold at least 5% of the shares in the Company.

30.  Mr Hollander submitted that the various obligations (set out in the table) which (to varying extents) may continue indefinitely, render redemption “a mere pretence”.  He referred to Fairclough v Swan where the mortgaged property was a leasehold of 17 years and the mortgagor was precluded from redeeming it until just a few weeks before the expiry of the lease.  The House of Lords held that equity will not permit any device or contrivance being part of the mortgage transaction or contemporaneous with it to prevent or impede redemption[48].  He submitted that there is nothing the Pledgors could do unilaterally to bring about the discharge of the obligations in the IRA.  

31.  Taking the last point first, Mr Manzoni[49] for the 1^st - 4^th Respondents said there has also been a failure to satisfy monetary obligations[50], and therefore in any event, the relief sought on the preliminary issue is inappropriate.  Mr Hollander said there is a dispute in this regard which is subject to arbitration, and so I say no more about it.   

32.  Even assuming there are only non-monetary obligations, Mr Hollander accepted that it is valid for a mortgage to secure a non-monetary obligation[51].   And he has not referred us to any cases which says that such a mortgage is valid only if the mortgagor himself can discharge the obligation[52]. 

33.  In my view, the real issue is whether the obligation is such that redemption of the collateral pledged to secure such obligation is rendered illusory.  Looking at the nature of those obligations relied on by Mr Hollander (set out in the table), I take the view that the fact that some obligations survive the closing of the IPO[53] and some survive until the Investors’ shareholding drops below 5%[54] does not render redemption illusory.  One must consider the intention of the parties in the factual matrix.  As Mr Manzoni pointed out, the Investors are private equity funds, and given the definite life of funds, they would not be investing for an indefinite period.  Further one can see from the factual matrix (and the parties were well aware) that the Investors were acquiring shares of the Company with the aim that the Company would achieve an IPO within a relatively short period of time, rather than holding them as a long-term investment.  This is evidenced in the IRA where there were provisions not only for the Investors to demand an IPO within two years[55] but also for the Investors to put (to the Company or the Founders) for sale all their shares in the Company if an IPO has not occurred within 36 months (or 42 months)[56] of April 2015[57].  To suggest that in the present case, there was no certainty that those two categories of obligations would everterminate[58] would be to ignore these parties’ intentions and the realities of this transaction.

34.  As for Mr Hollander’s 3^rd “survival” column, he has referred specifically to the obligations in Sections 9.6, 9.7 and 10. 

35.  In relation to Sections 9.6 and 9.7[59], I note that section 11.1 provides that they survive the closing of an IPO, but they are not included in the proviso in Section 11.2[60] (which provides that if the Agreement is terminated under Section 11.1, the Agreement shall become null and void and of no further force and effect).  It seems to me that objectively reading all these clauses together, what the parties intended was that Sections 9.6 and 9.7 survive only the closing of an IPO which otherwise would have terminated the Investors’ rights under the agreement to these reports.  One can envisage, after the closing of the IPO, the IRA with some clauses (those which do not survive) struck out on the document, and these Sections (which do survive) remaining on the document.  For the latter, the IRA remains a live agreement.  However if that agreement is then terminated under the Section 11.1 (a) limb, i.e. by reason of the Investors ceasing to hold any shares of the Company, Sections 9.6 and 9.7 would be similarly struck out as these sections are not included in the proviso to Section 11.2, the proviso being then the only parts of the IRA still alive.  It seems to me that this construction does not do violence to the language of either Sections 11.1 and 11.2, and it is fortified by the fact that one cannot see why the parties would have intended that persons (the Investors) who have no further interest in the Company should still enjoy the right to be given reports on the latter’s environmental performance or conditions for employees, etc.  

36.1  That leaves Section 10 (confidentiality and restrictions on announcements). Unlike Sections 9.6 and 9.7, this has been included in Section 11.2 as an obligation which continues to bind even if the IRA is terminated pursuant to Section 11.1.  As the Pledges would not be terminated until satisfactory performance of this obligation (even if the IRA is terminated), Mr Hollander submitted the “perpetual” nature of this obligation would in effect render the Pledges incapable of redemption.  On this submission, the analysis would be that this provision is a condition that is repugnant even to the contractual right to redeem the mortgage[61] and may be regarded in substance as a clog on the equity of redemption[62]. 

36.2  However it is necessary to look at the substance (and not the form) and consider the real nature of the bargain[63]. The shares in the 5^th defendant were pledged by the Pledgors in consideration of the Investors’ investment, the express aim of both parties being an IPO within two years, with a backstop date of 42 months.  During this period of the Investors’ interest in the Company, they demanded profit guarantees, IPO preparations, corporate governance standards etc.  To ensure the performance of these demands which were clearly for the commercial benefit of the Investors, the Pledgors provided their shares in the 5^th defendant as security.  That was the nature of the bargain. 

36.3  In light of this, applying the approach discussed at §13.6 above, it seems to me it could not have been the intention of the parties that the keeping of confidentiality, a passive requirement of “perpetual” duration, would be part of the obligations which were intended to be secured by the Pledges (in the same way as say, the provision of profit guarantees for certain years or making proper preparations for the IPO).  In my view, this Section of the IRA does not touch the mortgage relationship and stands outside the equitable principles protecting the right to redeem.  

37.  In any event, if I am wrong in the above view, the appropriate remedy would be to strike down the reference to Section 10 in Section 11.2 as a repugnant condition to the contractual right to redeem[64].  This would be the more appropriate remedy, rather than to hold, on the preliminary issue, that the Pledges are void in their entirety[65]. In Knightsbridge Estates Trust Ltd v Byrne[66], the English Court of Appeal said that equity is concerned to see two things – one that the essential requirements of a mortgage transaction are observed, and the other, that oppressive or unconscionable terms[67] are not enforced, such as not to lead to inequitable results especially in a situation where a bargain has been entered into by business people negotiating at arms’ length[68].

38.  I now come to Mr Hollander’s submission on issue (ii), which is the complaint regarding the requirement of satisfactory performance “in the judgment of the Pledgees”.  In this regard, I respectfully agree with the judge that on the principles of law set out in Tadjudin,it would not be lawful for the Pledgees to judge performance in bad faith, or in a capricious or arbitrary manner. 

39.  Mr Hollander’s submission is that even then, the Pledgors would need to show that the Pledgees’ judgment fell below the standard of “Wednesbury unreasonableness” before they could redeem the pledged collateral.  I do not think it is helpful to import standards from other areas of the law.  The standard of performance required is that set out in the agreement.  Any dispute as to whether it had been reached could be resolved by a court applying the Tadjudin principles.  Consequently I do not think one would need to resort to Mr Manzoni’s submission that, if necessary, the words referring to the Pledgees’ judgment could be struck out. 

Order

40.  For the reasons set out above, I would dismiss the appeal with costs to the 1^st to 4^th defendants.  I thank counsel for their assistance.

Hon Chu JA:

41.  For the reasons given by Yuen JA, I agree that the appeal should be dismissed with costs to the 1^st to 4^th defendants.

Annex

IRA Obligations

(as per Appellant’s submissions)