AGIFEL INTERNATIONAL LTD. v. JAMES WARDELL AND ANOTHER

HCMP 4394/2002

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

MISCELLANEOUS PROCEEDINGS NO. 4394 OF 2002

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D E C I S I O N

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Introduction

1. This is the Applicant's application for a declaration that the floating charge created by the debenture over Dream Asia Limited ("Dream Asia") is not invalidated by virtue of section 267 of the Companies Ordinance, Chapter 32, and further or alternatively for determination of the extent to which the said floating charge is not invalidated by reason of cash paid to Dream Asia.

2. The facts are substantially agreed. Dream Asia is a wholly owned subsidiary of Dream Limited, which in turn is a 65% held subsidiary of SC Dream Limited ("SC Dream") which has been experiencing liquidity difficulties. On 5 June 2001, the Applicant and M & M Investors Limited, as lenders ("the Lenders"), entered into a bridging loan agreement with Dream Asia as borrower and five other parties, including Dream Limited, SC Dream and Strategic Capital Group Limited ("SCG"). The loan shall be repaid on 30 June 2001 and secured by way of a first floating charge over the undertaking and all assets of Dream Asia. This short term loan was to provide what it called "working capital" to Dream Asia, pending a review by Ferrier Hodgson as to the Dream group's viability and profitability and a presentation to SCG of a restructuring proposal for the Dream group of companies and acquisition of another company called Strawberry Limited. The loan shall be applied to pay direct to selected creditors of Dream Asia as notified by Dream Asia to the Lenders. A sum of $1,344,837.71 was thus paid direct by the Lenders by cheques to selected creditors of Dream Asia. Another sum of $154,567 was paid to Dream Asia with a direction that it be converted into French Francs for payment to another creditor of Dream Asia, Fiabila.

3. On 8 August 2001, the Board of Directors of Dream Asia passed a resolution to voluntarily wind up the company. Hence, the floating charge created was caught within the period of 12 months of the winding up. The issue is whether the amount of $1,499,404.71 paid by the Lenders was "cash paid to the company", i.e. Dream Asia, within the exception under section 267 of the Companies Ordinance such that the validity of the floating charge is preserved.

The law

4. Section 267 of the Companies Ordinance provides (so far as is material for the present purposes):

"Where a company is being wound up, a charge which, when created, was a floating charge on the undertaking or property of the company and which was also created within 12 months of the commencement of the winding up shall ... be invalid, except to the amount of any cash paid to the company at the time of or subsequently to the creation of, and in consideration for, the charge, together with interest on that amount at the rate specified in the charge or at the rate 12 per cent per annum whichever is the less."

5. The Applicant's contention is that the words "cash paid to the company" are to be given a broad interpretation and that payments amounting to $1,344,837.71 paid by the Lenders direct to the creditors of Dream Asia together with the amount of $154,567 paid direct to Dream Asia are to be treated as cash paid to the company within the meaning of that section. The Respondents argue that these payments fall outside the exception provided by section 267 and the floating charge is invalid.

6. I do not see how any question of interpretation could arise from these five very plain words "cash paid to the company". In my view, these words could admit of no other meaning than that the floating charge is not invalidated only to the extent of the amount of any cash actually paid to the company and received in the hands of the company.

7. The English Court of Appeal decision in In re Matthew Ellis, Limited [1933] 1 Ch 458 is the leading authority on the interpretation of section 266 of the English Companies Act 1929, which is equivalent to our section 267. In that case, the company was in financial difficulty. Its chairman was a partner in a firm which supplied the company with the bulk of its stock of goods. After consulting his partners, the firm agreed to continue to supply the company with goods on credit if the past debt was paid. The chairman then advanced a sum of money to the company on the security of a debenture, part of which was used to discharge the debt owed to his firm. The Court of Appeal held the advance to repay the pre-existing debt was "cash paid to the company". Lord Hanworth MR held at 469:

"... I think this case and other cases under this section must, each of them, depend upon their own facts. It is very difficult to lay down a precise test which shall bring a case within or without the section. It is wiser to adhere to the clear words of the section, which require the sum in respect of which the debenture is valid to be the amount of any cash paid to the company. One has therefore to look at the facts and see whether or not in substance there was cash paid to the company."

8. His view was echoed by Romer LJ at 477 where he said,

"We have heard a certain amount of argument as to the construction to be placed upon s. 266 of the Companies Act, 1929. For myself I have never been able to understand how any question of construction arises on that section. Its words appear to be quite plain, and I can see no justification for excepting from the words "cash paid" in the section payments of cash made conditionally as to their mode of application."

9. Lord Hanworth MR then went on to hold that the company had secured a valuable advantage in the continuation of the supply of goods by the chairman's firm and the charge was valid although part of the money received under the charge was used in payment of pre-existing debts, including a debt due to the chairman's firm. He concluded at 474 as follows:

"But I prefer, as I have said already, to treat the case as one in which the facts must be examined in the light of the terms of the section itself. The Court has, in regard to transactions which may often be complicated and difficult, to come to a conclusion whether in substance the debenture it is sought to invalidate has been issued for cash paid to the company. If it has been, then, although the cash may be used by the company for the purpose of meeting a liability already incurred, the security stands good."

10. In re Matthew Ellis, Limited was applied by the Court of Appeal in In re Destone Fabrics, Limited [1941] 1 Ch 319. In that case, a floating charge was created in favour of Z who made payment into the company's account. On the same day, the company paid out of that account directors' fee due to two directors and another amount to D representing an amount guaranteed by him in respect of the company's overdraft. The Court of Appeal applied the two limb test of form and substance as in In re Matthew Ellis, Limited. Despite that as a matter of form money was paid into the company's account, the Court of Appeal held that there was no cash bona fide paid to the company and the charge was invalid. Simonds J held at 321:

"It is clear that, in form at least, if not in substance, cash was paid to the company. ... The question is whether, in those circumstances, I am to treat the payment as a payment of cash to the company not only in form, but also in substance.

... I find as a fact that the money advanced to the company, which was paid into the company's account and afterwards paid out of it, was provided by Davis as principal, and that, throughout the transaction, Zimmerman was merely the agent or nominee and, in the events which happened, the trustee of the debenture for Davis. I must therefore regard this money as paid to the company by Davis, and it is in the light of that fact that I must examine the transaction.

It is obvious from what I have said that, so far as Davis himself was concerned, the transaction was one by which, instead of being an unsecured contingent creditor in the sum of 200 l., he became a secured creditor in the sum of 900 l., having had the 200 l. paid off by the company. It is also quite clear, I think, that, so far as he was concerned, the transaction was a mere subterfuge, and, to use the words of an authority to which I shall refer, that the company was a mere conduit pipe through which a sum was paid, part of which was paid out afterwards to him.

...

The ultimate test in such cases may well be whether the transaction is to be regarded as one intended bona fide for the benefit of the company, or whether it is intended merely to provide certain moneys for the benefit of certain creditors of the company to the prejudice of other creditors of the company."

11. While the words "for the benefit of the company" were used, those words do not, in my view, necessarily require proof that the company assets had been swollen and become available for creditors. In In re Matthew Ellis, Limited, Lord Hanworth MR doubted whether the company's asset had to be swollen as a result of the cash paid to the company. Indeed, in all cases of this kind, as and when cash is advanced, a corresponding debt is created which is secured by the floating charge over the asset of the company. In absolute terms, the cash advanced cannot bring about an increase in the asset of the company. However, it can enhance the company's earning potential in that the cash may be used to acquire assets which it did not have and hence increase its earning capacity or profitability. It can pay off creditors who are threatening winding up action so as to keep the company afloat. It can pay off creditors so as to ensure future supplies as in In re Matthew Ellis, Limited. Indeed in that case, the Court of Appeal held that the cash paid in may be used for the purpose of discharging a pre-existing liability. In Re GT Whyte & Co Ltd [1983] BCLC 311 at 317, Nourse J, as he then was, held that underhand conduct is not a prerequisite before a floating charge would be rendered invalid. Thus, in my view, the words "for the benefit of the company" were used by Lord Hanworth MR to emphasise the words "bona fide" which preceded them. Together they mean that the cash paid to the company must be genuine payment both in form and in substance and not a subterfuge used to convert unsecured creditors to secured creditors in preference to other unsecured creditors.

12. Mr Blanchflower SC referred me to the Scottish case of Libertas-Kommerz GmbH [1978] SLT 222, which he submits is on all four with the facts of the present case. In that case, a series of loans was advanced by E and G to the company through their solicitors. They paid sums of money into an account opened by their solicitors. From this account, their solicitors paid out sums of money either direct to the company or to its creditors on behalf of the company. Lord Kincraig followed In re Matthew Ellis, Limited and applied the two limb test of form and substance. He held at 227:

"I am not able to accept counsel's submission. The exception in s. 322 is applicable in terms only to cash payments to the company, and I do not think that the court would be justified in construing that phrase as including cash payment made to any other person albeit on behalf of the company. In the cases cited where the payments were held not to fall within the exception the cash payments were made to the company as a matter of form, but the courts were able to hold on the facts that in substance they never were made to form part of the assets of the company at all, being immediately paid out to nominated creditors as an integral part of the bargain under which the advances were made to the company. In effect the company was being used as a mere conduit pipe for the transference of cash to one unsecured creditor, at the same time creating another debt of the same amount but secured over the company's property. The effect was to take away part of the assets of the company which were, before the creation of the charge, available to the ordinary creditors. To construe a cash payment to the company as including a payment direct to a creditor of the company the payment to be secured by a floating charge and thus to be beyond the grasp of the liquidator is to produce the same result, the only difference being that the coffers of the company have not been used at all even as a conduit pipe. If, as Parker J said in Orleans Motor Company Limited (at p. 45) the section was designed apparently to prevent companies on their last legs from creating floating charges to secure past debts or for monies which did not go to swell the assets and become available for creditors, that purpose would be defeated by allowing to stand as valid a floating charge as a security for money paid direct to an existing creditor."

13. Apart from arguing that the Scottish case is not binding as a matter of precedent on this court, Mr Smith SC submits that the Scottish court was not referred to an earlier English authority of In re Thomas Mortimer Ltd [1965] Ch 186. This case was decided in 1925 but was not reported until 1965 when it was approved by the Court of Appeal in In re Yeovil Glove Co Ltd [1965] 1 Ch 148. In these two cases, payments to third party creditors were treated as cash paid to the company. To these cases, I now turn.

14. In In re Thomas Mortimer Ltd [1965] Ch 186, the company was indebted to its banker, the National Provincial Bank Ltd, to the amount of ￡58,180, being the amount of their overdraft on their current account with the bank on 11 January 1924. On the same day, the company issued a debenture in favour of Branch Nominees Ltd to secure the sum of ￡50,000 held on trust as a continuing security for the payment by the company to the bank. As at 11 March 1924, ￡41,311 was paid by the company into its current account at the bank and a sum of ￡51,248 was paid out by the bank in honouring cheques drawn on it by the company. The difference between those sums was ￡9,936. The liquidators argued that at the highest the debenture was valid only for the difference of ￡9,936. The bank contended that by operation of the rule in Clayton's case, the payment in of ￡41,311 discharged the earlier indebtedness so that the sum of ￡51,248 paid out in honouring the company's cheques were new advances and hence the bank was entitled to hold the debenture as a valid security for the whole ￡50,000 for which it was given. Romer J held that the debenture was valid for the whole amount. He held at 189:

"It was said that the bank never paid the company any cash, and it is only payments to the company in cash that are excepted from the provisions of section 212. It seems to me that the answer to that is that the bank paid cash at the request of the company to persons who were creditors of the company, the bank, of course, not being liable itself to such creditors. Again, if I may say so with all respect to the argument which has been addressed to me, why that is not a payment in cash by the bank to the company for the purposes of this section passes my comprehension. My attention was called to the decision of Parker J in In re Orleans Motor Co Ltd. The facts of that case were as follows: A company owed its bankers a considerable sum of money on overdraft; the overdraft had been guaranteed by the directors; the bank was pressing the company and the directors for a reduction of the overdraft, and at a meeting of the directors it was resolved that the directors, or three of them, should find ￡1,500, which should be applied, through the company, in reduction of the overdraft, and that the directors should, in consideration of that payment, receive a debenture for ￡1,500. That debenture was to constitute a floating charge on the assets of the company, and it was issued within three months of the company's liquidation. Parker J held that, in the circumstances, no cash had been paid by the directors to the company, for although in point of form ￡1,500 had passed through the company on its way to the bank, yet the ￡1,500 was really a payment by the directors in discharge of their own liability to the bank - a fact which was rendered abundantly clear by the fact that in the King's Bench Division one of the directors who had paid sought, I think within 12 months, to recover his contribution from his co-directors on the ground that they were co-sureties. Of course, there was no payment in cash there, and never was intended to be any cash payment, by the directors to the company. Had the directors been under no liability whatsoever to pay the overdraft to the bank and then agree to advance this sum of ￡1,500 for the purpose of guaranteeing that overdraft, that would have been a payment in cash by the directors to the company although they paid the ￡1,500 direct to the bank and did not first go through the form of paying it into the company's banking account and then drawing a cheque on that in favour of the bank. Of course, such a payment as that would have been a payment in cash to the company, and, of course, it is equally clear to my mind that when the bank, after the issue of the debenture, honoured the cheques of the company in favour of creditors, on each occasion they made a payment in cash to the company within the meaning of section 212."

15. The facts in In re Yeovil Glove Co Ltd were indistinguishable from those in In re Thomas Mortimer Ltd. The company had two accounts with its bank which were overdrawn by nearly ￡65,000 in 1957. With a view to giving the bank by subrogation the statutory preference under section 319 of the Companies Act 1948, the company opened two other accounts for payment of wages and authorized the bank to periodically transfer into these accounts from the first two accounts the exact amount of wages to be paid. In June 1957, the company created a legal charge in favour of the bank over certain of its assets. At the end of 1957, the bank threatened to call in the overdraft unless further security was provided. As a result, the company executed a mortgage and a floating charge over its undertaking and asset to further secure payment of the moneys already covenanted to be paid by the legal charge. The charge imposed no obligation on the bank to make any further advances, and no cash was either paid or promised by the bank to the company upon the taking of that security. The accounts of the company continued thereafter to be operated as before. The overdraft remained at about the same level, some ￡111,000 being paid into the main account by the company between the date of the charge and 20 August 1958 during which period about ￡110,000 was paid out by the bank. The Court of Appeal approved In re Thomas Mortimer Ltd and after applying the rule in Clayton's case reached a similar conclusion that the charge was valid.

16. Mr Smith SC submits that in these two cases, no cash had been paid to the companies as a matter of form but had been paid to third parties in discharge of the companies' liability and the charges were held to be valid. He argues that payment of debts due to trade creditors, a transaction the equivalent of cash among business men, is in substance a payment of cash to the company and the mere fact that money went to a third party creditor does not prevent it from being a payment of cash to the company. He argues that the Scottish court in Libertas-Kommerz GmbH did not have the benefit of being referred to In re Thomas Mortimer Ltd. He submits that as In re Thomas Mortimer Ltd was approved by the Court of Appeal in In re Yeovil Glove Co Ltd, there are two lines of conflicting authorities. He further submits that what is important is payment in substance rather than in form and urges me to follow In re Thomas Mortimer Ltd and In re Yeovil Glove Co Ltd.

17. I do not think In re Thomas Mortimer Ltd and In re Yeovil Glove Co Ltd are inconsistent with the line of authorities represented by In re Matthew Ellis, Limited. These cases as well as other cases under this section must depend upon their own facts. It is wrong to jump to conclusion as to what the law is by merely looking at the outcome whether a charge was held to be valid or otherwise. The lenders in both In re Thomas Mortimer Ltd and In re Yeovil Glove Co Ltd were banking institutions lending money to the companies in the normal course of their business by honouring cheques drawn on the overdraft accounts of the companies. This is an important feature which distinguishes these two cases from the In re Matthew Ellis, Limited line of authorities. These lending banks were under no obligation to pay the creditors of the companies. They honoured cheques drawn by the companies pursuant to the borrowing arrangement between the banks and the companies. The cheques were drawn by the companies from their overdraft accounts with the banks. Usually when a cheque was presented and paid over the counter, cash was handed over by the bank to the payee, and in these cases a creditor of the company. The cash was cash from the company's accounts and not from the banks' accounts. If there was sufficient credit balance in the account, the cash obviously came from the company. If the account was already overdrawn, then notionally, the bank must place funds into the account equivalent to the amount of the cheque before it could hand over the cash to the payee over the counter. Thus when putting funds into the account as aforesaid, albeit debiting the account and increasing the amount overdrawn, the bank in fact made a payment of cash to the company. The same transactions took place when a cheque was cleared through the banking system instead of being paid over the counter. While Romer J did not refer to this mechanism in his judgment in In re Thomas Mortimer limited, it is implicit that he had such mechanism in mind when time and again he repeated in the dicta cited above the distinguishing feature of the bank honouring cheques of the company and said "the banks of course not being liable itself to such creditors" and that "why that is not a payment in cash by the bank to the company for the purposes of this section passes my comprehension." I think this mechanism is something which is too obvious to be mentioned and too easy to be overlooked by counsel. In my view, the conclusions reached in In re Thomas Mortimer Limited is based on a finding of fact peculiar to banking institutions honouring cheques of the company pursuant to their overdraft agreement. In fact, cash was paid by the bank into the account of the company and not to third party creditors as misinterpreted by counsel. Neither that case nor In re Yeovil Glove Co Limited established any principle of law, which Mr Smith SC urges me to accept, namely that cash payment in form is unnecessary or that payment direct to a third party creditor may be treated as payment to the company for the purposes of section 267.

18. Given that payment of debts due to trade creditors is recognised even in In re Matthew Ellis, Limited as payment in substance, Mr Smith SC argues that cash payment in form assumes little importance and the court should look at substance rather than form. Indeed, if the payments are genuine payments to trade creditors for the benefit of the company in the sense of keeping it afloat, I can see little merit that the payment must be received first in the hands of the company. What is important is to ensure that such payments are not used as a subterfuge to favour selected creditors to the prejudice of others in the sense of depriving the others of a share in the assets of the company which would otherwise be available. In the absence of statutory subrogation or sometimes for the purpose of ensuring money advanced would be properly and prudently applied for the purpose of keeping the company afloat, it may be desirable or even necessary to make payment direct to trade creditors rather than to the company. In the United Kingdom, following the recommendations contained in the Report of the Review Committee on Insolvency Law and Practice, Cmnd 8558, June 1982, amongst other things, section 245(2)(b) of the Insolvency Act 1986 was enacted to preserve the validity of a floating charge to the value of so much of that consideration as consists of the discharge or reduction at the same time as or after the creation of the charge of any debt of the company. Similar enactments were made in Australia's Corporations Act 1989 in respect of floating charges created after 23 June 1993. However, such enactments have not been introduced into our laws. Mr Smith SC ingenuously argues that section 245(2)(b) of the Insolvency Act 1986 was to clarify rather than to enlarge the exception contained in section 266 of the Companies Act. With respect, this is inconsistent with the authorities as I have analysed them and is inconsistent with the views of text book writers in this subject of the law both in the United Kingdom and in Australia: see: Palmers' Company Law 24th ed, 1987, para 90-69, Lightman and Moss, The Law of Receivers and Administrators of Companies (1994) para 11-01 - 11-06, and Keay and Mason, The Law of Company Liquidation, 4th ed 1999, pp 471-476. Much I would like to agree with him in view of current commercial practice and the law in other jurisdiction, I do feel I am bound by the words of section 267 and the authorities.

19. The law as I see it is as follows. Section 266 is designed to avoid any floating charge created shortly before liquidation as a subterfuge by payment to the company which acting as a conduit pipe pays over to an unsecured creditor, with the result of converting an unsecured debt of one creditor into a secured debt of another. The cases have shown that not only must there be cash payment to the company in form, it must also be paid to and received by the company in fact and in substance. This rule is a very rigid one and there is no need to show underhand conduct before a charge would be rendered invalid. Provided that cash has been paid and received by the company, it may be applied to discharge an antecedent debt owed to its creditors. While, in my view, it is not always possible to show that the company's asset has swollen as a result of such cash payment, the presence of some benefit would suggest that it is a genuine loan and the charge is a valid one.

Conclusion

20. There is no dispute that the amount of $154,567 was paid to and received in the hands of Dream Asia. Dream Asia was obliged by the terms of the loan to convert that into French Francs and pay over to its trade creditor, Fiabila. Mr Blanchflower SC submits that the purpose of the loan was for the benefit of the Lenders and other parties to the bridging loan agreement and not for Dream Asia. Dream Asia was not free to use the money in any way it desired. Dream Asia could not exercise independent decision and was a mere delivery agent. In effect, his submission is that while there was payment in form there was no payment in substance.

21. In accordance with Lord Hanworth MR's dicta in In re Matthew Ellis Limited, loans to the company may be used to discharge antecedent debts owed to the company's creditors. The Dream group was in financial difficulties. The purpose of the bridging loan was to keep the status quo pending a review by Ferrier Hodgson as to the viability and profitability of a take over. There is nothing to show that the assets of Dream Asia has swollen. As I have said, it is always difficult to show a swelling of the asset as payment in of a loan on the one hand necessarily creates a liability on the other. The survival of the Dream group must be in the interest of Dream Asia. Dream Asia was a party to the bridging loan agreement. It must be taken to have fully understood the terms and freely consented to those terms being imposed on it, in particular those terms as regards how the loans were to be applied. Dream Asia should know best what is in its interest. In the absence of evidence of bad faith on the part of those making the decision, the court should be slow in interfering with the company's decision. In law, the company was free to apply those loans for the purpose of paying debts owed to its creditors. If in accordance with the terms on which the loans were obtained, it paid selected creditors to keep the company afloat, I do not see how this could not be said to be in the benefit of the company. The threshold of proving benefit is a very low one. The benefit of keeping the group afloat as a going concern, albeit only for the short term is, in my view, a sufficient benefit to meet this threshold. I have no difficulties in finding that this loan was bona fide for the benefit of Dream Asia and hence a payment in substance.

22. As for the balance of the loan, it was paid direct by the Lenders' cheques to other trade creditors of Dream Asia. The funds never passed into the hands of Dream Asia, though the cheques were. I think the Lenders only had in mind the take over and had never directed their minds to preferring certain creditors of Dream Asia to others. Who were to be paid and from what assets in the event of winding up is a matter of indifference to them. They only had in mind to preserve the status quo of the group as a going concern for the purpose of the take over. For reasons as explained in the preceding paragraph, I am satisfied that the bridging loan agreement was bona fide for the benefit of the Dream group and of Dream Asia and not a subterfuge. The loans represented by the various cheques to the trade creditors of Dream Asia were payment to the company in substance, but not in form for the purposes of section 267.

23. I am sympathetic with the Lenders. There is nothing to suggest bad faith on their part. Had the transaction taken place in the United Kingtom, or in Australia, these payments would have been protected. As the law now stands in Hong Kong, it is not that there is nothing the Lenders could have done to protect their interest, had they ever thought about it. They could have done what they did as with the payment in French Francs to Fiabila. They could have required Dream Asia to open a special account for payment out to selected creditors and put funds into that account as and when they were satisfied that their directions were or would be followed.

24. What is the benefit to be gained by hanging onto the rigidity of the decision in In re Matthew Ellis, Limited which has been abandoned in other jurisdiction, one may ask? Businessmen conduct their business according to the law as it now stands. Creditors enjoy their rights over the assets of the company in accordance with what they anticipate is the protection given to them by the law. There are lots of benefits to be said in preserving the certainty of the law. In the face of clear and unambiguous language of the statue and well established authorities, it is not for the judge to legislate by distorting that clear and unambiguous language in favour of some enactments in other jurisdiction, however sensible those enactments may be.

25. For the above reasons, I find that the floating charge created by the debenture is valid only to the extent of the $154,567 paid to Dream Asia, together with interest. The Applicant is only successful in respect of a relatively small part of the loan while the Respondents are substantially successful in resisting the Application. I think justice would be best served by ordering the Applicant to pay three quarters of the Respondents' costs. Accordingly, I make an order nisi to that effect.