RE SWEETMART GARMENT WORKS LTD

HCCW 755/2005

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

COMPANIES WINDING-UP NO. 755 OF 2005

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J U D G M E N T

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Introduction

1.  On 30 November 2005, Sweetmart Garment Works Limited (“the Company”) went into compulsory liquidation on a creditors’ petition presented against it by Overseas-Chinese Banking Corporation Limited (“OCBC”) on 28 September 2005.  A little over a month prior to the presentation of the petition, the Company had granted a mortgage over the “Florence”, a pleasure craft owned by it, in favour of another of its creditors, the Hong Kong branch of HSH Nordbank AG (“the Bank”).

4.  The liquidators and the Bank having been unable to resolve their differences, on 14 May 2007, the liquidators issued the summons which is now before the court.  By their summons, the liquidators seek the following relief:-

(1)	A declaration that the mortgage constituted an unfair preference of the Bank by the Company within the meaning of sections 50, 51, 51A and 51B of the Bankruptcy Ordinance (Cap. 6) and section 266B of the Companies Ordinance (Cap. 32) and is, accordingly, void;
(2)	An order that the Bank should pay to the liquidators the sale proceeds of the vessel, together with the interest accrued thereon; and
(3)	Costs.

The relevant statutory provisions

5.  Section 266B of the Companies Ordinance provides that in any winding up that commences after the coming into effect of section 36 of the Bankruptcy (Amendment) Ordinance 1996 a reference in section 266 or 266A of the Companies Ordinance shall be deemed to be a reference to an unfair preference as provided for in section 50 of the Bankruptcy Ordinance, and that a reference in section 266 of the Companies Ordinance to “a period of 6 months” shall be read as a reference to either 6 months or 2 years, depending on whether or not the person to whom the preference is given is an “associate” as defined in section 51B of the Bankruptcy Ordinance.  Where the person preferred is an associate of the company in liquidation, the longer period is to apply.  The effect of sections 266 to 266B of the Companies Ordinance is to apply the unfair preference provisions contained in section 50 to 51B of the Bankruptcy Ordinance to companies in liquidation, with the necessary modifications.

6.  Section 50 of the Bankruptcy Ordinance provides, relevantly, as follows:-

“	50.	Unfair preferences
		(1)	Subject to this section an sections 51 and 51A, where a debtor is adjudged bankrupt and he has at a relevant time (defined in section 51) given an unfair preference to any person, the trustee may apply to the court for an order under this section.
		(2)	The court shall, on such an application, make such order as it thinks fit for restoring the position to what it would have been if that debtor had not given that unfair preference.
		(3)	For the purposes of this section and sections 51 and 51A, a debtor gives an unfair preference to a person if –
			(a)	That person is one of the debtors creditors or a surety or guarantor for any of his debts or other liabilities; and
			(b)	The debtor does anything or suffers anything to be done which (in either case) has the effect of putting that person into a position which, in the event of the debtor’s bankruptcy, will be better than the position he would have been in if that thing had not been done.
		(4)	The court shall not make an order under this section in respect of an unfair preference given to any person unless the debtor who gave the unfair preference was influenced in deciding to give it by a desire to produce in relation to that person the effect mentioned in subsection (3)(b).
	….”

7.  Section 50(5), which provides that where the person to whom the preference is granted is an associate of the debtor within the meaning of section 51B, the relevant desire required by section 50(4) shall be presumed unless the contrary is shown, is not applicable in the present case, as it is common ground that the Bank was not an “associate” of the Company.

8.  Section 51(1) provides that in the case of a non-associate, an unfair preference is only susceptible to challenge where it is given at a time in the period of 6 months ending with the date of the presentation of the bankruptcy petition against the debtor.  Section 51(2) requires, in addition, that the debtor should have been insolvent at the time of the giving of the unfair preference, or should have become insolvent in consequence of it.  For this purpose, section 51(3) provides that a debtor is to be taken as being insolvent if he is either unable to pay his debts as they fall due, or the value of his assets is less than the amount of his liabilities (including prospective and contingent liabilities).

9.  Section 51A sets out a (non-exhaustive) range of orders that the court may make in respect of an unfair preference caught by sections 50 and 51, and section 51B defines “associate” for the purposes of sections 50, 51 and 51A.  As I have noted, it is not suggested that the Bank was an “associate” of the Company.

The issue for determination

10.  It is not in dispute that the granting of the mortgage by the Company to the Bank had the effect of putting the bank in a better position in the Company’s liquidation than that in which it would have been had the mortgage not been granted.  This was obviously the case – by the granting of the mortgage, the Bank was transformed from an unsecured creditor of the Company to a secured creditor.

11.  It is also clear that the mortgage was granted within 6 months of the presentation of the winding up petition against the Company, and it is not (and cannot seriously be) disputed that the Company was insolvent at the time the mortgage was entered into.

12.  The Bank does, however, dispute that the Company, in granting the mortgage to it, was influenced by the desire to put it in a better position than it would have been in had the mortgage not been granted.  Whether or not the Company was influenced by such a desire was the sole issue for determination in these proceedings.

The relevant authorities

13.  Before I examine the facts that bear upon this point, I should note that both Mr Maurellet, appearing for the liquidators, and Mr Pao, appearing for the Bank, were in broad agreement as to the approach that should be adopted when considering this issue.  That approach is as stated by Millett J (as he then was) in Re MC Bacon Limited [1990] BCLC 324, and by Kwan J in Re Phantom Records Limited (unreported, CFI, HCMP 2770 of 2003, 7 December 2006).

14.  In Re MC Bacon Limited, Millett J explained the difference between the old test of “dominant intention to prefer” and the new test of “influenced by the requisite desire” as follows (at 335e to 336d):-

“	This is a completely different test.  It involves at least two radical departures from the old law.  It is no longer necessary to establish a dominant intention to prefer.  It is sufficient that the decision was influenced by the requisite desire.  That is the first change.  The second is that it is no longer sufficient to establish an intention to prefer.  There must be a desire to produce the effect mentioned in the subsection.
	The second change is made necessary by the first, for without it it would be virtually impossible to uphold the validity of a security taken in exchange for the injection of fresh funds into a company in financial difficulties.  A man is taken to intend the necessary consequences of his actions, so that an intention to grant a security to a creditor necessarily involves an intention to prefer that creditor in the event of insolvency.  The need to establish that such intention was dominant was essential under the old law to prevent perfectly proper transactions from being struck down.  With the abolition of that requirement intention could not remain the relevant test.  Desire has been substituted.  That is a very different matter.  Intention is objective, desire is subjective.  A man can choose the lesser of two evils without desiring either.
	It is not, however, sufficient to establish a desire to make the payment or grant the security which it is sought to avoid.  There must have been a desire to produce the effect mentioned in the subsection, that is to say, to improve the creditor’s position in the event of an insolvent liquidation.  A man is not to be taken as desiring all the necessary consequences of his actions.  Some consequences may be of advantage to him and be desired by him; others may not affect him and be matters of indifference to him; while still others may be positively disadvantageous to him and not be desired by him, but be regarded by him as the unavoidable price of obtaining the desired advantages.  It will still be possible to provide assistance to a company in financial difficulties provided that the company is actuated only by proper commercial considerations.  Under the new regime a transaction will not be set aside as a voidable preference unless the company positively wished to improve the creditor’s position in the event of its own insolvent liquidation.
	There is, of course, no need for there to be direct evidence of the requisite desire.  Its existence may be inferred from the circumstances of the case just as the dominant intention could be inferred under the old law.  But the mere presence of the requisite desire will not be sufficient by itself.  It must have influenced the decision to enter into the transaction.  It was submitted on behalf of the bank that it must have been the factor which ‘tipped the scales’.  I disagree.  That is not what [subsection (4)] says; it requires only that the desire should have influenced the decision.  That requirement is satisfied if it was one of the factors which operated on the minds of those who made the decision.  It need not have been the only factor or even the decisive one.  In my judgment, it is not necessary to prove that, if the requisite desire had not been present, the company would not have entered into the transaction.  That would be too high a test.”

15.  In Re Phantom Records, Kwan J had this to say at paragraphs 86 and 87 of her judgment:-

“	86.	In relation to [the need for the company to have been influenced by the desire to produce the requisite effect], two elements are required to be established: a desire to produce the effect of improving the creditor’s position in an insolvent liquidation, and such desire had influenced the decision to enter into the transaction.
	87.	A desire of improving the creditor’s position in an insolvent liquidation is a subjective state of mind.  Desire is different from intention.  Whereas intention is objective in that a person is taken to intend the necessary consequences of his actions, a person is not to be taken as desiring all the necessary consequences of his actions and one can choose the lesser of two evils without desiring either (Re MC Bacon Limited [1990] BCLC 324 at 335f to 336a; Re Hau Po Man Stanley [[2005] 2 HKC 227] at 233C).  There is often no direct evidence of the requisite desire and the existence of this state of mind may be inferred from all the relevant circumstances, even ‘contrary to the denials of those whose state of mind is inquired into to determine what state of mind is attributed to the company making the decision’ (Re Fairway Magazines Limited [1993] BCLC 643 at 649f).”

16.  Mr Pao also relied on the observation in Parry, Transaction Avoidance in Insolvencies to the effect that a preference will normally escape censure if there is a good explanation for it having been made (see paragraph 5.113), and on the fact that such an explanation could consist of the fact that the preference was made in response to pressure being placed on the debtor by the creditor, whether such pressure be commercial (as in Re Fairways Magazines Limited) or moral (as in Re Hau Po Man Stanley).

17.  I accept that it is insufficient to show that the Company intended, objectively, to prefer the Bank, and that it is necessary to establish both that it desired to do so, and that such desire influenced its decision to grant the mortgage to the Bank.  However, it is clear from the authorities that I have referred to that both of these matters may often be matters that are inferred from all of the evidence in the particular case.

The evidence

18.  In this case, the relevant evidence includes, in my view, the contemporaneous correspondence between the Bank and the Company in the months leading up to the grant of the mortgage, and also the evidence of the steps being taken by other creditors of the Company at and shortly before the time when the mortgage was entered into.  The former will throw some light on the nature of the relationship between the Bank and the Company, the degree of pressure that may have been exerted by the Bank on the Company to improve its position, and the advantages, if any, to the Company in granting the mortgage.  The latter will provide material against which the conduct of the Bank and the Company can be compared, and will also throw light on the financial position of the Company at the relevant time, a matter which, as I explain below, bears on whether or not there was good reason for the Company to enter into the mortgage in favour of the Bank.

19.  Apart from these matters, there is also a suggestion by the liquidators that there is direct evidence (from Mr Spencer Wong, one of the directors of the Company) that the Company actually wished or desired to prefer the Bank.  This suggestion is based on a statement which the liquidators have said was made to them by Mr Spencer Wong at an interview with the liquidators on 30 May 2006, when he said that the mortgage had been granted “to do a favour for their friend” Mr Dickens Fung, the relationship manager at the Bank with responsibility for the Company’s business with the Bank.

Correspondence between the Bank and the Company

20.  Dealing first with the contemporaneous correspondence between the Bank and the Company, this starts with an e-mail from Mr Fung to Mr Spencer Wong dated 27 January 2005, in which Mr Fung expresses disappointment that the Company had failed to keep its promise to settle a trust receipt that had already been deferred by 21 days, and stated that “If the bank does not tolerate, the consequence can be serious”.  Another e-mail from Mr Fung of the same date stated that the Company “is in quite serious financial problem”.

21.  Thereafter, on 23 March 2005, Mr Fung e-mailed to enquire how the Company intended to deal with two outstanding trust receipts under which HK$5 million was outstanding.  A few days later, on 29 March 2005, Mr Fung expressed the view that the “situation would be very unfavourable” if the Company could not repay its outstanding facilities, and that the Bank could not wait any longer.

22.  Notwithstanding this, it was not until 19 April 2005 that Mr Fung appears to have sent a further e-mail, complaining about the Company’s failure to live up to its promises to effect repayment, and observing that the Bank would issue a demand letter for the entire outstanding amount if any item was overdue for 90 days or more.  This threat does not appear to have been implemented, as on 27 May 2005, more than a month later, Mr Fung referred to an item which had been outstanding for more than 100 days, and said that the Bank was “losing its patience” and might take “drastic action” (which was not specified) if the Company did not deal with matters satisfactorily.  It may be that the “drastic action” which Mr Fung had in mind was the need for the Bank to make provisions against long overdue amounts and to issue a demand letter to the Company, these being matters which Mr Fung complained might become necessary if long overdue amounts were not cleared shortly, in an e-mail of 10 June 2005, in which Mr Fung also complained to Mr Eric Wong that he (Mr Fung) was losing his own credibility with the Bank.

23.  Further chasing e-mails were sent by Mr Fung to the Company on 20, 22 and 25 June 2005, after which Mr Fung e-mailed the Company on 28 June 2005, saying that absent progress in relation to repayments, the Bank would have to seek more tangible securities from the Company – the example given being a guarantee from a related company.  In response to this e-mail, Mr Eric Wong e-mailed Mr Fung on 5 July 2005, offering security over the vessel, describing it as the “family yacht” and saying “We treasure our relationship with your bank and we are willing to give this asset to your bank as additional security for the trade line …”.  Mr Fung’s response on 7 July 2005 was to ask when funds would actually be in place to enable the facilities to be paid down, as the consequences would otherwise be serious, in that the Bank would have to make provisions in respect of its loans to the Company.

24.  Mr Eric Wong then suggested that the vessel should be used as security for a short-term loan to pay down the overdue amounts, so as to avoid the need for the bank to make any provision, a suggestion which Mr Fung accepted with alacrity.  Unfortunately, the relevant licence documentation relating to the vessel could not be provided promptly, causing Mr Fung to write again on 15 July 2005 to complain about the constant failure of the Company and the Wongs to live up to their promises to take steps to provide funds to cover the outstanding amounts that were long overdue.

25.  Thereafter, the relevant licence documentation appears to have been provided, and the loan and security documentation was prepared.  As noted above, the mortgage was entered into on 15 August 2005, with a loan of HK$6.8 million being made to the Company three days later in order to repay long overdue trust receipts.

26.  Although Mr Pao submitted that this series of correspondence demonstrated that the Bank was putting real, if subtle, pressure on the Company to take steps to deal with the outstanding amounts and improve the state of its facilities with the Bank, I am bound to say that I do not consider that any meaningful commercial pressure was placed on the Company through the course of this correspondence.  Although there were frequent complaints as to the Company’s failure to make repayments when due, and in relation to its inability and failure to honour its promises to secure fresh sources of funding, the nature of the steps that it was suggested would have to be taken were, to my mind, mild in the extreme.  It does not seem to me that a threat to issue a demand letter would have exerted much pressure on the Company to rectify the position, and indeed, the Company in fact did nothing over a period of several months after that threat was made.  Similarly, I am unable to see how a threat that the bank would have to make provisions in respect of the amounts which it had lent to the Company would have been likely to have caused the Company to be concerned, as the making of provisions would be a matter internal to the Bank, and would, moreover, indicate that the Bank regarded the advances which it had made to be potentially irrecoverable, an admission which would hardly be likely to cause the Company much concern.  Finally, even when it was suggested that “tangible” securities would be required, the nature of the securities sought was merely a guarantee from an associated company, rather than real security in the form of realisable property or other assets, which the Company in the event offered.

27.  Mr Pao also suggested, I think, that this form of pressure might be viewed as moral, or at least informal, pressure on the Company to honour its obligations.  I do not think that it can be so characterised.  It is certainly very different from the sort of moral pressure that was held in Re Hau Po Man Stanley to be such as to negative an inference that might otherwise be drawn that a particular transaction was entered into influenced by a desire to improve the position of the creditor concerned.  In that case, the moral pressure appears to have been a desire on the part of the debtor to preserve family ties with his relatives, a matter that might well exert real pressure on a debtor so as to lead him to grant a preference with that aim in view.  In the present case, however, I do not see that the requests by Mr Fung for repayment can sensibly be regarded as constituting pressure in any real form, whether commercial or moral, formal or informal.

The steps taken by the Company’s other creditors

28.  The Bank’s approach to the problems which it was facing with the Company’s failure to effect punctual repayment of facilities which the Bank had extended to it stands in stark contrast to the steps being taken by the many other banks and financial institutions to which the Company was indebted.  Such other banks had, between March and July 2005, taken the following steps against the Company and its directors:-

(1)	By 4 March 2005, OCBC had demanded repayment of the facilities which it had extended to the Company by a formal letter of demand issued by solicitors acting for it.  No such repayment having been made, OCBC would eventually serve a statutory demand on the Company on 17 August 2005, on the basis of which its winding up petition was subsequently presented on 28 September 2005.
(2)	Equitable PCI Bank Inc., Hong Kong branch terminated the facilities which it had made available to the Company and demanded their immediate repayment by a letter to the Company dated 3 May 2005.  No payment having been received, statutory demands were served on the Wongs as guarantors of the Company’s indebtedness to Equitable PCI Bank on 19 May 2005, followed by bankruptcy petitions against the Wongs presented on 8 July 2005.
(3)	Delta Asia Credit Limited caused a formal demand for immediate repayment of all outstanding and overdue amounts from the Company to be issued by its solicitors to the Company on 2 June 2005.
(4)	On 16 June 2005, UFJ Bank Limited terminated the facilities which it had made available to the Company and demanded immediate repayment of all outstanding amounts, threatening the institution of legal proceedings if no repayment were made.  On 11 July 2005, UFJ Bank issued a statutory demand against the Company in respect of amounts owing to it by the Company, a step which would have entitled it to present a winding up petition against the Company by the beginning of August 2005.
(5)	The Bank of East Asia served letters of demand on the Company’s directors in respect of guarantees provided by them on 5 July 2005.
(6)

29.  In each of these cases, the steps taken were, it is evident, more concrete, more serious, and instituted much more promptly, than those threatened by the Bank over a period of several months in Mr Fung’s e-mails to the Company.

The absence of any good reason for granting the mortgage

30.  Moreover, the financial position of the Company disclosed by the steps being taken by its other creditors was, quite clearly, critical.  The number of such other creditors, and the extent of the debts owing to them, was such that it does not appear that there could have been any real prospect of the Company trading on through its difficulties, with a view to winning through to an improved financial position.  That being so, it is not, in my view, realistic to suggest, as Mr Pao sought to do, that the (or at least one) purpose of granting the mortgage to the Bank was to preserve the ongoing commercial relationship between the Company and the Bank.  Given the Company’s parlous financial position, which must have been known to it (and its directors, against whom statutory demands were served and bankruptcy petitions presented), it cannot seriously have been thought that the Company would be able to carry on business for any appreciable length of time so as to benefit from such a relationship.

31.  It is also, as I have noted, clear that the loan granted by the Bank against the security of the mortgage did not involve fresh credit being given to the Company, as the proceeds of the loan were immediately applied to reduce the Company’s indebtedness to the Bank under other, long outstanding, facilities.  The upshot was that the overall indebtedness of the Company to the Bank was not reduced, although the Bank’s position was improved by the obtaining of the security afforded by the mortgage.  It cannot therefore be said that the Company benefited in any tangible way from the granting of the security, so as to provide a good reason for the grant of the mortgage.

32.  Mr Maurellet also submitted, I think rightly, that given the personal bankruptcy proceedings threatened against the Company’s directors consequent on the service of statutory demands against them, both in May 2005, and on the very day that the vessel was offered to the Bank as security, the fact that such security was offered to the Bank rather than the creditors serving such statutory demands is strong evidence of a desire to prefer the bank, even at the cost of the personal bankruptcy of the directors.  Although Mr Pao suggested that it would not have been proper to offer the Company’s property as security to creditors with claims against the directors, this is, I think, to overlook the fact that those claims were in fact based on guarantees given in respect of the Company’s indebtedness, so that the provision of security to those creditors would have benefited the Company as well as its directors.

Conclusion

33.  Although the onus of proving the relevant desire and that it was, at least, one of the factors which influenced the Company in its decision to grant the mortgage lies with the liquidators (as the Bank was not an “associate” of the Company), it seems to me that, for the reasons which I have endeavoured to explain, the indirect evidence to which I have referred in the preceding paragraphs comfortably discharges that burden, even without the “direct” evidence in the form of the statement which Mr Spencer Wong is said to have made to the liquidators when interviewed by them, on which I do not think it appropriate to place much weight, having regard to the fact that it is only hearsay and has not been confirmed on affirmation or otherwise on oath.

Disposition and costs

34.  I am therefore satisfied that it would be appropriate to grant the declaration sought by the Company and I do so.  It follows that the order for payment which is sought should also be made.

35.  So far as costs are concerned, there is no reason why they should not follow the event, and I shall therefore make an order nisi that the costs of and incidental to this application shall be paid by the Bank to the liquidators, to be taxed on the party and party basis if not agreed.  To the extent that there remains any shortfall in the costs recovered, these are to be met out of the assets of the company, subject to the usual requirement of taxation of such costs in the course of the liquidation.