PEARLDELTA GROUP LTD v. HUGE WINNERS INTERNATIONAL LTD AND OTHERS

HCA 595/2008

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

ACTION NO. 595 OF 2008

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BETWEEN

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J U D G M E N T

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The parties:

1.  Huge Winners International Limited, (Huge Winners), a British Virgin Islands (BVI) company, through its wholly owned subsidiary, Huge Winners CNC (Shenzhen) Ltd, (Huge Winners Shenzhen), designs and manufactures equipment used to manufacture printed circuit boards and light-emitting diodes. The 2^nd to 6^th defendants in HCA 595/2008 are the shareholders in Huge Winners.

2.  The 2^nd defendant, Lee Man Bun, (Mr Lee), a Hong Kong resident, and the 4^th defendant, Dr Yang Shao Chen, (Dr Yang), were at all material times directors of Huge Winners, and Huge Winners Shenzhen, and held 33.3% and 18% respectively, of the shares in Huge Winners.

3.  The 3rd defendant, Ng Sio Kok, (Ms Ng), is the wife of Mr Lee, and holds 28% of the shares in Huge Winners. She was, prior to the execution of the documents at the heart of the dispute in this case, also a director of Huge Winners.

4.  The 5^th defendant, Han Jin Long, holds 10.7% of the shares in Huge Winners, and the 6^th defendant, Luo Hui Cai holds 10% of the shares in Huge Winners. By virtue of their shareholdings in Huge Winners each of the 2^nd to 6^th defendants hold the same proportion of shares in Huge Winners Shenzhen. They too, prior to the execution of the documents, were directors of Huge Winners.

5.  Mr Lee was the formal PRC “Legal Representative” of Huge Winners Shenzhen, which is incorporated in the PRC. The 2^nd to 6^th defendants, together with a Mr Niu Zenqiang, are shareholders in a Hong Kong company, Huge Winners Laser System (Hong Kong) Corp Ltd, (Huge Winners Laser). From time to time, the various Huge Winners companies will be referred to collectively as “the Group”.

6.  Pearldelta is beneficially owned by Asian Value Investment Fund II, L.P., (AVIF), an “exempted limited partnership” organised under the laws of the Cayman Islands. AVIF, which is managed by Mr Kyle Shaw, (Mr Shaw), specialises in equity and equity-related investments in China, Hong Kong, Taiwan and Singapore. SKP Capital Ltd is a general partner of AVIF, and operates in Hong Kong through Shaw Kwei & Partners (SKP). Pearldelta was the corporate vehicle used by AVIF and SKP in the ultimate transaction at issue in the proceedings.

A convertible bond:

7.  A document called a Subscription and Investment Agreement, (SIA), dated 23 August 2005, was made between Pearldelta, on the one hand, and Huge Winners, Huge Winners Shenzhen, and the 2^nd to 6^th defendants, on the other hand. The SIA is a convertible bond. By that agreement, Pearldelta subscribed for HK$20 million of convertible bonds in Huge Winners Shenzhen. The 2^nd to 6^th defendants, collectively referred to in the SIA as the “Principals”, each gave personal guarantees to the sums secured by the SIA. In the course of this judgment, where I refer to the 2^nd to 6^th defendants collectively I shall refer to them as “the Principals”.

8.  At common law a bond is an instrument under seal, usually a deed poll, whereby one person binds himself to another for the payment of a specified sum of money either immediately or at a fixed future date: see Halsbury’s Laws of England, 4^th Edn Vol 13 para 89. In simple terms, a convertible bond is a bond that can be exchanged for shares at a certain time at the request of the bond holder.

9.  A particular feature of a convertible bond is that it is a hybrid security, with both debt and equity features: see The Legal Aspect of Swaps, Paul Goris, para 3-15. A convertible bond is a bond that gives the holder the right to “convert”, or exchange, the par amount of the bond for common shares of the issuer at some fixed, or adjustable, ratio during a particular period. As bonds, a convertible bond has some of the characteristics of fixed income securities, or simple debt instruments. The conversion feature also gives such agreements features of equity securities.

10.  A convertible bond, in so far as it contains a right to convert the par amount of the bond for common shares of the issuer, may be described as a derivative. I understand from the evidence of Deret Au, who undertook a valuation of the SIA, that that is because the ratio at which the amount of the bond may be converted may adjust depending upon the performance of the issuer company. This circumstance was at the centre of this litigation.

Redemption of the bond is demanded:

11.  The convertible bond, or SIA, in the present case, effectively contained three options for redemption. They were, first, conversion into shares in the company, second, repayment of the sum of HK$20 million with an internal rate of return, (effectively, interest), of 12% per annum, and third, a sum determined by the application of a formula related to the total assets, less the total liabilities, excluding the SIA, of the company and its subsidiaries on a consolidated basis. The particular provisions will be set out in due course.

12.  The SIA provided that Pearldelta would be entitled to redemption or conversion, in accordance with the provisions of the SIA, on the final redemption date, (36 months from the Issue Date): see Bond Conditions, 8.1; or, if any Event of Default has occurred, at the option of Pearldelta: see Bond Conditions, 8.2.

13.  In the event, Pearldelta asserted that the Huge Winners Group was in default under the SIA in two respects, and demanded redemption in accordance with the third option, that is the formula related to the total assets. The amount claimed, (which by the end of the trial was, in so far as calculation, not in dispute), is a sum in excess of HK$86.5 million. Pearldelta seeks judgment for that sum against the Principals as guarantors as well as judgment against Huge Winners.

The proceedings:

14.  The first action, HCA 595/2008, relates to Pearldelta’s argument that upon the default it was entitled to redeem HK$19,900,000 of the bonds. At the time that action was commenced, that sum was the limit of bond which could be redeemed by Pearldelta at that time. The second action, HCA 818/2008, relates to the balance of the bond in the sum of HK$100,000, Peal Delta contending that by the time of the commencement of that action, it was then entitled to redeem the balance. Identical issues on the SIA arise in both actions.

15.  An ancillary feature of the litigation between the parties, is HCA 818/2008, (dealt with at paras 75-79 below), in which Pearldelta sought, and was granted, on an interlocutory basis, injunctions in relation to steps taken by Mr Lee and Dr Yang to issue new shares in Huge Winners Shenzhen. The effect of those steps was to substantially dilute the value of Huge Winners’ interest in that company, and to appoint a Mr Mo Yu-bin (Mr Mo) as a director of Huge Winners.

16.  On 6 June 2008 Burrell J, following an inter partes hearing, granted injunctions in final form. Other than the issues arising from the claim for redemption of the bond itself, the only remaining issue in HCA 818/2008 is the reinstatement of the original board of Huge Winners Shenzhen, and the costs of the action. Those costs were ordered by Burrell J to be in the cause in HCA 818/2008.

Steps leading to the signing of the SIA:

17.  The facts as I now state them are not generally in dispute and come primarily from the witness statements of the parties. Where there is a dispute as to the evidence I will indicate how I have resolved that dispute.

18.  Huge Winners was incorporated in the BVI on 28 March 2003. It is not an operational company, but merely a holding company conducting its operations through its wholly-owned subsidiary, Huge Winners Shenzhen. That company had its own manufacturing plants in China and employed some 350 staff.

19.  At the time the SIA was executed, the directors of Huge Winners were the Principals, Mr Lee, Ms Ng, Dr Yang, Mr Han and Mr Luo. The shares held by Ms Ng had been gifted to her in early 1993 by her husband.

20.  Although Mr Han and Mr Luo filed a joint defence to the proceedings together with the other defendants, they filed no witness statements, nor were they called to give evidence. Their position, as advanced by Mr Lam, was that they adopted the case of Huge Winners, Mr Lee, Ms Ng and Dr Yang.

21.  Ms Ng, the wife of Mr Lee, was separately represented as she sought to resist the personal guarantee on the additional basis that she had signed the SIA only as a consequence of undue influence on her by her husband. The defence of undue influence was not advanced by the other individual defendants.

22.  Towards the end of 2004, in order to meet the needs of business development and with a view to a potential stock exchange listing (IPO) of Huge Winners Shenzhen, the directors of Huge Winners sought a new investor in the company. The defendants instructed a Mr Kevin Miu of Grand Vinco Financial Group Ltd to approach prospective investors on their behalf. Mr Miu brought the proposal to SKP.

23.  On 22 April 2005, following initial interest on the part of SKP, a letter was sent by e-mail from SKP to Mr Lee, Dr Yang and Mr Miu which was said to outline the terms, “subject to negotiation and mutually acceptable legal documents, of a proposed investment by funds and advised by (SKP) in Huge Winners”. The letter gave SKP eight weeks exclusivity, during which period Huge Winners undertook not to hold discussions or negotiations with other investors.

24.  On 11 May 2005, Mr Jack Tsai of SKP e-mailed both Mr Lee and Dr Yang a draft Letter of Intent, (LOI), which was translated into Chinese for the benefit of the various defendants by Mr Miu. The draft LOI contained the following statement:

“2.  Investment Structure

1)  SKP will invest in a convertible bond that will be convertible at anytime over the next three years into new shares at a valuation representing 28% of (Huge Winners).  This valuation will be subject to adjustment based on net profit targets of RMB20mm in 2005 and RMB40mm in 2006.

2)  In the event SKP chooses not to convert the bond, the convertible bond will be redeemable at the higher of 12% IRR or 1.2x net asset value as of the most recent audited statement if not converted into shares within three years.

3)  SKP recognises that Mr Lee has been a loyal customer and important supporter of the Company and understands Mr Lee will receive a quantity discount on a purchase order of equipment from the Company over the next 12 months.  This purchase order, including number and type of equipment as well as price and payment terms, will be finalized prior to SKP’s investment.”

25.  On 13 May 2005, Mr Miu e-mailed SKP seeking revision of particular aspects of the LOI, and informED SKP that:

“the Hugewinner team has finished the internal discussion and can sign the LOI”.

The e-mail went on to say that certain matters were sought by way of revision.  They were:

“The 28% stake as mentioned in the LOI is before exercising the 10% Management Option

1.2 X net asset value refers to the NAV attributable to SKP’s portion as per the latest audited account at the time that the Bond is not to be converted (ie it should be upon the maturity).

Minimum valuation for the Drag along right and this can be agreed between you and Hugewinner later

You will consider lowering the profit requirement for the discount on subscription price for the Management Option and if possible please give some indication ”

26.  SKP responded on 16 May 2005, in the following terms:

“1.  The 28% stake for SKP is BEFORE the management options.  The final legal agreements will carefully detail the number of shares for the avoidance of doubt.

2.  The 1.2 times NAV will refer to the latest audit account NAV of Huge Winner.

3.  We agree in the final investment agreement between SKP and Huge Winner there will be a mutually agreed minimum valuation on the drag along condition.  The final legal agreements will detail the minimum valuation as determined by all of us in further discussions.

4.  We agree to lower the profit target for determining the subscription price under the Management Option program.  We can accept a reduction of the target net incomes in 2005 to Rmb 20mm and 2006 to Rmb 48mm.”

27.  The case advanced in the pleadings for the Principals was that they were essentially unaware of these provisions in the SIA. Two matters are plain from the fact that the revisions were sought, and from the response by SKP. First, an adjustment based on the net profit targets, and second, that redemption at 1.2 x net assets, (if that were higher than 12% IRR), was envisaged during the negotiations. Second, it is plain from Mr Miu’s e-mail that the Principals were aware of these facts.

28.  On 16 May 2005, the LOI was signed by Mr Shaw, and accepted by Mr Lee and Dr Yang on behalf of Huge Winners. The signed document contained the three paragraphs under the heading “Investment Structure” as had been set out in the draft, (see para 24 above).

29.  The letter also recorded the steps that were then required to complete the transaction. These included final negotiations regarding the detailed terms of the investment and a number of particulars which may be generally described as appropriate due diligence.

30.  The LOI, in clause 9, specifically recorded that:

“With the exception of Clauses 7 & 8 which are binding, this letter is not intended to be binding on the parties.  For the avoidance of doubt, nothing in this letter should be construed as creating an obligation to invest, or an obligation to accept an investment, on the part of any of the parties.  The parties agree that this letter is subject to Hong Kong Law.”

Clause 7 relates to exclusivity, and clause 8 relates to confidentiality.  It was later necessary to extend the exclusivity period, but nothing turns on this extension.

31.  Due diligence on the part of SKP thereafter took place. On 5 July 2005, Mr Jack Tsai of SKP sent a draft of the SIA to Mr Lee and Dr Yang, with a copy to Mr Miu, saying in his accompanying e-mail:

“In order to save time and costs, the attached was prepared by SKP, this basic format was used by us before.  We circulate a draft for all parties’ perusal, for the purposes of reaching an agreement smoothly.  Once we have reached an agreement, we will invite the lawyers to give final confirmation.”

32.  The Draft SIA contained the personal guarantee of each of the Principals. It is accordingly plain that as early as 5 July 2005, personal guarantees from the Principals were to be part of the agreement.

33.  As part of their due diligence, SKP instructed a firm of accountants, Grant Thornton, to undertake an audit of Huge Winner and Huge Winner Shenzhen’s accounts and to report to SKP. This audit covered the pre-SIA period, from the date of Huge Winner’s incorporation to 31 December 2003, the year ending 31 December 2004, and the five months ending 31 May 2005. This audit was completed by 2 August 2005.

34.  There is a dispute as to the precise date on which the SIA was executed. The document itself bears a typewritten date, 23 August 2005. A document entitled “Bond Certificates and Bond Conditions”, given under the common seal of Huge Winners, and signed by Dr Yang, bears the handwritten date 31 August 2005. The evidence for SKP was that the document was signed by all parties at SKP’s solicitors office, with a subsequent lunch by the individuals concerned on 26 August 2005. The evidence for the defendants was that the documents were signed at the lunch, at the Royal Hong Kong Yacht Club on 26 August 2005.

35.  Nothing turns on the difference because there is no doubt that at about the end of August all the parties duly executed the SIA. Precisely where it was executed, or on what particular date it was executed, does not assist the Principals at all in the arguments they advance.

36.  The signatures on the part of Huge Winners, Huge Winners Shenzhen, and the guarantors were witnessed by Mr Miu, and that of Pearldelta by Mr Jack Tsai.

37.  Mr Shaw’s evidence was that the purpose of Pearldelta’s investment in the Huge Winner Group was to enable the Group to boost its revenue and bring its corporate governance to an international standard, thereby enabling it to be listed on a major stock exchange, or its business sold by way of a trade sale. In either of those two circumstances both Pearldelta and the Principals’ investment in the Group would be very substantially enhanced.

38.  It was a condition of the SIA that Mr Shaw be appointed a non-executive director of Huge Winners, and that Ms Ng, Mr Han and Mr Luo should each resign as directors of Huge Winners. Mr Shaw’s appointment, and the resignation of the three directors took place on or about the day the SIA was signed.

39.  It was not intended that either Mr Shaw or Pearldelta would have any active participation in the running of the Group’s business. They were merely private equity investors. That position was entirely consistent with the appointment of Mr Shaw as a non-executive director, and the resignation of Ms Ng, Mr Han and Mr Luo as directors of Huge Winners. The appointment of Mr Shaw in this way gave him what he described as “negative control” by ensuring that certain decisions could not be made without his consent. Such decisions included the appointment of auditors.

40.  A vital provision of the SIA was that the accounting records of the Group should meet international standards. That requirement was reflected in the SIA. It was an essential requirement bearing in mind the ultimate goal, on the part of both SKP on the one hand and the Huge Winners shareholders on the other hand, for either an IPO or the sale of the business by way of a trade sale. Either of those courses potentially carried huge profits for both SKP and the existing shareholders.

The key provisions of the SIA:

41.  The documents that were signed by the parties comprised first the SIA itself, of 37 pages, (of which two pages are specifically devoted to the personal guarantees), thereafter a further 71 pages, comprising schedules setting out, inter alia, particulars of the Group, conditions, certain undertakings and warranties, the Bond Certificate, a deed of charge, a statement in relation to certain intellectual property rights, and finally a letter of undertaking.

42.  The following provisions of the SIA are of particular relevance to this litigation:

(i)  Definitions, including:

“(a)  “AAS” means applicable accounting standards, consisting of:

(i)  Hong Kong Financial Reporting Standards, Hong Kong Accounting Standards, Statements of Standard Accounting Practice and Interpretations issued by the Hong Kong Institute of Certified Public Accountants;[1]

(b)  “Conversion Price” means, in relation to each one denomination of the Bonds, the sum of HK$685.70, subject to adjustment from time to time in certain circumstances in accordance with Condition 7.

(c)  “NPAT” means the net profit after tax (expressed in RMB) of the Company and its subsidiaries on a consolidated basis determined in accordance with AAS.

(d)  “Redemption Amount” means, in relation to any Bonds as at any date of determination, an amount that would provide to the holder of such Bonds the higher of:

(i)  the amount provides an internal rate of return of 12% per annum based upon the number of days elapsed from the Issue Date through the date on which such Bonds are actually redeemed as determined by the following formula:

[I x (1.120)^N/365] – D

where:

I  =  the Issue Amount of the Bonds;

N  =  the number of days from and including the Issue date of the Bonds to but excluding the actual date of redemption of the Bonds; and

D =  the aggregate amount (if any) paid to the holder pursuant to condition 5.2;

(ii)  the amount determined by the following formula:

1.2 x V

S

where:

V =  total assets less total liabilities (excluding the Bonds) of the Company and its subsidiaries on a consolidated basis, as reflected in the most recent Accounts; and

S =  the total number of Ordinary Shares outstanding as if the Bonds had been converted into Ordinary Shares at the then current Conversion Price as provided in Conditions 6 and 7;

provided, that in no event will the Redemption Amount of any Bonds be less than the Issue Amount thereof.”

(ii)  By clause 14.1 of the SIA, Pearldelta had the right to appoint a “Designated Director”.  Mr Shaw was so appointed.

(iii)  By clause 16 of the SIA, an audit committee was to be established by Huge Winners which was required to meet at least quarterly, with the Designated Director serving as chairman of the committee.  The committee was to comprise at least the Chief Financial Officer and the Designated Director.  Both were duly appointed as the audit committee.

(iv)  By clause 17 of the SIA, Huge Winners and the Principals were required to provide Pearldelta with certain accounts on a regular basis, including, in particular audited consolidated annual accounts and reports for the Group for each financial year of the company prepared in accordance with defined applicable accounting standards.

(v)  By clause 19 of the SIA, any breach of the SIA, or the undertakings given with it, or any related agreement by either Huge Winners or any of the Principals, constituted an event of default.

(vi)  By an undertaking given in Schedule 3, Part 1 para (6) of the SIA, Huge Winners was required, on the dates falling two and three years after the “closing” of the transaction, to establish a “Sinking Fund Account” with HSBC, by way of two payments.  On the two relevant dates, each payment to be a sum equal to not less than 50% of the Redemption Amount.  Provision was made in the clause to permit Huge Winners use of the funds in the Sinking Fund Account, with the consent of Pearldelta.

43.  Clause 7 of the Bond Conditions is of particular importance. The SIA was structured so that if there were no adjustment to the Conversion Price, SKP would, on conversion, acquire a 28% interest in Huge Winners. Clause 7 makes provision for the adjustment of the Conversion Price (see para 43(i)(b) above for the definition of Conversion Price). In simple terms, if the performance of Huge Winners was better than certain standards set, then the Conversion Price would increase, and the interest in Huge Winners ultimately received by SKP would be reduced. However, if the performance of Huge Winners fell below those standards, the Conversion Price would reduce, and the interest in Huge Winners ultimately received by SKP would be increased.

44.  The meaning of this clause is central to the argument mounted by Mr Lam and it is necessary to set out the relevant parts of that clause extensively.

“7  Conversion Price

7.1  The Conversion price shall from time to time be adjusted as provided in this Condition 7; …

7.2  (f)  If and whenever the NPAT for any Financial Period are less than the targets established by the Company and the Initial Bondholder, then the Conversion Price shall be adjusted as follows:

(i)  If upon the determination of the NPAT for the financial year ending 31 December, 2005 (“FY05 NPAT”) the FY05 NPAT are less than RMB 20,000,000, then the Conversion Price shall be multiplied by a fraction (1) the numerator of which is equal to FY05 NPAT, and (2) the denominator of which is RMB 20,000,000.  Such adjustment will be effective from the date on which the FY05 NPAT is certified in accordance with Condition 7.6.

(ii)  If upon determination of the NPAT for the financial year ending 31 December, 2006 (“FY06 NPAT”) the FY06 NPAT is less than RMB 40,000,000, then if (1) the ratio of FY06 NPAT divided by RMB40,000,000 is less than (2) the ratio of the FY05 NPAT divided by RMB 20,000,000, the Conversion Price shall be multiplied by the product of:

X x Y

where:

X =	RMB 20,000,000
	FY05 NPAT

and

Y=	FY06 NPAT
	RMB 40,000,000

Such adjustment will be effective from the date on which the FY06 NPAT is certified in accordance with condition 7.4.

7.4  Any adjustment to the Conversion Price will be rounded upwards to the nearest HK$0.01, and subject as hereafter provided in this Condition 7, in no event shall any adjustment (otherwise than as provided in this Condition 7 or upon the consolidation of Ordinary Shares into shares of a larger par value) involve an increase in the Conversion Price.  No adjustment to the Conversion Price shall be made unless it has been certified in accordance with this Condition 7 by the Auditor.  No adjustment will be made to the Conversion Price in any case in which the amount by which the same would be reduced would be less than HK$0.01.  And any adjustment which would otherwise then be required will be carried forwards and taken into account appropriately in any subsequent adjustment.”

Events after the signing of the SIA:

45.  By documents signed at the same time as the SIA was signed, all of the directors of Huge Winners resigned, and Mr Shaw, Mr Lee and Dr Yang were appointed directors of Huge Winners with effect from 1 September 2005. For reasons that were not explained these resolutions were repeated on 1 December 2005. It is not suggested that anything should turn upon this fact.

46.  At the same time the share capital of Huge Winners was increased to US$75,000 divided into 75,000 shares of US$1.00 each. Those shares were allotted, as to Mr Lee, 33.3%, Ms Ng, 28%, Dr Yang, 18%, Mr Han, 10%, and Mr Luo, 10.7%; that is in the same proportions as prior to the increase. Mr Shaw was appointed chairman of the audit committee and a director of Huge Winners Laser.

47.  At a directors meeting on 6 January 2006, the board noted that Huge Winners had apparently met its profit target for 2005, and that Grant Thornton would serve as the auditor for the 2005 financial results.

48.  By 2 March 2006, Mr Shaw was complaining about the failure to have delivered to him, as required by the SIA, Huge Winner’s management accounts. He was also raising queries on adjustments that had been made to the audited accounts to 31 May 2005, that had been prepared by Grant Thornton.

49.  At a directors meeting of 3 March 2006, the share capital of Huge Winners was further increased to US$117,040, but the increased number of shares, 42,040 were not allotted.

50.  Between 30 May 2006 and 26 June 2006, e-mails between Grant Thornton and Mr Shaw revealed that the 2005 audit report, expected to be ready by 31 March 2006, was now very late. When it was received it was not satisfactory to SKP. Mr Shaw did not feel able to sign off on the audit. In an internal SKP note made on 25 July 2006, Mr Shaw recorded that he had told Dr Yang the reasons why he was unable to agree to the terms of the audit.

51.  The principal reason was that, prior to the investment by SKP through Pearldelta, Huge Winners had not produced consolidated accounts for the whole Group. Grant Thornton had not picked this up in the due diligence. Consolidated accounts might not have been necessary prior to the SIA, but with a view to listing or a trade sale, it was necessary for the Group to meet international accounting standards. Consolidation of the accounts was therefore essential.

52.  In January 2007, Mr Shaw sought quotes from five different audit firms, Grant Thornton, RSM, Nelson Wheeler (RSM), Ernst & Young, Deloitte, and Baker Tilley to undertake the audit of the 2006 financial year. On 18 May 2007, the directors, Mr Shaw, Mr Lee and Dr Yang, unanimously agreed to appoint RSM as the auditor.

53.  Preliminary audit work began in June 2007, but the main audit fieldwork did not start until 27 August 2007. That work was not able to begin because, first, there were missing books and records, and second, Huge Winners did not promptly pay the required interim audit fees.

54.  When the audit work did start, RSM found a number of problem areas. First, sales were recorded to a company known as Shenzhen Guan Han Technology. A company search revealed that no such company existed anywhere in the PRC. Enquiries with the accounts staff revealed that these sales were fictitious sales, fabricated to artificially boost the sales record.

55.  Second, after these fictitious sales were explained to the Chief Financial Officer, Mr Cao Rui, (Mr Cao), the auditors had great difficulty in contacting Mr Lee and Dr Yang or Mr Cao. Any attempt to contact them resulted in them being not available. Telephone calls were not returned. Meetings scheduled to discuss the matter were cancelled. Attempts to reschedule meetings met with refusal.

56.  It is plain from the evidence that there were difficulties in dealing with the Group’s financial records. But Mr Shaw and the auditors experienced even more difficulty in ascertaining information, principally because of a marked reluctance on the part of Mr Lee and Dr Yang and those acting under them to supply information promptly or efficiently. For the reasons explained, adapting the Group’s financial records to international accounting standards, as required by the SIA, was an important aspect of moving towards either an IPO or a trade sale. As the Group’s financial records stood prior to the SIA, they did not meet international accounting standards. Equal difficulty was faced by Mr Shaw and Pearldelta in taking steps towards establishing an accounting system within the Group that would meet international accounting standards. These difficulties are clearly established through numerous memoranda and e-mails, all forming part of the evidence.

57.  Pursuant to clause 19, and Schedule 3 (part 1(6)) of the SIA, and clause 8.2 of the Bond Conditions Huge Winners was required, by 30 September 2007 at the latest, to make a deposit to the Sinking Fund Account. No such deposit was made.

58.  On 15 October 2007, Mr Lee and Dr Yang, without consulting Mr Shaw, purported to terminate RSM’s position as auditors. RSM were unable to contact Mr Lee and Dr Yang about this act, and so they contacted Mr Shaw. He instructed them that the audit should not be terminated without his agreement. RSM consequently continued with the audit.

59.  A necessary feature of the audit was a valuation of the convertible bond. On 23 October 2007, on the instruction of Mr Shaw, Deret Au, a registered business valuer, and a director of Castores Magi Asia Ltd, was employed to undertake the valuation of the convertible bond and its redemption value. No objections were raised as to Mr Au’s expertise, and I am satisfied that he was appropriately qualified to give expert valuation evidence.

60.  It was put to Mr Au that he had been chosen to undertake the valuation by Mr Shaw because he was willing to agree to Mr Shaw’s interpretation of the formula for redemption. Mr Au’s response was that he had not been provided with any documentation whatsoever concerning the SIA until after his engagement was confirmed. He undertook the valuation and provided it to RSM and it was incorporated into the draft audit report. I am satisfied that he was completely independent.

61.  After receiving the valuation report, a question was raised by the auditors as to whether or not the convertible bond could be converted into 2 billion shares, (that being the consequence of the application of the formula), when the authorised capital of the company was only HK$117,040, with only 75,000 shares allotted. It was the evidence of the two RSM persons involved in the audit, Ronald Yam and Robin Szeto, that after receiving further information, and upon their own consideration they were in agreement with Mr Shaw that the application of the formula resulted in the redemption value of the convertible bond being RMB87,191,000.

62.  On 3 December 2007, Mr Shaw notified members of the audit committee that he was convening a meeting of the committee to be held in Hong Kong on 8 December 2007. The CFO, Mr Cao said he was unable to attend in person and asked that it be rescheduled. The meeting was rescheduled to 13 December 2007, with a meeting of directors to follow. On 12 December 2007, Mr Cao informed Mr Shaw by fax that:

“… the other members of the board of directors and the Audit Committee are busy with the other business of the company…”

and hence could not attend.  Thereafter a number of attempts were made by Mr Shaw to hold the meeting, each attempt at fixing a meeting being resisted by various excuses from Mr Lee and Dr Yang.

63.  On 13 December 2007, Mr Shaw proceeded to hold the audit committee meeting himself, with Mr Robin Szeto in attendance. At that meeting the audit report was approved.

64.  It was subsequently argued that the audit report had not been properly approved as the meeting was inquorate under clause 16.2 of the SIA. That clause does not provide for a quorum for the audit committee merely stating that the committee shall be comprised of “at least the CFO and the Designated Director”. Mr Shaw was the Designated Director. By clause 16.4 each member of the audit committee has one vote and the chairman, Mr Shaw, had a casting vote.

65.  On 15 January 2008, either Mr Lee or Mr Lee and Dr Yang, as directors of Huge Winners caused Huge Winners to transfer its ownership in Huge Winners Hong Kong to Huge Winners Shenzhen. Mr Shaw was not to discover this until about August 2008.

66.  On 17 December 2007, Pearldelta called for a board meeting, noting that clause 15.3 of the SIA required a board meeting every three months, and that the last meeting had been held on 18 May 2007. Dr Yang declined to attend, asserting that he and Mr Lee knew nothing of the matters to be discussed, asserting that he was very busy, and could not spare time to attend a meeting with details unknown.

67.  In fact, the e-mail from Pearldelta calling the meeting had clearly set out an agenda. The e-mail, prepared by Mr Shaw’s assistant, Ms Simty Yau said:

“Details for the meeting are as follows:

(1)  RSM Nelson Wheeler’s 2005 & 2006 audit report for Huge Winners

(2)  Huge Winners’ 2007 financial report

(3)  Huge Winners’ 2008 budget

(4)  Any other business”

Any suggestion as to any doubt about the purpose of the board meeting was patently without foundation.

68.  On 15 January 2008, Mr Lee and Dr Yang, as directors of Huge Winners purported to resolve to cause Huge Winners Hong Kong to remove Mr Shaw as a director of Huge Winners Hong Kong, and appointed Mr Mo as a director in his place. Mr Shaw was not to discover this until late March 2008. At the same time Mr Lee and Dr Yang caused Huge Winners to transfer its ownership in Huge Winners Hong Kong to Huge Winners Shenzhen. Mr Shaw was not to discover this until early August 2008.

69.  In the light of the refusal of Mr Lee and Dr Yang to attend a board meeting, Mr Shaw now instructed solicitors. On 17 January 2008, a solicitor’s letter was sent to all defendants demanding the convening of a board meeting. Further demands for a board meeting were made only to be met by various excuses such as the absence of visas to enter Hong Kong. In fact two of the three directors were permanent residents of Hong Kong, who did not require visas, and most of the previous board meetings of the company had in fact been held in Hong Kong.

70.  On 14 March 2008, Pearldelta gave notice to Huge Winners that exercised its conversion right in respect of 0.5% of the convertible bond and its redemption rights over 99.5% of the convertible bond. Based upon the Castores Magi valuation the amount due for redemption was HK$86,755,068.

71.  Pearldelta relied upon two breaches of the SIA to justify its demand for conversion and redemption. They were first, the failure to provide financial accounts within the prescribed time, and second, the failure to deposit the sum required in the Sinking Fund Account.

72.  On 27 March 2008, Mr Shaw, Mr Lee and Dr Yang finally met together at the Excelsior Hotel. Mr Lee and Dr Yang, holding a majority, voted not to accept the RSM audit report and to dismiss the audit committee.

73.  On 2 April 2008, there having been no response to the notice of redemption, demand was made to the Principals as guarantors. There was no response to the demand, and on 10 April 2008, the first writ was issued in these proceedings.

HCA 818/2008:

74.  On 18 September 2007, Mr Lee and Dr Yang, acting as directors of Huge Winners Shenzhen had resolved to remove Mr Shaw as a director and to appoint Mr Mo in his place. An identical attempt to appoint Mr Mo in place of Mr Shaw on the board of Huge Winners Hong Kong was undertaken by Mr Lee and Dr Yang.

75.  On 15 January 2008, Huge Winner’s 100% shareholding in Huge Winners Hong Kong was transferred to Huge Winners Shenzhen. On 11 April 2008, Mr Lee and Dr Yang and Mr Mo resolved to increase the share capital of Huge Winners Shenzhen from RMB50,000,000 to RMB200,000,000 and, if Huge Winners did not acquire the additional shares, to offer these to prospective outside investors. This action had the effect of diluting Huge Winners shareholding in the Group’s principal operating subsidiary from 100% to 25%, and consequently enormously devalued Huge Winners shares and consequently Pearldelta’s bonds. Mr Shaw did not learn of this until 5 May 2008.

76.  These actions resulted in HCA 818/2008. An appropriate injunction was issued on an interlocutory basis by Kwan J, and made final by Burrell J on 6 June 2008. Under the injunction Mr Lee and Dr Yang were restrained from:

1.  Recognising the resolution to increase Huge Winners Shenzhen’s share capital;

2.  Approaching or dealing with prospective investors in Huge Winners Shenzhen, other than Huge Winners itself;

3.  Causing or permitting Mr Mo to act as a director of Huge Winners Shenzhen;

4.  Holding further board meetings in Huge Winners Shenzhen unless Mr Shaw was given reasonable notice and an adequate opportunity to attend.

77.  Remarkably, in the face of the injunctions, instead of removing Mr Mo as a director of Huge Winners Shenzhen, he was kept on. In what can only be described as contumacious breach of the injunction, on 28 November 2008, Mr Mo was appointed the formal Legal Representative of Huge Winners Shenzhen. To compound the breach, on the same day a Mr Wang Zhe Hua was also appointed a director of Huge Winners Shenzhen. In addition to being flagrant breaches of the injunction, all of these actions constitute breaches of the SIA.

78.  The actions and steps taken by Mr Lee and Dr Yang in breach of the injunction are, prima facie, a plain contempt of court. No explanation nor excuse was offered during the proceedings, other than that Mr Lee tried to say that he had left it all to Dr Yang as CEO of Huge Winners. That is no excuse. Their actions deserve condemnation in the strongest terms.

Was Huge Winners in breach of the SIA:

79.  Two specific defaults of the SIA are relied upon by Pearldelta. They are first, the failure to provide financial accounts within the prescribed time, and second the failure to deposit monies into the Sinking Fund Account.

The failure to provide accounts within time:

80.  The requirement to provide financial accounts is contained in clause 17.1 of the SIA. The requirement was not in dispute. The requirement was that audited consolidated annual accounts be provided within four months of the end of the financial year: clause 17.1(A); that unaudited consolidated monthly management accounts be provided within 15 days of the end of each month: clause 17.1(C); and that unaudited monthly management accounts for each company be provided within 10 days of the end of each month: clause 17.1(D).

81.  It was not in dispute that no audited consolidated annual accounts were prepared within time for either 2005 or 2006. Grant Thornton had prepared accounts for 2005, but for the reasons set out in para 51 above, they were not ultimately not acceptable to either Mr Shaw or Dr Yang.

82.  RSM later produced audited consolidated annual accounts but these too were late for the reasons set out in paras 55-57 above.

83.  The monthly management accounts were consistently late despite being the subject of constant demands by Pearldelta. There was copious documentary evidence substantiating that fact.

84.  In the light of the evidence, the denial of this breach contained in the Statement of Defence simply cannot stand. The denial was not persisted with during the trial. An assertion both in the statement of defence and witness statements of Mr Lee and Dr Yang that Mr Shaw and his staff had kept their own set of accounts, which were not produced, goes nowhere to absolve the defendants from the plain obligations under the SIA.

85.  I conclude that the defendants were in breach of clause 17.1 of the SIA in relation to the requirement to provide financial statements.

The Sinking Fund:

86.  By Schedule 3, Part 1 para (6) of the SIA, Huge Winners was required to deposit into a sinking fund sums equal to not less than 50% of the Redemption Amount, two and three years after the closing of the transaction, that is at the end of August 2007 and the end of August 2008.

87.  The defendants admit that this was not done. Instead, they contend that there was an oral agreement reached between Mr Shaw and Mr Lee in August 2006, by virtue of which no payment was required.

88.  This assertion arose from evidence from Mr Lee that in August 2006, at a lunch at which Mr Lee’s brother Mr Thomas Li was present, Mr Shaw had given Mr Lee a “notice”. Mr Lee said that he could not read it, it being in English, but that Mr Shaw told him that concerned money that was “not in a hurry to be paid”. Mr Lee said that he later asked his brother to translate the document, and was told that the notice concerned HK$10 million to be paid into an account, but that that sum should not be paid yet.

89.  I reject any suggestion that there was such an oral agreement. First the alleged “notice” was never produced by Mr Lee. Mr Shaw denied that there was any such document. His evidence was that the only notice ever given on the sinking fund was the demand made on 30 August 2007, when the first payment due had not been made. That was duly produced.

90.  I have not the slightest doubt at all that if a document, such as that alleged by Mr Lee existed, Mr Lee would have retained it and produced it in evidence. It was a vital document and would undoubtedly have been kept. It relieved the defendants of a considerable burden.

91.  Mr Lee was never able to say just what was in the document. His brother was not called to give evidence about the content of the document. Mr Carolan relied upon the following passage in Rafidain Bank v Agom Sugar Ltd [1987] 1 WLR 1607at 1612, per Nourse LJ:

“Mr Lightman further says that the first defendants are entitled to a trial on the defences pleaded and that the plaintiffs are sufficiently protected by the principle that, if the documents are not disclosed, the first defendants will be debarred from relying on them at the trial.  That was an automatic provision of the rules in the old days.  It has now gone, but it would be the usual practice at trial the judge not to allow reliance to be placed on the documents if they had not been produced.”

92.  This is a plain case for the application of that practice. The defendants asserted the document in the very vaguest of terms. They do not produce the document. They do not call as a witness the brother, Mr Li, nor is any explanation offered for his absence. In this respect, the comments as to the law on the failure to call a witness, made in relation to Mr Miu, at para 121 below, are equally apposite to the absence of Mr Li..

93.  I place no reliance on any assertion in relation to that document.

94.  It was not in dispute that the sinking fund payments were not made in accordance with the SIA. No proper explanation was offered to the failure to make those payments. Huge Winners was plainly in breach of Schedule 3, Part 1 para (6) of the SIA, in relation to the requirement to make payments to the sinking fund.

95.  I accordingly conclude that Huge Winners was in default and in breach of the terms of the SIA.

Other defaults:

96.  In fact there were numerous defaults on the part of Huge Winners, upon which Pearldelta are entitled to rely.

97.  The removal of Mr Shaw, and the appointment of Mr Mo, as a director of Huge Winners Shenzhen, was a breach of clause 14.1 of the SIA which required the board of Huge Winners, and each of its subsidiaries, including expressly Huge Winners Shenzhen, to comprise the same three directors, Mr Lee and Dr Yang and Mr Shaw. It was also a breach of clause 15.2(L) of the SIA, which required the consent of Mr Shaw for any change in the composition of the board of directors of any of the companies in the Group.

98.  The identical attempt to appoint Mr Mo in place of Mr Shaw on the board of Huge Winners Hong Kong was a breach of the same provisions.

99.  Fortunately, the attempt by Mr Lee and Dr Yang in their letter of 16 April 2008, to pass off the removal of Mr Shaw and the appointment of Mr Mo as “inadvertent mistakes”, was not persisted with at trial. The assertions in the letter bordered upon a farcical attempt on the part of Mr Lee and Dr Yang to excuse what can only be described as quite inexcusable conduct.

100.  The steps taken, (see para 75 above), to purportedly increase the share capital of Huge Winners Shenzhen from RMB50 million to RMB200 million, were steps taken in breach of the SIA and the undertakings, in particular the undertakings given that the defendant should not approach or deal with any outside investors, nor allow Huge Winners Shenzhen to do so.

101.  I am quite satisfied that Huge Winners was in breach of the provisions of the SIA.

The defences:

102.  A number of matters were raised by way of defence. They include an assertion that the SIA was inconsistent with the LOI, misrepresentation, non est factum, an assertion that the terms of the SIA were unworkable, and the consequences of the “true interpretation” of clause 7.4. The defendants also take a preliminary technical point that the form of the Redemption Notice was defective. In addition, for herself, it is argued that Ms Ng was subject to the undue influence of her husband, which undue influence was such as to release her from her personal guarantee.

The form of the Conversion and Redemption Notice:

103.  Clause 8.3 of the Bond Conditions in the SIA provided:

“Redemption of the Bonds under Condition 8.2 shall be effected on the date specified in the relevant notice given by the Bondholder (which shall be a date falling not less than ten Business Days after the date on which the notice is given) and shall be at the Redemption Amount.”

104.  The Notice of Redemption followed precisely the form contained in the SIA, and was dated 14 March 2008. Mr Lam argued that that date was the “effective date specified in the Notice of Redemption”, but that was plainly not so. That was merely the date of the notice. The date upon which the redemption was required was, in accordance with the terms of the SIA, calculated as not less than 10 days after the date of the notice. That is the plain effect of what the covering letter stated when it required Huge Winners to:

“… remit $86,321,292.66 within ten business days of the Notice of Redemption.”

105.  Mr Lam’s submission that the Notice of Redemption was defective for having an uncertain period must fail. A certain period was plainly ascertained by simple reference to the SIA and the Notice of Redemption.

106.  The period of 10 days expired on 25 March 2008, and by not paying the amount due pursuant to the Notice on that date, Huge Winners was in default. In the Statement of Claim, Pearldelta has pleaded that the time for payment ended on 1 April 2008. That is plainly wrong, but it is wrong in favour of the defendants so no point can be taken.

107.  Huge Winners having failed to pay, the liability on the part of the Principals on their personal guarantees arose, (subject to any defences they might have), on 25 March 2008. The letters of demand on the guarantee, issued on 2 April 2008, cannot, in those circumstances, be criticised.

108.  I reject the contention that there was any technical error in the form of the Redemption Notice.

109.  An argument was also made in respect of the Conversion Notice, that there was no basis to apply a conversion price of HK$0.01 and that consequently the notice was defective. This argument depends upon the interpretation of the provisions in relation to conversion which will be dealt with below, (see paras 165-171).

The SIA is inconsistent with the LOI:

110.  I accept Mr Carolan’s submission that Dr Yang, who said that he was able to read and write a reasonable amount of English, and that he had, to use the word he used in evidence, “perused” the draft SIA, must have known of the personal guarantee provision. As Mr Carolan points out, the personal guarantee is specifically referred to in the table of contents. A straightforward reading of the SIA reveals the existence of the personal guarantee provisions. A perusal of the document would disclose to the reader the precise nature of the guarantee.

111.  First, it is quite clear that the SIA was in broad accordance with the content of the LOI, although it is right that there was no reference to the personal guarantees in the LOI. But the draft SIA submitted on 5 July 2005, contained personal guarantees. It was not signed until sometime between 23 August 2005 and 31 August 2005. Consequently, it was in the hands of the Principals for between 50 and 57 days. During that time they had ample time to negotiate a variation of the plain requirement that they give personal guarantees, or to take any advice they may have wished to take in respect of the requirement for personal guarantees.

112.  But more importantly, there was no requirement that the SIA should contain no terms other than those set out in the LOI. That is plain from the fact that with the exception of clause 7, (Exclusivity), and clause 8, (Confidentiality), the LOI was not binding on the parties: see clause 9 set out in para 30 above. Even without this provision, in the absence of any provision suggesting otherwise, it is facile to suggest that a concluded agreement, completed after a letter of intent could only contain provisions signalled in the letter of intent.

113.  It is clear from clause 5 of the LOI that further negotiations, which might result in any provision being suggested by either party, were to take place. Clause 5 provides:

“5.  Next Steps.

1)  Upon signing of this letter, both parties agreed to begin various preparations for investment, most of which will happen at the same time including:

a.  Final negotiations regarding the detailed terms of investment.

…

e.  Drafting of relevant legal documents, and application for relevant approvals from government.”

114.  Having regard to these provisions it is quite clear that the parties intended the LOI to provide nothing more than a basic guide to the nature of the investment that was hoped to be made, with the final terms yet to be settled.

115.  In those circumstances the fact that there was no reference to a personal guarantee in the LOI does not assist the Principals.

Misrepresentation:

116.  The defence filed by all defendants contended that Mr Miu was acting on behalf of Pearldelta and the witness statements relied upon by the defendants made the same assertion.

117.  Contrary to that position, Dr Yang confirmed in cross-examination that Mr Miu had been engaged by Huge Winners as a financial consultant. Dr Yang confirmed that Mr Miu had approached a number of prospective investors, including SKP, on Huge Winners behalf. The documentary evidence that Mr Miu was solely a representative of Huge Winners is plain in that it shows that Mr Miu made the first approach to SKP by way of a fax on 8 March 2005. In later correspondence Mr Miu plainly refers to Huge Winners as “my client”.

118.  On the occasion on which the SIA was signed, Mr Miu had witnessed the signatures of the defendants. Mr Jack Tsai witnessed the signature of Pearldelta. That those persons witnessed those particular signatures tends to indicate that those persons represented the parties whose signatures they witnessed.

119.  Ultimately, after the transaction was completed, Mr Miu was paid an advisory fee of HK$800,000 by Huge Winners. Nothing was paid to Mr Miu by SKP or Pearldelta.

120.  Mr Miu was not called to give evidence. He has a close relationship with Mr Lee, as evidenced by his appointment of a director of LED Holdings Ltd, a personal company owned by Mr Lee. There was no explanation for his absence, and no suggestion was made that he was not available to give evidence. The assertion by the defendants that Mr Miu was an agent of Pearldelta or SKP cried out for him to be called to give evidence of that fact.

121.  Mr Carolan was entitled to say that it was open to the court to infer from the fact that Mr Miu was not called to give evidence, that any evidence he might have given would have been unfavourable to the defendants: see Phipson on Evidence 17^th Edn, para 11-15. The principles as to the drawing of adverse inferences have been summarised by Brooke LJ, in Wisniewski v Central Manchester Health Authority [1998] PIQR 324 at 340:

“From this line of authority I derive the following Principals in the context of the present case:

(1)  In certain circumstances a court may be entitled to draw adverse inferences from the absence or silence of a witness who might be expected to have material evidence to give on an issue in an action.

(2)  If a court is willing to draw such inferences they may go to strengthen the evidence adduced on that issue by the other party or to weaken the evidence, if any, adduced by the party who might reasonably have been expected to call the witness.

(3)  There must, however, have been some evidence, however weak, adduced by the former on the matter in question before the court is entitled to draw the desired inference: in other words, there must be a case to answer on that issue.

(4)  If the reason for the witness’s absence or silence satisfies the court then no such adverse inference may be drawn. If, on the other hand, there is some credible explanation given, even if it is not wholly satisfactory, the potentially detrimental effect of his/her absence or silence may be reduced or nullified.”

122.  The evidence, as I have set out in paragraphs 23-37 and 118-120 above, raises a very strong inference that Mr Miu was the agent for the defendants. The failure to call Mr Miu strengthens that inference.

123.  Notwithstanding the clear state of the evidence, Mr Lam did not abandon the contention that Pearldelta should be liable for what he described as “misrepresentations” on the part of Mr Miu. But he was unable to say that Mr Miu was an agent for Pearldelta. The best he could put it was to assert that:

“Practically, (Mr Miu) was all along acting for both SKP (or Pearldelta) and the shareholders of the company (D2-D6).”

The evidence simply did not support that assertion.  The evidence clearly established that Mr Miu was engaged by the defendants to find an investor, he did so, and he was paid for his services by the company.  In that sense he may well be described as a “middleman”, but it is abundantly clear that he was the defendants’ middleman, and that he did not represent in any way either SKP or Pearldelta.

124.  I conclude that in this transaction Mr Miu was an agent for the defendants.

125.  In so far as any reliance is made by the defendants on any so-called “misrepresentation” on the part of Mr Miu, the assertion must fail. Mr Miu was the defendants’ own agent and if they believe that he has misrepresented anything, it is to him the defendants must look, not SKP or Pearldelta.

126.  The evidence of Mr Lee and Dr Yang was that in mid-August 2005 they met with Mr Miu to discuss the details of the draft SIA. None of the defendants took legal advice in relation to the SIA, preferring to rely upon their own examination of the documents, and the advice of Mr Miu.

127.  Part of the case advanced by the Principals in the pleadings, and by Dr Yang in evidence, was that Mr Miu failed to properly explain to them the terms of the SIA, including the personal guarantees. As it is absolutely plain that Mr Miu was representing all the defendants in the transaction, and was not in any way a representative of SKP, any such failure cannot be the responsibility of SKP. Again, if the defendants believe that Mr Miu failed to explain the documents to the defendants, they must look to him for relief.

128.  The accusations of misrepresentation extended also to Mr Jack Tsai. There is no doubt that he represented SKP and Pearldelta.

129.  It was the evidence of Dr Yang that Mr Jack Tsai had told him that it had been he, Mr Jack Tsai, who had drafted the SIA, that he had done so in a hurry and that its contents were similar to or in accordance with the contents of the LOI, and that Mr Jack Tsai had failed to inform him of the personal guarantee. It was also asserted that Mr Jack Tsai said that the SIA was an ordinary document. Mr Jack Tsai was not called to give evidence in answer to these assertions.

130.  Having regard to the terms of the e-mail by which the draft SIA was sent to Dr Yang, (see para 31 above), Mr Jack Tsai may well have said these things. But even if he did, it does not advance the case of the Principals at all. It is not in dispute that the SIA was drafted by the Pearldelta side. That it was does not provide a defence. The Principals had the document for at least 50 days during which time they had ample time to take any advice they may have wished on its terms. They elected to confine that advice to advice from Mr Miu.

131.  If Mr Jack Tsai drafted the document or did so in a hurry, those are mere facts, and do not go at all to substantiate the contentions of the Principals. They do not go at all to provide a basis for any of the defendants to escape liability under the SIA.

132.  Having regard to the terms of the e-mail, it may well be that Mr Jack Tsai did say that the SIA was an ordinary convertible bond. That he may have said so does not go to substantiate the contentions of the Principals.

133.  First, it may well be that the provisions of the SIA are common to convertible bonds. In order to substantiate a misrepresentation in this respect there would need to be evidence from the defendants that the SIA was not an ordinary document. No evidence at all was led to suggest that the various forms of redemption were not common in convertible bonds. To the contrary, having regard to the commercial risks involved in a convertible bond, I would not be at all surprised if such provisions were common in convertible bonds.

134.  The assertion that the SIA was not a usual document was one made by the defendants. The onus lay upon them to establish that that was so. No other convertible bondsby which I could make comparison were put before me. No financial expert was called to assist me on the nature of convertible bonds. In simple terms, there was nothing in the evidence upon which I could say that the terms and structure of this convertible bond were in any way special.

135.  The plea of misrepresentation seemed to include an assertion on the part of the defendants that Pearldelta and Mr Shaw were under a duty to advise them to seek independent legal advice and to proffer explanations on the nature and effects of the terms of the charge. Putting aside the question of undue influence in relation to Ms Ng, this proposition must plainly be rejected.

136.  Mr Carolan relied upon Barclays Bank plc v Khaira [1992] 1 WLR 623 where it was held that in the normal course of events, a bank was not under a duty to explain to a person who came to its premises to sign a charge as a security for a loan the nature and effect of the proposed transaction. The same result was reached in Kincheng Banking Corp v Kao Yu Kuei [1986] HKC 212 CA. In any event, as I have pointed out, the defendants had their own adviser, Mr Miu, and could at any time have taken their own legal advice.

137.  The allegations of misrepresentation are rejected.

The invalidity of the audit report:

138.  The RSM audit report had been approved by a meeting of the audit committee, duly called, but at which only the chairman, (also the Designated Director), Mr Shaw, attended. There was no requirement in either the Articles of Association or the SIA for a quorum for the audit committee.

139.  As a matter of general law, two persons is the minimum number for a meeting to be properly constituted, since the term “meeting” prima facie means a coming together of more than one person: see Shackleton on the Law and Practice of Meetings, 11^th Edn, 2008, para 6-03. The word quorum denotes the number of members of any body of persons whose presence at a meeting is requisite in order that business may be validly transacted.

140.  Shackleton notes, at 6-05, that the event of no quorum being prescribed is an “unlikely event”. At 6-05, the following statement is made:

“Where a board of directors delegated powers to a committee, without any provision as to the committee acting by a quorum, all acts of the committee must be done in the presence of all the members of the committee.”

Re Liverpool Household Stores Association Ltd (1890) LJ Ch 616 is cited as authority.

141.  Pursuant to the SIA, Huge Winners appointed the CFO, Mr Cao, and Mr Shaw to be the audit committee. Mr Shaw had a casting vote, but there was no provision for a quorum. Consequently, for there to be a lawful meeting of the audit committee, both Mr Shaw and Mr Cao must be present.

142.  The audit committee meeting at which the RSM audit report was purportedly approved was duly called, but, of the committee members, only Mr Shaw attended. The presence of Robin Szeto, one of the auditors does not assist in the calculation of a quorum.

143.  Shackleton says, at para 6-06, and it must be right, that it is a generally accepted principle that business transacted at a meeting at which a quorum is not present is invalid. Consequently, the resolution purportedly passed by Mr Shaw on 13 December 2007, approving the audit report was not a valid resolution.

144.  But the fact that it was not a valid resolution does not detract in any way from the breaches of the SIA that have been set out above.

145.  The attempts by Mr Lee and Dr Yang to avoid attending the audit committee meeting were, I am satisfied, merely a device on their part in an attempt to prevent the audit report being approved, with a view to a subsequent argument in litigation that the audit report was invalid and ought not to be relied upon. I am satisfied that it would be quite wrong to allow such a patent device to prevent the court from considering the RSM audit report in this litigation.

146.  It is pertinent to note that on 16 April 2008, Mr Lee and Dr Yang emailed Mr Shaw asserting that:

“At the outset, the draft (RSM audit) report is problematic due to the lack of communication between the auditors and the directors of the Company.  In the Board Meeting, various explanations were given to such lack of communication, and Mr Shaw was first to point fingers.  Obviously, Mr Shaw also recognised that there was a problem of lack of communication.

Regardless of whose fault it was, at the end of the day, it cannot be denied that the resulting draft report is inaccurate.  Of all the directors, only Mr Shaw believed that the audit report was accurate, explaining that “the auditors said so”.  It was drafted under a serious lack of information and represents a compromise of best.  Even the draft report concedes to this point and we suggest you read the first three pages of it.” (sic)

147.  It is right that Mr Shaw pointed fingers. He made it plain in his evidence that there was lack of communication, and that responsibility for that lack lay with Mr Lee, Dr Yang and Mr Cao. The steps taken by Mr Lee and Dr Yang were merely a device, and a device that cannot succeed.

148.  Mr Shaw maintained the position that the RSM audit report was accurate. There was no evidence to the contrary. The defendants elected to put no alternative audit report to the court, and other than the argument based upon quorum, nothing was suggested as to why the court ought not to rely upon the RSM audit report. The assertion by Dr Yang in his email that the RSM audit report was “problematic” was quite unsupported by any evidence at all. The lack of communication was caused by the deliberate acts of Mr Lee, Dr Yang and Mr Cao in avoiding the RSM auditors. That lack of communication was not demonstrated to have any impact on the quality of the audit report.

149.  While it may not have been lawfully approved by Huge Winners, there is nothing in the evidence to indicate that it would not be proper for me to rely upon the RSM audit report as establishing the appropriate figures in this case. As to the accuracy of the report, the defendants elected to put no contrary report to the court and put nothing to the auditors in cross-examination that could lead me to conclude that I should not accept the audit report as being accurate.

Non est factum:

150.  Non est factum is a category of mistake. It is described in the following way in Chitty on Contracts 30^th Edn Vol 1 para 5-101:

“The general rule is that a person is estopped by his or her deed, and although there is no such estoppel in the case of ordinary signed documents, a party of full age and understanding is normally bound by his signature to a document, whether he reads or understands it or not.  If, however a party has been misled into executing a deed or signing a document essentially different from that which he intended to execute or sign, he can plead non est factum in an action against him”

151.  The plea is not lightly to be allowed where a person of full age and capacity has signed a written document embodying contractual terms. In exceptional circumstances it will be available so long as the person signing the document had made a fundamental mistake as to the character or effect of the document: Chitty para 5-104.

152.  A rare example of the plea succeeding, and a good illustration of the true nature of the plea, is contained in Petelin v Cullen [1975] 132 CLR 355, where the High Court of Australia accepted the defence in circumstances where a person signed a form in the belief it was a simple receipt, when in fact the document purported to extend an option to the sale of land.

153.  But the plea is not available to someone who is negligent. At para 5-106, Chitty goes on to say:

“A person who signs a document may not be permitted to raise the defence of non est factum where he has been guilty of negligence in appending his signature.”

154.  That is the case in the present situation. The defendants, both in their capacity as directors of Huge Winners, and as guarantors in their individual capacity, say that they did not know the true content of the document they were signing. They knew they were signing security documents in relation to a convertible bond and they knew the essential terms of that document. That is a long way from the circumstances in Petelin. What the defendants in this case say, in truth, is that they did not understand the legal effect of the document they were signing.

155.  What the Principals assert is a plea of non est factum. But the defence is not available to anyone who has signed a document without taking the trouble to find out at least the general effect of the document, neither can it be available to a person whose mistake was really a mistake as to the legal effect of the document (see Gallie v Lee [1971] AC 1004). In simple terms, a person who elects to sign a document without reading it or having it explained cannot thereafter be heard to complain about the terms of the document and will be taken to have agreed to its terms.

156.  The plea of non est factum must fail.

The terms of the SIA are unworkable:

157.  The argument made by Mr Lam in this respect turned upon the mathematical consequence that to multiply a negative by a negative, a positive is produced. Consequently, he demonstrated mathematically, that if substantial losses were suffered by Huge Winners in both years involved in the formula, 2005 and 2006, a very high conversion price would result, with Pearldelta receiving only a very modest share of a loss-making company for a very high sum.

158.  It is right to say that is the mathematical consequence of that circumstance. But the submission entirely overlooks the fact that there are three options available to the bond holder, Pearldelta, for the redemption of the bond. First, Pearldelta may demand repayment of the original advance of HK$20 million with interest at 12%. Second, they may seek the conversion of the bond into shares at the conversion price in accordance with the formula. Third, they may demand redemption on the basis of the assets less liabilities formula. It is this basis upon which Pearldelta now seeks judgement.

159.  That there are three alternatives available to the bond holder overcomes the suggestion that the formula is unworkable. If any of the three results produce a conclusion that is unsatisfactory to Pearldelta, there is nothing in the SIA to prevent Pearldelta from electing to demand redemption on another basis. This they have done.

160.  As part of the argument that the redemption formula is unworkable, it was contended that the application of the formula would require the issue of new shares at a conversion price of HK$0.01. This, it was contended could not be done as new shares must be issued at par, US$1.00.

161.  This argument too must fail. Schedule 3 of the SIA contains undertakings on the part of Huge Winners. The undertakings contain the following provisions:

“Part 1 Covenants of the Company

(9) for as long as any of the Bonds remain outstanding, (Huge Winners undertakes to) maintain sufficient authorised but unissued share capital, and provide the Directors with sufficient authority to allot new shares, as is necessary to allow the Company to issue and allot shares to the Bondholder upon an exercise of conversion rights in full;”

If that were not enough, the Bond Conditions attached to the SIA provide:

“6.4  Upon conversion, the Company shall allot and issue the relevant Conversion Number of Ordinary Shares, credited as fully-paid and such Ordinary Shares shall rank pari passu in all respects with the Ordinary Shares of the Company then in issue.

6.5  Conversion of the Bonds as are due to be converted as aforesaid on any Conversion Date shall be effected in accordance with these Bond Conditions and subject to all applicable laws or regulations.

6.9  The Company shall procure that there shall be sufficient authorised but unissued share capital available for the purposes of satisfying the requirements of any Conversion Notice as may be given by any Bondholder and the terms of any other securities for the time being in issue which are convertible into or have the right to subscribe for shares in the Company.”

162.  These provisions more than amply ensure that an appropriate number of shares, at an appropriate face value, will be available to meet the demands of any conversion notice.

163.  The argument that the redemption formula is unworkable must fail.

The true interpretation of clause 7.4:

164.  Contiguous with the “unworkable” argument was a contention from Mr Lam that clause 7.4 of the Bond Conditions of the SIA was wrongly interpreted by Pearldelta. The argument was that the clause could never be interpreted as taking the conversion price to be HK$0.01. The relevant provision is:

“No adjustment will be made to the Conversion Price in any case in which the amount by which the same would be reduced would be less than HK$0.01 and any adjustment which would otherwise then be required will be carried forward is taken into account appropriately in any subsequent adjustment.”

165.  Mr Fung, for Ms Ng, accepted that the interpretation placed upon this provision by Mr Carolan was plainly correct. Both agreed that the minimum sum to which the Conversion Price should be adjusted by the application of the formula was HK$0.01.

166.  It is unarguable that the mathematical application of the redemption formula results in a conversion price of a sum less than HK$0.01. That is because of the extent of the losses suffered. That was confirmed by the evidence of Deret Au, a matter that I am satisfied is within his expertise. Given that it is impossible to apply a negative value for the share price for the purpose of conversion, I am satisfied that the only sensible interpretation of the provision is that in the event that the formula would produce a negative value for the share price, then a value of HK$0.01 shall be taken.

167.  Mr Lam pointed to the provisions of clause 21.1 of the SIA which, he said, demonstrates that the parties entered into the agreement with a view to making a capital gain through the disposal of the shares obtained by it upon conversion of the bonds either through a qualifying IPO or qualifying trade sale. In those circumstances, he said it could not have been possible for the parties to have intended that Pearldelta could, to use his phrase, “rip off” the Principals, and the entire company, when the company had missed just one year’s profit target.

168.  The submission entirely fails to note, and pay proper regard to, the reason why profit targets were met. It is plain from the evidence that, amongst other reasons for the poor performance of the company, a significant reason that profit targets were not met was that there had been fictitious sales involving Mr Lee, and the consequences that had on the operation of the company. In those circumstances it cannot be said that Pearldelta was “ripping” anyone off.

169.  But in any event it was open to the Principals, during the 50 or so days in which they had to peruse the SIA to apply to the formula various computations of figures. Dr Yang said that he did so, but did not take them so far as to see what the result would be if losses were incurred in any year. Had he done so, in my view a prudent course when faced with such a formula, he would have seen immediately the likely result. That he chose not to, and that the other Principals chose not to examine the document in any detail at all, certainly does not justify a submission that Pearldelta was engaged in “ripping off” the Principals.

170.  In simple terms, the proper consequence of the application of the results achieved by the Group to the formula contained in the SIA is to produce a conversion value of HK$0.01 per share. The results were entirely in the hands of the Principals. They must accept the consequences of their own steps.

The terms of the SIA are unreasonable:

171.  This argument was made as part of a contention that the SIA should be invalidated for unilateral mistake. A number of contentions were raised in argument, although not pleaded, in this respect. These included an assertion that Pearldelta knew that the defendants needed a Chinese translation of the formal documents, and also the LOI; that Pearldelta knew that there was no Chinese translation of the draft SIA; that Pearldelta knew that the defendants did not notice the onerous provisions contained in the redemption formula or the guarantee or that the defendants did not understand that those provisions were onerous.

172.  These contentions may be rejected without reference to the legal concept of unilateral mistake.

173.  First, the defendants had a Chinese translation of the LOI. It had been prepared for them by their agent, Mr Miu. Second, Pearldelta had no reason to consider that Mr Miu had not dealt with the SIA either by a written translation or by oral discussion with the defendants in the 50 day period in which they had the draft.

174.  That being the case it simply cannot be argued that Pearldelta knew that the defendants had not given proper consideration, and therefore did not understand either the redemption formula or the presence of the personal guarantee. In any event, Mr Lam was quite unable to demonstrate any basis upon which Pearldelta should be concerned as to the extent of the advice the Principals were taking.

175.  Certainly as far as Dr Yang was concerned, he was fully aware of the redemption formula because, on his own evidence, he had used variable figures to ascertain the effect of the adjustments in the profit situations contained in the formula.

176.  It was put to Mr Shaw in cross-examination that the redemption formula had never been explained to the defendants. Mr Shaw responded by saying that any explanation could have come from the defendants’ own financial adviser. That was an entirely sensible response and completely justifiable in the circumstances.

177.  First there was no obligation on Mr Shaw to take any step whatsoever to satisfy himself of the extent of the defendants’ understanding of the documents. This was a commercial transaction between men of business in which the defendants had their own financial adviser. Mr Shaw had no reason whatsoever to believe that the defendants did not have a proper understanding of the terms of the document. That is especially so when dealing with the company the size of Huge Winners.

178.  It is probably right that none of the parties contemplated the possibility that Huge Winners could suffer losses that, when applied to the formula, would produce a conversion result of HK$0.01. Mr Shaw believed that he was buying into a profitable and successful business and had no reason to suspect that the accounts would be artificially and falsely buoyed by fictitious transactions. Plainly, having agreed to the figures for profit in the redemption formula, the defendants believed that they could reach those figures. They are the ones who are responsible for the figures not having been met.

179.  To suggest that it was unconscionable on the part of Mr Shaw not to have pointed out to the defendants that these were possible consequences is both facile in the extreme and without any basis whatsoever as a matter of law. It cannot found an argument for a unilateral mistake on the part of the defendants.

180.  Mr Lam extracted various statements of principle of law of unilateral mistake from Chitty, but was quite unable to apply the facts of the present case to those statements.

181.  I reject the submission that Mr Shaw did not understand the effect of the formula. The effect of the formula was plain. If Huge Winners did better than the profit numbers contained in the formula, upon conversion of the convertible bond, the share received by Pearldelta in Huge Winners would be reduced. If Huge Winners did not do as well as the profit numbers contained in the formula then upon the conversion of the convertible bond, the share received by Pearldelta in Huge Winners would be increased. Both results are entirely logical and sensible. All the parties understood those results. The defendants, had they chosen to, could have applied any number of figures to the formula to ascertain what might happen in the event that the results that were in fact achieved, might happen.

182.  Neither were the parties under any common mistake about the effect of the redemption formula. It is true that neither side anticipated that the losses suffered would be such as to reduce the conversion price to HK$0.01, with the consequence that Pearldelta would effectively own the whole of the Group. But I am satisfied that that is not a mistake as to the effect or operation of the formula.

183.  I reject completely the contention that either Mr Shaw or Pearldelta shut his/its eyes to what Mr Lam described as “the obvious”, by which I understand him to mean an absence of knowledge on the part of the defendants to the nature of the documents.

184.  I reject the concept that there has been any unilateral mistake on the part of any of the defendants, or any common mistake between Pearldelta and the defendants.

Undue influence on Ms Ng:

185.  The law is clear that the burden of proving undue influence rests upon the person arguing they had been subjected to that undue influence. In the present case Ms Ng carries the burden of establishing that she was subjected to undue influence, as she alleges, by her husband, Mr Lee.

186.  It is accordingly entirely irrelevant that there might have been particular advantages to Pearldelta in the transaction. If there was, as Mr Fung described it, a windfall redemption amount available to Pearldelta in the form of the third option for redemption, the net asset value calculation, or the option for conversion which, on the figures in this case enable Pearldelta to take virtually complete control of Huge Winners, then neither of those facts can constitute undue influence on the part of Mr Lee.

187.  Mr Fung’s submissions on the consequences of the transaction are consequently completely irrelevant to the issue of undue influence.

188.  The evidence from both Mr Lee and Ms Ng in this case is that Mr Lee simply asked Ms Ng to sign the SIA, and that she did so because she trusted him. Mr Carolan was perfectly entitled to rely upon the statement by Recorder Ma SC, (as Ma CJHC then was) in Bank of China (Hong Kong) Ltd v Wong King Sing & Ors [2002] 1 HKLRD 358 at 380C:

“As to actual undue influence, there is not the slightest evidence to support such a plea.  It is true that WKF was instructed by his brother to sign the second legal charge and other documents relating to the Property.  But this goes a long way short in establishing any actual undue influence.”

That was precisely the situation in the present case.  Even if there was some form of influence by the husband over the wife, there was simply nothing in the evidence to show that that influence was undue influence.

189.  In fact the evidence positively demonstrated that Mr Lee did not exercise undue influence. He denied that he had given misleading or inaccurate information about the SIA to Ms Ng. His evidence was that he simply told her that someone was going to invest in Huge Winners and asked her to sign documents. Ms Ng agreed with that evidence. She said that he did not tell her anything about the documents or the transaction. Both agreed that Mr Lee had not lied or misled Ms Ng. Neither was there any allegation that he had coerced, bullied or intimidated her into signing documents. Just because Ms Ng trusted her husband does not establish that he has subjected her to “undue influence”, as that expression is known to the law.

190.  Neither has it been demonstrated that undue influence can be presumed.

191.  First, the relationship of a husband and wife is not one which gives rise to a presumption of undue influence: see Royal Bank of Scotland plc v Etridge (No 2) [2002] AC 773, per Lord Nicholls at 797G, and Lord Scott at 842B.

192.  Second, this is not a case where it can be contended that the transaction cannot be readily explainable by the relationship of the parties.

193.  Mr Fung described Ms Ng’s position as being a wife standing as a surety for a husband’s debt. But that is very far from the real circumstances of this case.

194.  Ms Ng was a shareholder in her own right in Huge Winners. She was a director of the company. That the shares were gifted to her by her husband is simply irrelevant. They were her shares and she was the director. The fact that she was a substantial shareholder and director of Huge Winners by itself explains the transaction. Nothing would be more normal than to require a substantial shareholder and director of the company to offer a personal guarantee to a financial arrangement made by that company. It makes no difference that she agreed immediately to resign her position as a director. The circumstances of the investment by Pearldelta in Huge Winners, and the need for negative control on the part of Mr Shaw, explains and justifies that resignation. Ms Ng still stood to benefit personally and substantially through her shareholding should there have been an IPO or a trade sale.

195.  In those circumstances it cannot in any terms be said that the transaction, or her guarantee of the transaction, was in any way disadvantageous to Ms Ng.

196.  Ms Ng was not a naive or innocent person. She describes herself as a merchant in the company records of a group of companies which may be described as the Strong Base companies, said to be her husband’s companies. She acknowledged in cross-examination that she held her positions in those companies because she was a businesswoman who had been actively involved in the management of the companies since the 1990s. She may have done so merely to assist her husband, but since his resignation as a director of those companies on 9 March 2009, she remains sole director and a substantial shareholder in the companies.

197.  She admits that the companies now operate under her sole supervision. She is sufficient of a businesswoman that on 18 May 2009, part at least of the Strong Base business in China was sold for RMB107,049,200. In any terms that is a very substantial transaction in which a sole director should be involved. It is a testament to her ability as a businesswoman, and a clear demonstration that she was not a naive person, who was taken in by undue influence.

198.  It may well be possible to argue that an inference of undue influence may arise when a wife, who does not have a personal involvement in her husband’s business, is asked to guarantee her husband’s, or his company’s, business borrowing. But that scenario is so far removed from the present scenario that such an inference of undue influence simply does not arise.

199.  The plea on the part of Ms Ng that she should escape liability in the transaction as having been a victim of undue influence must fail.

The Moneylenders Ordinance:

200.  The Moneylenders Ordinance, Cap 163, (MLO) contains a prohibition against excessive interest rates. It provides in s 24:

“(1)  Any person (whether a money lender or not) who lends or offers to lend money at an effective rate of interest which exceeds 60 per cent per annum commits an offence.

(2)  No agreement for the repayment of any loan or for the payment of interest on any loan and no security given in respect of any such agreement or loan shall be enforceable in any case in which the effective rate of interest exceeds the rate specified in the subsection (1).”

201.  The arguments for the defendants is that the SIA offends against s 24(1) MLO, in that the effective rate of interest exceeds 60% pa.

An Exempted Loan:

202.  I reject that submission.

203.  First, it is rejected because I am satisfied that in the circumstances in which the SIA was made, the SIA constitutes an exempted loan pursuant to MLO, Sch 1 Part 2 para 12. By s 24(5) MLO, nothing in s 24, shall apply to a loan specified in paragraph 12 in Part 2 of Schedule 1. That paragraph provides:

“12  (a)  A loan made to a company that has a paid up share capital of not less than $1,000,000 or an equivalent amount in any other approved currency.

(b)  For the purposes of this paragraph “approved currency” means a currency-

(i)  freely convertible into Hong Kong dollars; or

(ii)  approved in writing by the Registrar for the purposes of this paragraph.”

204.  Huge Winners, being a BVI company, has issued its share capital in US dollars, a currency freely convertible into Hong Kong dollars. Consequently, no issue arises under para 12(b)(ii). For the purpose of the most recent accounts the share capital has been converted into RMB, but as the notes to the financial statements for the year ended 31 December 2005 and 2006, (bundle 4(f) p1928) demonstrates:

“On 17 April 2003, the Company issued 50,000 ordinary shares of US$1 each at a premium of US$50.28 per share to the shareholders of a total consideration of US$2,564,102.  As a result, share premium account should have been credited by US$2,514,102 (RMB20,507,300).” (sic)

It should be noted that the conversion in the accounts to RMB is purely for the purposes of the accounts, the company capital is in fact issued in US dollars.

205.  The nominal share capital of Huge Winners, in 2004, when the SIA was entered into, was, after conversion, HK$390,000. But if regard is had to the US$2,514,102 in the share premium account, the total capital of Huge Winners plainly exceeds HK$1 million, (converted to Hong Kong dollars it is a sum of HK$19,999,995.60).

206.  The law is that the sum in a company’s share premium account is to be treated as paid-up share capital. That is so by virtue of the provisions of s 48B(1) Companies Ordinance Cap 32, (CO), which provides:

“48B  Application of premiums received on issue of shares

(1)  Where a company issue shares at a premium, whether for cash or otherwise, a sum equal to the aggregate amount or value of the premiums on those shares shall be transferred to an account, called “the share premium account”, and the provisions of this Ordinance relating to the reduction of the share capital of the company shall except as provided in this section, apply as if the share premium account were paid-up share capital of the company.”

This provision is identical in all respects to s 56(1) Companies Act 1948 (UK).

207.  That provision applies in respect of any circumstance in which it is necessary to have regard to the share capital of a company. It is not limited to certain purposes. That argument that it might be so limited was made but rejected in Re Duff’s Settlements [1951] 1 Ch 923 CA. Jenkins LJ, delivering the judgment of the court said, at 928:

“Taking all these considerations together Mr Walton invited us to hold that s 56 merely imposes (for the protection of creditors) restrictions on the distribution or other application of the share premium account, without depriving a distribution, made in conformity with those restrictions, of sums representing share premiums, of its essential character as a distribution of income and not of capital.

We do not think the effect of s 56 ought to be so limited.  It is true that the section does not in terms convert the share premium account into paid up share capital, but merely makes the provisions of the Act relating to the reduction of share capital apply as if the share premium account was paid up share capital.  But the provisions thus made applicable are the essential provisions on which the distinction between share capital and divisible profit depends, and on which the implied prohibition against the distribution of paid-up share capital otherwise than in pursuance of a duly authorised reduction of capital is based.  It is thus clear at all events that s 56 does take the share premium account out of the category of divisible profit and prevents it from being distributed by way of dividends.”

208.  The court found that in order to achieve a distribution of funds from a share premium account, there must be, effectively, an actual capitalisation. Thus, a sum in the share premium account must be treated as capital of the company. This may be seen from the following passage in Re Duff, at p 930:

“The provision in ss (2) permitting the application of a share premium account in paying up bonus shares does not, in our view, assist the tenants for life.  This merely enables a company to substitute actual capitalisation for the notional capitalisation produced by the section itself.  The section, as we read it, produces the same result on a direct distribution of a share premium account as if the company had first gone through the formality of actual capitalisation by bonus shares and then paid off the bonus shares by way of reduction of capital.”

209.  Jenkins LJ went on to say, also at p 930:

“A company, having an artificial person, can (as it has been laid down) make a distribution amongst its members (otherwise than in a winding up) in one of two ways - but only in one of two ways: that is, by a distribution of divisible profit, that is, by way of dividend; and by way of return of capital pursuant to an order of the court upon a petition for reduction of capital in accordance with the Act.”

210.  The whole effect of s 48B is, I am satisfied, to demand that a share premium account be treated in all respects as part of the share capital of a company. On this basis I am satisfied that Huge Winners had, at the time the SIA was entered into, a share capital exceeding HK1,000,000, and that accordingly the SIA is exempted from the provisions of the MLO.

211.  As Mr Fung pointed out in his skeleton argument, the rationale for such an exemption may be found in the statement of the Financial Secretary in LegCo, on the moving of the second reading of “A Bill to Amend the Money Lenders Ordinance”, Hong Kong Hansard, 22 June 1998 pp 1660-1:

“The Money Lenders Ordinance was enacted in 1980 principally to curb loansharking.  It provides a framework for the licensing of money lenders, the control of money lending transactions and the prohibition of excessive interest rates.  In the operation of the Ordinance over the years, a number of weaknesses has (sic) emerged.  Experience has also shown that certain genuine commercial transactions have been caught even though they were not intended to be, and indeed, ought not to be, caught by the provisions of the Ordinance. The purpose of this Bill is to remedy these problems.

…

The third set of amendments seeks to widen the scope of existing exemptions from all or part of the provisions of the Ordinance.

“The terms of large corporate and syndicated loans which may make references to wholesale money market interest rates, are also to be exempted from the interest rate ceiling.  Large borrowers should be able to protect themselves.  It is, therefore proposed that the provisions on excessive interest rates should not apply to any loans specified in the first schedule that are made to a company with a paid up share capital of not less than $1 million.” (My emphasis)

212.  I am accordingly satisfied that the SIA is exempt from the provisions of the MLO. Irrespective of what interest rate may be calculated, s 24 or s 25 MLO cannot operate to assist the defendants. It was not intended that the MLO should catch a loan such as the convertible bond, plainly a large borrowing, by a substantial company, well able to protect itself.

213.  That conclusion, and the reasons for that conclusion are also sufficient to dispose of the argument advanced by Mr Fung based upon a consideration of the legislative purpose of the MLO and a subsequent statutory interpretation in the light of that legislative purpose. Again, in simple terms it could not be, for one moment, in any way, suggested that the transaction under consideration is in the nature of loansharking. It may have a very adverse commercial consequence for the Principals, but they were independently advised by Mr Miu, and had ample time in which to consider their position.

Does the SIA constitute a “loan” under the MLO:

214.  In case I am wrong in that conclusion I turn now to consider whether or not the SIA is caught by the provisions of the MLO.

215.  The defendants rely first, on the following provisions from s 2, Interpretation, MLO, (irrelevant words omitted):

“(1)  In this Ordinance unless the context otherwise requires-

“interest”….. includes any amount (by whatever name called) in excess of the principal, which amount has been or is to be paid or payable in consideration of or otherwise in respect of a loan;

“loan” includes …… every agreement (whatever its terms or form may be) which is in substance or effect a loan of money, and also an agreement to secure the repayment of any such loan, and “lend” and “lender” shall be construed accordingly;

(2)  For the purposes of this Ordnance, where by an agreement for the loan of money the interest charged on the loan is not expressed in terms of a rate, any amount paid or payable to the lender under the agreement (other than simple interest charged in accordance with the proviso to section 22) shall be appropriated to principal and interest in the proportion that the total amount of principal bears to the total amount of the interest, and the rate per cent per annum represented by the interest charged as calculated in accordance with Schedule 2 shall be deemed to be the rate of interest charged on the loan.”

216.  The argument that the SIA is a loan is dependent upon the expression used in the definition of “loan” in s 2 MLO:

“and every agreement (whatever its terms or form may be) which is in substance or effect a loan of money”

The argument made by Mr lam and Mr Fung is that it is unarguable, and indeed it is Pearldelta’s case, that the SIA is in part a loan, and that consequently, irrespective of the precise nature of the balance of the arrangement between the parties expressed in the SIA, the whole arrangement falls within the definition of a loan as contained in the MLO.

217.  The argument is superficially attractive and requires close examination. Counsel for the defendants say first, that the SIA, being a bond, is a loan, because that is the substance and effect of a bond.

218.  For the proposition that the SIA is a loan, reliance was placed by the defendants on a publication by The Wall Street Journal entitled “Guide to Understanding Personal Finance”, 1992, by Kenneth M Morris and Alan M Siegel. Mr Morris is said by the credits page of the publication to be an expert in creating plain language communications. He holds a Ph.D. and MA in English from Columbia University, and a BA (Hons) from Cornell University. Mr Siegel’s academic qualifications are not specifically set out although he is said to be a graduate of Cornell University, (inferentially, in English), and has taught a course in drafting contracts in plain English at Fordham Law School. He is a corporate communicator. Neither claim to have any legal qualification.

219.  It is right that the following statement is made, at p 132, in that publication:

“Bonds are loans you make to corporations or governments.  Unlike buying stocks (also called equity securities) which makes you a part owner in a company, buying bonds (or debt securities) makes you a creditor.”

And at p 137:

“What are Convertible Bonds?  Convertible bonds offer the option of acquiring stock instead of getting your cash back.  The terms of exchange - generally a certain number of shares for each $1,000 bond - are spelled out in the initial offering.  However, you don’t have to exercise the option.

Convertibles appeal to investors who think the corporation is growing and that the price of its stock is going up.  The question is whether the stock potential is worth the lower interest.” (original emphasis in both)

220.  Those definitions are entirely consistent with the discussion of the nature of a convertible bond, set out at paras 8-11 above. There is no doubt that an element of a convertible bond is a loan. It is clear also that in the present case that element, requiring as it does an internal rate of return, or interest rate, of 12% pa, does not offend against the MLO.

221.  Next, counsel for the defendants looks to the sum payable by the application of the alternative options under the redemption formula, and argues that any part of those sums in excess of the original investment of HK$20 million, constitute interest.

222.  This argument relies on the following passages from the decision of Le Pichon JA, in the Court of Appeal in Kwok Ying Lung v Ko Chi Hung [2001] 3 HKC 480, first at 490D-I:

“It is also clear from the majority judgement in Askinex[2] that so long as the interest is capable of being expressed in terms of a simple actual rate per centum per annum, it matters not that the actual amount of interest payable is set out rather than being expressed as a rate per centum per annum.  That is precisely the situation in the present case: interest at $55,000 per month corresponds to simple interest on the loan at 60%pa.

In my judgment, Sch 2 to the Ordinance has no application unless the interest payable under a loan is not capable of being expressed in terms of an actual rate per cent per annum.  In such case, the calculations set out in Sch 2 yield a deemed rate.

It is, to say the least, curious that the draftsman has chosen to define ‘effective rate’ in the interpretation section by reference only to the deemed rate.  As noted above, the expression ‘effective rate’ has no counterpart in the 1927 Act.  It is evident that the question of statutory construction that has arisen in the present case stems from the changes that the draftsman saw fit to make to the provisions of the Act upon which the Hong Kong provisions were modelled.  As will become apparent, no such problem arises under the 1927 Act.

The question of statutory interpretation is the meaning to be given to ‘the effective rate of interest’ in s 24 and, for that matter, s 25 of the Ordinance.  Those sections are meant to strike down excessive interest rates.  Given my view of the construction of Sch 2, the expression ‘effective rate’ when read literally by reference to its statutory definition, only agreements with a deemed rate calculated in accordance with Sch 2 would come within the purview of these sections.  This clearly could not have been the intention of the legislature.  Plainly, s 24 is meant to render unenforceable cases where the actual interest is stated and that exceeds 60%, for example, where simple interest rate is charged at 65% pa.  That being so, the context that requires ‘effective rate’ used in s 24 (and s 25) be given a different meaning in cases where Sch 2 can have no application, i.e., where the interest charged is capable of being expressed in terms of a rate.  In such cases, ‘effective rate’ must mean the actual rate of interest per centum per annum.”

And 492G-H:

“The definition in s 2(1) of ‘effective rate’ as the ‘true annual percentage rate of interest calculated according to Schedule 2’ is qualified by the words ‘unless the context otherwise requires’.  In the context of a single constant rate of interest under the first formulation in s 18(2)(i), the true annual percentage rate of interest is just that.” (italics in original)

223.  Applying this interpretation, the defendants say that Pearldelta claims a little over HK$86 million, in return for a sum of HK$20 million advanced to the company for three years. That, they say, represents total interest of HK$66 million more than the principal invested. Spread over three years, that, they say, is interest of HK$22 million each year. Thus, they say that the actual percentage rate of interest is 110% pa. That sum exceeds 60%, and consequently, it is argued, pursuant to s 24 MLO, neither the agreement for the repayment of the loan nor the payment of any interest is enforceable, nor is the security, the SIA enforceable.

224.  Mr Carolan argued that while a convertible bond may have a loan element in it, it is not at law a loan simpliciter, nor is it a loan in terms of the MLO. This, he says, it because is in fact a form of investment in a company in the nature of the security which gives the bond holder a right to convert, or exchange, the principal amount of the bond in the common shares of the issuer at a fixed ratio during a particular period. Such a conversion, Mr Carolan says, cannot be described as a loan.

225.  It is only if the bond holder elects not to convert his secured investment in the company into shares that the principal sum becomes repayable with an interest rate. He accepts that that option would constitute a loan, but points out that the interest rate does not offend the MLO.

226.  Mr Carolan distinguishes the sum paid as a result of the calculation of the internal rate of return of 12%, from the increase in value in the investment consequent upon conversion into shares, or redemption on the net asset value option. The first, he acknowledges, is a sum that constitutes interest. Both the increase in value in the investment, or the difference in the original investment and the sum paid if redemption is undertaken on the net asset value option, are not interest, he argues. It is, he says, a capital sum received as a result of the investment. For convenience I will call either the increase in value in the investment on conversion or the difference received on net asset value redemption, “the redemption return”.

227.  There is a dearth of authority on convertible bonds. But there are two old English tax cases which give some guidance as to how the redemption return should be treated. Both are income tax cases and accordingly not directly in point. But if counsel for the defendants is right, and the redemption return is in reality interest, then as interest it will constitute income and not capital, and be potentially liable for income tax. Accordingly, I am of the view that the taxation treatment of the redemption return may be looked at for a guide to its true character.

228.  In Lomax (H M Inspector of Taxes) v Peter Dixon & Co Ltd [1943] 2 All ER 255, the appellants advanced £319,600 to a Finnish company. The two companies subsequently entered into an agreement to repay the loan by the Finnish company issuing to the appellants 680 notes of £500 each, totalling £340,000, i.e. £20,400 more than the principal outstanding. The notes were said to be issued at a discount of 6% (20,400 divided by 340,000). The notes would bear interest at 1% pa above the lowest discount rate of the Bank of England, subject to a maximum rate of 10% pa. In fact this worked out at 5% pa. Each note was to be redeemed at a premium of 20% if the net profits of the Finnish company reached a specified level.

229.  At issue was whether the discount and the premium were interest, and hence income payments assessable to income tax, or capital payments, which were not subject to income tax.

230.  Counsel for the defendants argued that Lomax was not even persuasive because it was an income tax case. That is right, but in that Lomax analyses whether or not both the discount and a premium were interest or capital, there is a clear parallel with the argument made by Pearldelta in the present case, that the redemption return is equivalent to the premium in Lomax, and therefore not interest, but capital.

231.  Mr Carolan helpfully, and in my view accurately, summarised the decision of the Court of Appeal, given by Lord Greene MR, with MacKinnon and du Parcq LJJ agreeing, in the following terms, which I gratefully adopt:

(1)  The fact that the discount and premium were capable of being calculated in terms of a return on principal is no justification for asserting that they are to be treated as income (see p258A-B).  There is no presumption that a discount at which a loan is made or a premium at which it is payable is in the nature of interest: (see p 262H).

(2)  In some cases, the contract may explain the nature of the return.  “But in many cases mere interpretation of the contract leads nowhere.”: (see p 258H).

(3)  There can be no general rule that any sum which a lender receives over and above the amount he lends ought to be treated as income.  Each case depends on its own facts and evidence: (see p 260A).

(4)  There is a distinction between payments for interest with payments for capital risk.  Interest has a revenue character - it is a return to the lender for the money lent (see 258A-F & editorial note at 255H).  Interest therefore constitutes income and is assessable to income tax.

(5)  Conversely, a payment for capital risk (being the risk that all or some of the money lent may not be repaid) is not interest.  Payments for capital risk do not have a revenue character - they are not returns to the lender for lending per se, but rather compensation for assuming the capital risk in the first place: (see 285A-F and editorial note at 255H).

(6)  In the case of an issue of debentures by a limited company, if its credit is good and security ample, the debentures can be issued at par with a normal, reasonable rate of interest: (see 260B).  However, if the company’s credit and security are not good such that it cannot offer its debentures at par and a normal rate of interest, it has to make its debentures more attractive to prospective subscribers.  It can do this by issuing at par, but agreed to pay a higher rate of interest.  This is “unquestionably income and taxable as such although the high rate of interest is in part attributable to the capital risk”: (see 260E).

(7)  Alternatively, the company can fix a more normal rate of interest and issue the debentures at a discount, or issue at par and offer a premium on redemption, or combine both methods.  Here, the absence of good credit and security are expressed in terms of capital, and “I venture to think that no businessman would regard the discount or the premium as anything but capital matters”: (see 260F).

(8)  “Another way of making good the defect in the security would be for the company to take out a guarantee policy”:  (at 260H).  “No one would suggest that the premiums paid by the company were part of the subscriber’s income.  Yet the policy would be plain exactly the same part as would have been played by a reduction in the issue price or the offer of a premium on redemption or a combination of the two.”: (see 260H).

(9)  The fact that the discount on issue or premium on redemption can be reduced to terms of income, if one chooses to make the calculations, does not mean that these amounts are income.  “A premium on redemption and a premium on issue are in their nature precisely the same and come into existence for the same reason, viz., the desire to express in the former case the greatness, in the latter case the smallness, of the risk in terms of capital terms rather than in terms of interest.”: (see 260G – 261A).

(10)  “The Inland Revenue authorities have never sought to tax the amount by which the redemption price of debentures exceeds the issue price.  We were informed by the Solicitor-General that these amounts are regarded not as income but as capital sums which the company bears in consideration of the risk attaching to the investment which is borne by the investor.  In my opinion this view is undoubtedly correct.”: (see 261C).

(11)  Whilst a company could issue debentures at a discount and/or for a premium on redemption, rather than at par in return for a higher rate of interest, it is for the company to choose the method.  “The Crown is, in my opinion, bound by the company’s choice and cannot go behind it.”: (see 261B).

232.  The second case, Davies (Inspector of Taxes) v Premier Investment Company Ltd [1945] 1 All ER 681, Mcnaughton J, applied Lomax. There the convertible notes were issued repayable in six years at a premium of 30%, or earlier at a premium of 5% pa. There was no provision for interest, and the premium was the only return to the subscriber. In those circumstances it was held to be interest on money and subject to income tax. Unlike Davies, in both Lomax and the present case, there is provision for interest in the agreement between the parties.

233.  There is no suggestion in the evidence or the submissions that the Hong Kong tax authorities would view the redemption return as anything other than a capital return, not liable to tax, as distinct from interest, which as income may be liable to income tax.

234.  These propositions, and the passages cited in support, lead inexorably in my view to the conclusion that the redemption return in the present case is a capital sum reflecting the risk involved in the investment.

235.  In this case the parties all anticipated ultimately a very good capital return as a result of either an IPO or a trade sale. That was why Pearldelta made the investment. That there might also be a return by way of interest was always a mere fallback position. Notwithstanding that there has been neither an IPO nor a trade sale, both because of the poor performance of Huge Winners, the consequences of the redemption formula has been to protect that very substantial capital return to Pearldelta.

236.  A finding that the redemption returned constitutes capital and not interest, properly recognises the dual nature of a convertible bond, namely its aspect as a loan subject to interest, and its aspect as an investment, with an accompanying capital return in certain events.

237.  While it is right that the expression in s 2 MLO:

“and every agreement (whatever its terms or form may be) which is in substance or effect a loan of money”

tends at first light to encourage a disregard of the dual nature of the convertible bond, the true characteristics of the two different types of return mean that that dual nature cannot be ignored.

238.  One part of the SIA is a loan of money. That is plainly subject to the MLO. But the other part is a capital investment that will lead to a return of a capital nature, and I am satisfied, divisible from a loan, and accordingly not subject to the provisions of the MLO. The definition of a loan in the MLO, in my view, does not require the court to remove that plain division of character from the SIA.

239.  It is not without significance that in moving the amendment to the MLO in 1988, the Financial Secretary said:

“Experience has shown that certain genuine commercial transactions have been caught even though they were not intended to be, and indeed, ought not to be, caught by the provisions of the Ordinance.”

240.  It could not be for one moment suggested, no matter how disturbed the defendants may be as to the consequences of the SIA, that this is a transaction which might properly be described as loansharking. It is plainly a genuine commercial transaction made between substantial commercial concerns, each of whom had or was entitled to its own independent legal advice, and each of whom had its own independent financial advice. The amendments to the MLO sought to protect such transactions form the consequences of the MLO, in part, by making provision for the exemption, within which I have found this transaction falls. But if by proper interpretation it may be found that a transaction, never intended to fall within the scope of the MLO, should be outside its scope, then that interpretation ought in my view to be adopted.

241.  I am accordingly satisfied that the derivative, or capital investment aspect, of the SIA does not constitute a loan, as that expression is used in the MLO.

242.  The defence relying upon the MLO must fail.

Judgment:

243.  Pearldelta are entitled to judgment on the claim against all defendants, jointly and severally. Mr Carolan put to me a calculation of the amounts due as at 1 December 2009. As I understand his position he seeks judgment in the sum of HK$86,321,292.66, or alternatively a declaration that Pearldelta is entitled to the conversion shares and an order to specific performance of the obligation to allot and issue the conversion number of Ordinary Shares.

244.  If the parties are unable to agree upon the precise terms and formula for the judgment, leave is reserved to apply.

245.  If the judgment is to be a money judgment, then it will bear compound interest in terms of the contract, namely prime lending rate plus 4%, pursuant to Bond Conditions para 8.4 to the date of judgment, and thereafter at judgment rate. Leave is reserved to apply if agreement cannot be reached on the interest rate.

Costs:

246.  The Plaintiff has succeeded in all respects. There will be an order nisi that the defendants, jointly and severally, must pay the costs of and incidental to both actions, including any costs reserved, be taxed on a party and party basis.

247.  Leave is reserved to apply generally.