WILLIAM EDWARD DONNETT v. CHEUNG CHEUNG-SHUI AND OTHERS

1987 No. A428

IN THE SUPREME COURT OF HONG KONG

HIGH COURT

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JUDGMENT

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1. The plaintiff who holds 250 class A shares in the 5th defendant ("the company") gave notice in writing on 4th November 1986 pursuant to Article 25(2) of the Articles of Association of the company that he proposed to transfer those shares, and specified on the transfer notice that he fixed as their fair value the sum of $2,000,000.

2. On 24th November the company gave notice to the plaintiff that it had found purchasing members, namely the 1st, 2nd, 3rd and 4th defendants, the directors of the company. On the same date these four defendants, being in disagreement with the plaintiff as to the value he assigned to the shares, applied to the company's auditor pursuant to Article 25(4) for a certificate in writing as to the sum which in his opinion was the fair value of a class A share.

3. On 27th November the auditor certified that the fair value was $645.17. Thus the total value he ascribed to the plaintiff's shares was $161,292.50. Attached to his certificate were two pages in which the auditor set out his method of calculating that value.

4. The plaintiff complains that the value certified by the auditor was not the fair value and seeks the following relief

5. The relevant part of Article 25 reads as follows:

"25.       (1)   Save as provided by clause (6) hereof, no Share shall be transferred to a person who is not a Member so long as any Member (or any person selected by the Directors as one whom it is desirable in the interests of the Company to admit to membership) is willing to purchase the same at the fair value.

            (2)     Except where the transfer is made pursuant to clause (6) hereof, the person proposing to transfer any Share (hereinafter called the 'proposing transferor') shall give notice in writing (hereinafter called a 'transfer notice') to the Company that he desires to transfer the same.  Such notice shall specify the sum he fixes as the fair value, and shall constitute the Company his agent for the sale of the Share to any Member of the Company (or person selected as aforesaid) milling to purchase the Share (hereafter called the 'purchasing Member') at the price so fixed, or, at he option of the purchasing Member, at the fair value to be fixed by the auditor in accordance with clause (4) hereof. A transfer notice may include several Shares, and in such case shall operate as if it were a separate notice in respect of each. A transfer notice shall not be revocable except with the sanction of the Directors.

            (3)     If the Company shall, within the space of twenty-eight days after being served with a transfer notice, find a purchasing Member and shall give notice thereof to the proposing transferor, he shall be bound upon payment of the fair value as fixed in accordance with clause (2) or (4) hereof, to transfer the Share to the purchasing Member.

            (4)     In case any difference arises between the proposing transeror and the purchasing Member as to the fair value of a Share, the auditor shall, on the application of either party, certify in writing the sum which, in his opinion, is the fair value, and such sum shall be deemed to be the fair value.

            (5)     If in any case the proposing transferor, after having become bound as aforesaid, makes default in transferring the Share, the Company may receive the purchase-money, and shall thereupon cause the name of the purchasing Member to be entered in the Register as the Holder of the Share, and shall hold the purchase-money in trust for the proposing transferor. The receipt of the Company for the purchase-money shall be a good discharge to the purchasing Member, and after his name has been entered in the Register in purported exercise of the aforesaid power, the validity of the proceedings shall not be questioned by any person.

            (6)     If the Company shall not, within the space of twenty-eight days after being served with a transfer notice, find a purchasing Member and give notice in manner aforesaid, the proposing transferor shall at any time within three months afterwards be at liberty subject to Article 22 hereof, to sell and transfer the Share (or where there are more Shares than one, those not placed) to any person and at any price."

6. The plaintiff contends that although the auditor honestly arrived at the valuation it was plainly wrong and therefore not fair. It is accepted by Mr. Patrick Fung for the defendants that notwithstanding both the provision in Article 25(4) that the sum which the auditor in his opinion certifies to be the fair value shall be deemed to be the fair value, and the absence of any fraud, dishonesty or lack of bona fides on the part of the auditor, the plaintiff is not debarred from impeaching the valuation.

7. This is because the auditor's valuation was a speaking valuation. As Nourse J, as he then was, said in Burgess v Purchase & Sons⁽¹⁾ at 225:

"The question whether a valuation made by an-expert on a fundamentally erroneous basis can be impugned or not depends on the terns expressed or to be implied in the contract pursuant to which it is made. A non-speaking valuation made of the right property by the right man and in good faith cannot be impugned, although it may still be possible, in the case of an uncompleted transaction, for equitable relief - as opposed to damages - to be refused to the party who wishes to sustain  the valuation. On the other hand,  there are at least three decisions at first instance to the effect that a speaking valuation which demonstrates that it has been made on a fundamentally erroneous basis can be impugned."

8. Mr. Fung submits, however, that in deciding whether the valuation was made on a fundamentally wrong principle the issue is not whether the auditor's valuation was right but whether it was unreasonable.  Mr. Fung contends that for the plaintiff to succeed he must establish that no reasonable auditor acting on the information available to him could have arrived at the valuation at which the auditor in fact arrived.

9. The basic accepted principle governing valuations was laid down by Sir John Romilly MR in Collier v Mason⁽²⁾ in these terms:

"this court, upon the principle laid dorm by Lord Eldon, must act on that valuation" - and I observe that that was the relevant valuation by the agreed valuer in that case - "unless there be proof of some mistake .... as if the valuer had valued something not included, or had valued it on a wholly erroneous principle."

10. In Dean v Prince⁽³⁾. Lord Denning considered the question of the validity of a valuation of shares at their "fair value". He said at page 427:

"It can be impeached not only for fraud but also for mistake or miscarriage. That was made clear by Sir John Romilly MR in Collier v Mason (1858) 53 ER 613. For instance, if the expert added up his figures wrongly; or took something into account which he ought not to have taken into accounts or conversely : or interpreted the agreement wrongly : or proceeded on some erroneous principle. In all these cases the court will interfere. Even if the court cannot point to the actual error, nevertheless, if the figure itself is so extravagantly large or so. . inadequately small that the only conclusion is that he must have gone . wrong somewhere then the court will interfere in much the same way as the Court of Appeal will interfere with an award of damages if it is a wholly erroneous estimate. These cases about valuers bear some analogy with the cases on domestic tribunals, except of course that there need not be a hearing. On matters of opinion, the courts will not interfere; but for mistake of jurisdiction or of principle, and for mistake of law, including interpretation of documents, and for miscarriage of justice the courts will interfere."

11. I am satisfied that the authorities show that it is not just any mistake by the valuer that will suffice to have a valuation set aside.  Ungoed-Thomas J analysed the matter in some detail in Jones v Jones⁽⁴⁾ at pages 853 to 856. I respectfully agree with the learned judge that where a valuation made on a specified principle is being attacked on the ground that the principle is wrong, the only question is whether that principle is, in all the circumstances, wrong or not. It is the valuation that is the proper subject of attack not decisions that the auditor may have made that were not material to the question of whether the valuation itself was wrong in principle.

12. Indeed, as Ungoed-Thomas J pointed out, Roskill J, as he then was, in Frank H Wright Constructions Ltd. v Frodoor Ltd.⁽⁵⁾, whilst accepting the general principle that an immaterial error does not vitiate a valuation, was at pains to emphasise that a material error, however small, would suffice. He said, at page 529:

"Counsel for the defendants was unable to cite any case in which the court held a certificate not to be binding for error on its face where the error was not material. It seems to me, if I may say so, that the judgment of Sir Raymond Evershed MR in Dean v Prince is in line with the arbitration cases. If this error had been material, it would have been enough to vitiate the whole of the certificate, small as it might be and regrettable as the consequences might be. But in my judgment ..... this error is not material because it does not affect the result."

13. Moreover, I find myself in agreement with Ungoed-Thomas in his conclusion in Jones v Jones at page 856 that there is no requirement of general application that where a valuation is made on an erroneous principle it nevertheless stands unless it is also shown that a valuation on the right principle would produce a materially different figure from that of the valuation under attack.

14. As the learned judge pointed out, the plaintiff bears the onus of Proving no more than that the auditor has acted on a wrong principle; he is not required to shoulder the further burden and expense of a separate and independent valuation. The authorities show that if the plaintiff establishes that the auditor's valuation is erroneous in principle it will be set aside notwithstanding that it has not been established that the valuation figure itself is wrong.

15. I now turn to a consideration of the valuation performed by the auditor. It is plain from his speaking valuation that he. calculated the fair value of a class A share in the company on the basis of a three years purchase of the average profit after tax over the five years preceding the valuation. He stated that he had decided to average the Profits over a five year period in order to reflect fairly the present and immediate past positions of the company and that his choice of three years purchase was based on the view that the company's business, being mainly concerned with the China trade, looked uncertain in the long term and that forecasts of Profitability beyond three years in the uncertain, ever changing China market would be optimistic.

16. The plaintiff alleges that, in basing his valuation on the average net profit of the company over the five year period as an indication of the level of future maintainable profits, the auditor made the following mistakes and fundamental errors of principle.

17. Finally, the plaintiff contends that the auditor valued the shares at a figure which was so inordinately small, particularly in view of the assets of the company, that the valuation must have been based on an erroneous principle or have been arrived at by mistake.

18. In support of these contentions the plaintiff called as a witness Mr. Kenneth Morrison, a partner in Pannell Kerr Forster, chartered and certified accountants. Mr. Morrison is a qualified chartered accountant, a fellow of the Hong Kong Society of Accountants and holds the degree of Bachelor of Law. He is also a member of the Accounting Standards Committee of the Hong Kong Society of Accounts, a committee that is responsible for formulating accounting standards that are required to be adhered to in the preparation of financial statements.

19. On 7th September Mr. Morrison prepared a report on the auditors valuation, and when he gave his testimony more than four months later he formally adopted and enlarged on this report.

20. He testified that the value of an interest in a properly capitalised going concern depends on the future income that can be expected to accrue to the shareholder. A valuer must therefore reach a conclusion as to the company's maintainable level of future profits which may be defined as the level below which, in the absence of unforeseen and exceptional circumstances, the profits would not be likely to fall in an average year. Thus the past results of the company are of value only in so far as they are able to provide a fair indication of the future maintainable earnings.

21. Where the company's profits are rising the maintainable level will normally he taken as the latest year's profits or, if one exists, a properly drawn up forecast for the current year. Where the profits are falling, the maintainable level will normally be taken at a level somewhat below the profits shown in the latest accounts. If, however, the company's profit record shows fluctuations from one year to another, it may be appropriate to take the average profit level over a suitable period as the maintainable profit level.

22. The following is a table of analysis of the company's results for the years ended 30th July 1976 to 30th July 1986. The information relating to the number of directors also specifies the names of the directors for each year.  Each director whose name is given remained a director until his or her withdrawal is indicated.

23. Mr. Morrison pointed out that these figures show that during a period of 11 years there were only three years, namely, 1977, 1982 and 1983 in which the turnover figure was less than that of the previous year, that since July 1983 the turnover. had increased from $4.4M to $16.8M in the year ended 30th June 1986, and that in only two of the eleven years, namely, 1977 and 1982 had the results before tax been less than those of the previous year. Moreover, there were only two years, namely, 1982 and 1983, in which the company recorded a loss. These two years were included by the auditor in the five years he took into account for the purpose of his valuation.

24. As the auditor issued his written certificate on the 27th November 1986 he would therefore have had available to him the management accounts of the company up to October. These accounts disclose that the monthly turnover of the company in each quarter from August 1985 to October 1986 was as follows:

25. It is therefore apparent that although the turnover in the first quarter of the financial year ended 30th June 1987, namely, August to October 1986, declined from that of the previous quarter, it represented the same level as that achieved in the corresponding quarter of the previous year.

26. Whilst Mr. Morrison accepted that in arriving at an earnings based valuation of the company it was not wrong for the auditor to have taken into consideration the results of the company for the period of five years ending 31st July 1986, he said that it was not reasonable for him to have applied a simple average of the previous five years' results in determining the level of the future maintainable profits of the company.

27. According to Mr. Morrison the figures for the years 1982, 1983 and 1984 reflected an entirely different level of operations from those in 1985 and 1986.  Moreover, 1982 had been an exceptional year in that the poor results shown for it were due not simply to a downturn in sales but also to significant increases in administration expenses. In this connexion he referred to the minutes of a meeting of the directors on 23 June 1982 which attribute the loss sustained that year to six main reasons, one of which was that the gross profit percentage had dropped.

28. Indeed, the comparative gross profit percentage figures for the relevant years ended 31st July are as follows:

29. Mr. Morrison added that the greatly increased turnover figures for the years 1985 and 1986 over the earlier years indicated that the company had reached a higher plateau of activity and had become "an entirely different animal".

30. The administration expenses for the relevant years ended 31st July were:

31. Thus both the gross profit percentage figure and the ratio of administration expenses to gross profit figure as revealed by the above two tables disclose that 1982 was well out of line with the other years.

32. From his examination of the results of the company in the years ended July 1985 and 1986 and the six month period ended January 1987 (which latter period did not and could not fall for consideration by the auditor) Mr. Morrison said that the levels of directors' remuneration that had been paid had the effect of distorting the results for those periods.

33. The table of analysis of the company's results for the years ended 30th July 1976 to 30th July 1986 discloses that the sums paid for directors' remuneration for the years ended 31st July 1985, July 1986 and the six months ended January 1987 were $4.16M, $4.47M and $1.74M respectively. It is at once apparent from the table that these sums are larger by far than those paid in all previous years. The earlier remuneration paid ranged from $143,000 in 1976 to $813,000 in the year ended 31st July 1984.

34. A question that arises is whether the levels of remuneration that the first four defendants voted to themselves for the years ended 31st July 1985 and 1986 truly reflected their emoluments or whether a dividend element was also included in these payments. For the purpose of valuing a class A share in the company this distinction is important for the reason that the higher the net profit of the company in a particular year, the greater is the sum available for distribution of that profit among the shareholders by way of dividend. This would have a direct bearing on the valuation of a share in the company.

35. Mr. Morrison said that the fact that the sums paid as remuneration increased five fold in the years ended 31st July 1985 and 1986 from that of the preceding year coupled with the fact that despite having different job titles, responsibilities, and qualifications, each director received the same remuneration, indicates that those sums contained a dividend element.

36. The first four defendants claim that the remuneration paid to them in the two years ended July 1985 and 1987 represents a true market value for the services they performed. However, in a report dated 4th September 1987 the auditor stated that he was of the view that the directors had been underpaid during the formative years of the company and that "in 1985 and 1986, because of the extraordinary increase in turnover, generating more profits, [they] were able to receive a more substantial remuneration to compensate themselves for what they should have received in earlier years."

37. A Mr. Rowell of Boyden Associates Ltd. submitted a report on behalf of the defendants in which he expressed the view that there is no generally followed or accepted standard by which remuneration for the directors of a company is determined, but that persons engaged in specialist services work done by a company are normally remunerated on a basis commensurate with the profitability of the work performed by them.

38. According to him, how much of the annual profits of a company is distributed to its directors depends on the individual circumstances and policy of the company concerned, and this varies considerably. Where uncertain market conditions lead to wide fluctuations in profitability, these wide variations are frequently reflected in the remuneration paid.

39. Mr. Rowell was unaware of the existence of any company similar to the 5th defendant with regard to caotal, shareholding, directors, and business or market conditions. He was therefore unable to draw any direct comparison with other companies. Given his premise that there are neither rules nor guidelines for the remuneration of executives in companies such as the 5th defendant, he came to the firm conclusion that the remuneration paid to the first four defendants for the years ended 31st July 1985 and 1985 was not unreasonable or excessive. He expressed the view that since the company was operating a high risk business and the directors had run it like a partnership, had put in effort and had generated the profit, they were entitled to share the entire profit.

40. This means that, on the basis employed by the auditor in performing his valuation, had the directors' remuneration equalled the company's net income for the three of the five years used by him in which the company made profits, the value of a class A share would have been nil. Indeed, it `is difficult to escape the conclusion that the effect of Mr. Rowell's testimony, at least in the case of the company, is that the income left for distribution as dividends would almost invariably be nil and thus the value of a class A share calculated on a net profit basis would likewise almost invariably be nil. This approach does not commend itself to me. I consider that for the purpose of a share valuation a serious attempt should be made to determine what constitutes a fair remuneration for the work done by the directors.

41. Mr. Rowell testified that it is possible to obtain a market rate for almost any kind of job that is common to more than one company or industry but that such rate may cover a very wide remuneration scale. He said that in coming to the appropriate point on that very wide scale consideration must be given to the size of the company concerned, the nature of its product or services, the competiveness of the market and many other factors.

42. He estimated that a marketing director for a large multinational heavy equipment company and that for a cosmetic company might receive salaries of approximately $600,000 and $800,000 respectively. After the addition of a full range of perquisites the total compensation for each would be between two and two and a half times the base salary.

43. A Mr. Kamm, who is a close friend of Mr. Muir, the 4th defendant, and who is employed as vice president and general manager of Occidental Chemical (Far Cast) Ltd., was called as a witness for the defendants. He estimated that the general manager of one of his company's subsidaries, Occidental Chemical (China) Ltd., who is in charge of the management of all that company's business in China where it has three offices, would receive an annual remuneration of US$1.50,000 (HK$1,170,000). However this would include a vast range of perquisites valued at about US$68,000.

44. Mr. Kamm said that in 1984 he had asked Mr. Muir whether he was interested in applying for the position of general manager of a company that was involved in the same type of business as Occidental Chemical (China) Ltd. Mr. Muir, however, did not display any strong interest. According to Mr. Kamm that position commanded in 1984 a basic salary of US$60,000 per annum together with perquisites similar to those attaching to the Occidental Chemical (China) Ltd. position.  Mr. Muir told the court that he declined to submit an application because "I like being my own boss and I had and still have hopes that the company would provide me with compensation at a commensurate level." In saying this I understood him to mean that he had hoped that once that level was achieved it would be maintained.

45. His hope that the company will in effect provide him with an annual remuneration in excess of $1M does not sit easily with the impression that he appeared to be attempting to convey elsewhere in his testimony that the company's future was not altogether bright.

46. Despite both Mr. Muir's confidence that he would have secured the position had he applied for it and the fact that his close friend Mr. Kamm would presumably have strongly supported him, it is far from clear that the outcome would have been in Mr. Muir's favour. Moreover, it seems that the freedom of being one's own boss may reasonably be equated to a perquisite in that it has a value to the person who enjoys it. Since this benefit was the first reason Mr. Muir gave for not applying for such a lucrative position I think it is fair to say that its value to him must have been substantial.

47. It also seems tome that it is difficult to draw valid comparisons between marketing directors of multinational corporations and general managers of subsidiaries of such corporations on the one hand and the directors of companies such as the 5th defendant on the other hand.

48. A Mr. Kowalski of The Wyatt Company (HK) Ltd. submitted on behalf of the plaintiff a report on comparative remuneration. In order to prepare the report he considered a number of documents including extracts from two affidavits sworn by the aid defendant in related proceedings, two documents provided by the defendant's on request after the auditor had arrived at his valuation but before the writ was issued, a memorandum from the 2nd defendant, and the company's audited accounts for the year ended July 1986 and the interim accounts for the six months ended January 1987.

49. From the information contained in a data bank of current cash compensation, perquisites and benefits information relating to companies in Hong Kong that are concerned in Wyatts remuneration data service, Mr. Kowalski concluded that the total cash compensation payable to the four directors on a weighted average basis would be as follows:

50. These figures include housing allowance and housing loan subsidy value but do not include the provision of a company car, club membership fees, childrens education fees, leave passage, full medical benefits for the employee and defendants and maintenance of home country death and disability insurance.

51. According to Mr. Muir, all the directors of the company regard themselves as being equal in terms of contribution, responsibility, authority and other prerogatives within the company, and that the different titles they use, for example, President, in the case of the 3rd defendant, are merely for the benefit of persons outside the company.

52. Complaint is therefore made on behalf of the defendants that the information on which Mr. Kowalski based his figures for the 1st, 2nd and 4th defendants was not sufficiently detailed or accurate and that the importance of their functions in the company had been understated.

53. Mr. Kowalski, however, was of the view that the fact that the four directors might work as a single team and consider each other to be indispensible to the company is not a relevant determining factor. Likewise, he said that, as the important factor in assessing each position was its imput based on job content, his assessment would not have been different had he been informed that all board decisions are made on the basis of unanimity among the directors.

54. Assuming that all four directors had equal authority and status in the company and that they were equally productive, it seems to me that since Mr. Kowalski proceeded on the basis that the 3rd defendant was Director, Marketing, he would not have assessed the compensation payable to the 1st, 2nd and 4th defendants at a figure higher than that for the 3rd defendant. Indeed, if all four directors assume equal responsibility and are equally productive, I find it difficult to see how each one of them could properly be awarded the same compensation as that payable to a general manager who assumes overall responsibility for the running of a company.

55. Although Mr. Kowalski was not specifically asked by counsel for an estimate of the cash value of the perquisites he had referred to, it seems clear from the general figures that he gave with regard to perquisites that the average weighted total compensation plus the value of perquisites payable to a President, Marketing, would, on his analysis, fall far short of $1M per annum.

56. I found Mr. Kowalski's approach, based as it was on Wyatt's data bank of information relating to numerous Hong Kong companies, to be of far greater assistance than the rather simplistic one adopted by Mr. Rowell. Mr. Kowalski's much broader analysis appealed as having an altogether greater relevance to the assessment of remuneration levels in the company.

57. Moreover, I accept Mr. Morrison's contention that, in assessing the average profits of the five years ended 31st July 1986, the auditor should have reduced the figures for directors' remuneration by an amount which represented compensation for the underpayment of remuneration in the formative years of the company. Since the compensation for the formative years related to years earlier than the five years the auditor used in his calculation of the value of a class A share, the average profit for those five years would have been increased had that compensation been deducted from the remuneration paid in 1985 and 1986. By failing to take into account this consideration the auditor attributed, to those two years profits lower than those actually earned. Thus, even without taking into account the effect of Mr. Kowalski's testimony, it is clear that the value of a class A share must necessarily have been higher than the value arrived at by the auditor.

58. It is not clear how much of the increase in remuneration in 1985 and 1986 was attributable to compensation for inadequate remuneration in the formative years, but. it would seem from what the auditor stated in his report of 4 September 1987 that it was not insignificant. He that as it may, it is clear from what Denning L.J and Roskill J said in the cases to which I have already referred, that a material error, however small, is sufficient to vitiate a valuation.

59. The auditor testified that he had given the utmost consideration to all material factors in arriving at his valuation. I have no doubt that he considered in a general way some of the factors upon which the valuation should have been based, but having, heard his testimony and having considered two letters he wrote to the 2nd defendant on 15th September and 23rd October 1986 concerning the evaluation of a class A share, the certified valuation certificate issued on 27th November 1986 his written comments of 4th September 1987, and the actual figure he arrived at, I have come to the conclusion the evidence he gave was largely an exercise in ex post facto rationalisation.

60. Moreover, as Mr. Morrison pointed out, even after having made due allowance for the realisable value of the fixed assets component, the auditor's valuation was below that of the net tangible assets of the company.

61. The net asset position of the company for the years ended 31st July 1984 to 1986 was

62. Excluding the book value of fixed assets from those figures the following result is obtained

63. The net cash position for these years was：

64. Not only did the net tangible assets figures and the net cash figures increase with each successive year but the company had no significant net borrowing position in those years. And, as Mr. Morrison noted, the accounts for the year 1985 showed that, even after having acquired fixed assets of $1.6M and having paid directors' remuneration of $4.2M during that year, the company still had a net bank position of $215,000

65. Mr. norrison accepts that the valuation of a company as a going concern could be less than the net book value of the assets if it was considered that future maintainable earnings would be very low and the net realisable value of the net assets was likely to be much less than their book value. If, however, the net assets were effectively cash it would be most surprising to find a valuation on a going concern basis to be lower than the net value of the assets. Provided that, there was no good reason to believe that in continuing as a going concern the company would significantly deplete its assets, this would still be so even if it was thought that the future maintainable earnings would be low.

66. Despite fears expressed by Mr. Muir that the uncertainty of the China market and competition from other sources including the government of China itself might well lead to a reduction of the company's profits, I am not persuaded that there is any firm evidence that the profitability of the company is likely to decline to such an extent that its assets will be depleted.

67. After the poor results in 1982 the directors adopted a commendably conservative approach at a meeting on 18th January 1983 by passing a resolution to reduce their remuneration by 23 to 25% until the financial position of the company improved. If they had genuinely believed in 1986 that the excellent results for 1985 and 1986 had been due to an unprecedented China trade fever and that the company's profits might be seriously eroded in the subsequent years it certainly did not seem to affect their decision to award themselves a large remuneration for that year.

68. Moreover, it is apparent from the minutes of a directors meeting of 23rd June 1982 that as early as that date the directors were of the view that the need for the company's services would decline both because of the development of more direct contacts between the government of China and its trading partners, and of the lesser need for translation services as a result either of there being more communication in English or of those trading partners setting up their own means of translating documents when they eventually established their offices in Hong Kong or China.

69. Despite this early fear, the company's profits not only did not decline but actually improved, and eventually in 1985 and 1986, showed massive increases over those of previous years. I regard with considerable scepticism the reservations expressed by Mr. Muir concerning the future outlook for the company.

70. I am satisfied that Mr. Morrison is correct and that the evidence discloses that the company had risen to a higher plateau of profitability from 1985. While I accept that it might have been entirely reasonable to think that the turnover and net profit figures for 1985 and 1986 would not be sustained at such a high level for the succeeding few years, I am of the view there was no justification for thinking there was a likelihood that there would be a decline to the level of the years 1982 and 1983, and I do not believe that the directors or the auditor ever considered this to be a real possibility.

71. Although it is true that the auditor's letter to the 2nd defendant of 15th September 1986 was written before the formal request for valuation was made, it is plain from its terms that he was specifically addressing himself to the matter of evaluating the class A shares in the company. Having stated that the points for consideration in determining a value for those shares were that the company did not own real property, that the office partitions and redecorations had no resale value, that the furniture and equipment might realise only a fraction of the book value in a winding up situation and that the value of the company depended on its ability to earn profits, the auditor expressed the view that the value of a class A share was $645.17.

72. Since the specific points that the auditor raised might reasonably be described as obvious, it is perhaps surprising that if the China trade fever was considered to have been a significant factor affecting the company's ability to earn future profits it was not mentioned in this letter.

73. It is also true that in his letter to the 2nd defendant of 23rd October 1986 the auditor mentioned that his choice of three years purchase of the average profit was based on the view that the company's business, being mainly concerned with the China trade, looked uncertain in the long term and that forecasts of profitability beyond three years was extremely optimistic in the uncertain, ever changing China market. However, in cross examination the auditor made it plain that he made a distinction between the volatility of the China market and the decline in the China trade fever. Thus in his letter of 23rd October he was clearly not referring to the decline in the China trade fever, a phenomenon which in cross examination he said had begun in May 1986.

74. Indeed, in his testimony the auditor said that it was a normal practice in Hong Kong to apply the formula of three years purchase of the average profit over the previous five years.

75. Notwithstanding the earnest consideration the auditor said he gave to the valuation of the shares in the months leading up to the issue of his certificate of valuation on 27th November 1986, the figure that he then alighted upon was identical with the figure that he had given in his first letter of 15th September when he did not have available to him the management accounts up to and including the month of September. According to him he had been anxious to see whether the China trade fever was actually on the decline before arriving at his valuation. In fact, although the average monthly turnover did decline in the quarter from August to October 1986 from that in the three previous quarters it was the same as that in the august to October quarter in the previous year. It is difficult to see therefore that the auditor could justifiably have drawn anything from the turnover figures that would have lent weight to the belief that the China trade fever was declining.

76. It is also interesting that in paragraph 7(2) of the amended defence the defendants allege that the auditor considered and recognised that one factor which made the increase in turnover, gross profit and net profit in 1984-85 and 1985-86 was a strong increase in 1984-85 in investment interest in China by foreign companies, which dropped dramatically in 1986 due to investor frustrations with foreign exchange problems and high operating costs. The fact is, however, that the company's turnover in 1986 was $1.7M greater than that in 1985.

77. Having heard the auditor's testimony I regret that I am led to the conclusion that, in determining the future maintainable income of the company and in deciding that the valuation should be based on three years purchase of the average profits of the company over the five years prior to his valuation, he did not consider all the relevant matters that he now claims he considered. In particular I do not believe that he really turned his mind to a consideration of whether the directors' remuneration for the years 1985 and 1986 was a fair charge for management, or to whether there had been exceptional, extraordinary or non recurring profits or losses during the five year period he selected.

78. In arriving at his valuation I am satisfied that, having dismissed the "net asset value" method, he did no more than apply the rule of thumb "that an average profit or loss over the immediate past five years would fairly describe a company's ability to earn profits" which the auditor stated in his letter of 23rd October 1986 to be a principle "generally accepted in the commercial world".

79. Indeed in his letter to the 2nd defendant of 15th September 1986 the auditor dismissed consideration of the "net asset value" method for the simple reasons that the company did not own any real property and its furniture and equipment might realise only a fraction of their book value in a winding up situation.

80. During the course of the trial he was asked to produce the working papers on which his valuation was based. These comprised three pages, the first of which contained figures relating to the average profit method of calculation, and the remaining two concerned the net asset value method. There is nothing in these pages that provides any evidence of the thought processes he employed in arriving at his valuation or why he concluded that the average profit for the five years to July 1936 was a fair representation of the profitability of the company and did not include distorting factors. Nor is there any hint of the considerations that he referred to in the report which he prepared on 4th September 1987 more than seven months after the writ was issued and more than nine months after he issued his certificate of valuation.

81. An examination of the working paper dated 22nd October 1986 discloses an average net assets value of $1,649,453 for the five years on which the auditor based his valuation. This is more than twice the sum at which the auditor valued the class A shares.

82. As Lord Reid observed in Attorney-General of Ceylon v Mackie [1952] 2 all ER 775 at 779:

"

No doubt, the value of an established business as a going concern generally exceeds and often greatly exceeds the total value of its tangible assets. But that cannot be assumed to be universally true.   If it is proved in a particular case that at the relevant date the business could not have been sold for more than the value of its tangible assets, then that must be taken to be its value as a going concern."

83. Thus the average net asset for the five year period, including as it did the only two years in which losses had been sustained by the company, should have alerted the auditor that the figure he obtained by applying a simplistic rule of thumb method to calculate the value of a class A share was surprisingly low. When one considers that the net asset value of the company at the 31st July 1985, as disclosed by the last balance sheet available to the auditor when he arrived at his valuation, was $2,006,195, the disparity becomes even greater. Although he would not have had available to him the balance sheet which showed that the net current assets of the company as at 31st July 1986 stood at $3,280,099, he must have realised as the company's auditor, that the net assets were likely to be in that region. There is nothing in the working papers that indicates why the auditor concluded that the value of the class A shares was so much less than the net asset value of the company.

84. Mr. Morrison expressed the view that the correct approach to the valuation of a class A share in the company would have been to have considered both the net asset value and the earnings of the company rather than to have made a choice between the two.

85. The auditors valuation of a class A share at $645.17 in his letter of 15th September was arrived at only four days after a meeting that he had held with the directors. They had told him that, although 1985 had been a good year as the probable consequence of China's open door policy, the China trade fever would not last forever, and that this had been evidenced by a downturn in business for quite a few months. There was also some discussion about whether the net asset value method or the average profit method should be employed for the purpose of the valuation.

86. For the purpose of the meeting the auditor had assembled all the information at his disposal and had reviewed the most recent set of accounts, namely those for the year 1985. After the discussion was concluded he began preparation of a working paper for the valuation of a class A share using the average profit method only.

87. In that paper there are two calculations. The first applies the average profit method to five years profits after tax commencing from the year ended 31st July 1981. The second applies the same method to the five years profits after tax commencing from the year ended 31st July 1982.

88. Plainly the auditor had made a firm decision that a period of five years should be the basis of his averaging calculation. The obvious difference between the two sets of figures is that the latter includes the draft accounts for the year ended 31st July 1986 and, in order to accommodate the profit for that year and yet still preserve a period of five years for averaging purposes, the figures for the year ended 31st July 1981 were therefore omitted.

89. The fact that the calculations that he had had prepared at that time did not include any relating to the the net asset method clearly indicates that he thought that it was not relevant. This is reinforced by the letter sent three days after the working paper had been prepared in which he dismissed the net asset method and gave the two reasons to which I have already referred. His firm conclusion was that the value of a class A share was based on three years purchase of the average profit over the previous five years.

90. It is, of course, not surprising that of the two periods of five years used in his working paper he came down in favour of the one which concluded with the year ended 31st July 1986.   This is because the valuation was to be done after the conclusion of that year of the company's profits. It would have been very misleading to have ommitted the latest years profits simply because they had not yet been audited. Indeed, he stated at the conclusion of his letter that his calculation of the value of the share would have to be amended in accordance with any adjustments made after the audit was completed. As matters turned out the value he then gave remained unaltered.

91. In order to meet Mr. Morrison's criticism that the averaging of net profits over a period of five years was a simplistic arithmetical exercise, the auditor said that he had considered the question of weighting the results of those five years and that this is revealed by his two sets of figures. According to him, after learning from the directors that the China fever was not going to continue, he decided not to weight the two most recent good years 1985 and 1986 and, despite the fact that the years 1982 and 1983 showed losses, he concluded that they too should not be weighted "because they were not immediate enough and the company had moved away from that situation". He claims that he therefore elected to do a straight line averaging of the company's profits after tax for the most recent five years.

92. There is nothing in his working papers that shows that the auditor considered weighting various years. Had he done so it seems logical that he would have set those figures down for comparison purposes even if he had anticipated. that it was more likely that he would eventually favour another calculation. Indeed, when on 22nd October he had a working paper prepared for the net asset value method, he not only calculated the average net assets over a period of five years but also did a calculation of the net assets for the most recent year of audited accounts alone. As the auditor testified that these working papers had been Prepared by one of his assistants at his direction so that he would have "all the necessary information and calculations that I needed meaningfully arranged in order to help me formulate my thoughts", I find it difficult to understand how he could formulate his thoughts without having the various alternatives set down for his consideration

93. I also find it somewhat strange that, having concluded that the years 1982 and 1983 "were not immediate enough and the company had moved away from that situation", the auditor should have used those years in his calculation at all. He also made a puzzling distinction between what he called "the volatile China market" and "the China trade fever". He said that his selection of a period of three years purchase was influenced by the volatile China market with its risk of uncertainty, and that he decided not to give any weighting to the years 1985 and 1986 because of his belief that the China fever was declining.

94. When during cross-examination he was asked to explain the distinction between these two concepts he said that the decline in the China trade fever was factual, but that volatility means uncertainty and is therefore different. while he agreed that volatility means that the market is "going up and down" and that a decline means that it is "going down", he sought to explain that in this case "the going down was factual". It seems to me that his distinction is one without a difference and that, as counsel for the plaintiff contended, China trade fever is really an aspect of the volatile China trade. Thus it appears that, in the belief that he was dealing with two different factors, the auditor twice took into account what is in reality one factor. This also contributed to an unfair valuation.

95. It was not until 4th September 1987 when the auditor made written comments on the evaluation of the shares that he ever recorded in writing that he had considered giving weighting to the years ended 31st July 1995 and 1986. It is significant that these comments were made after Mr. Morrison had prepared his report in which he was critical of the auditor for not having adopted "at least a weighted average of the company's past results giving greater emphasis to the results of the current and recent past and much lesser weight to the results of the more distant past". I consider that, as with a great deal of his evidence, much of his commentary of 4th September 1987, was based on a mistaken recollection of his earlier thought processes. I do not accept that he gave to all the relevant factors the detailed consideration that now with the benefit of hindsight he has come to believe he did.

96. I have already mentioned that I do not believe that the auditor had given any more than a mere cursory consideration to the question of whether the massive increase in director's remuneration in the years 1985 and 1986 was partly composed of a distribution of profits. There is certainly nothing in the documentation prior to his certificate of valuation that mentions the matter. It seems that he thought that the increase was perfectly normal and proper and therefore warranted no further consideration. In fact it was not until the 25th August 1987, some nine months after the issue of the certificate of valuation, that the auditor actually prepared a working paper on director's remuneration. It is plain that the only working papers that the auditor has to show for the calculations on which the certificate was based are the very simple figures that were prepared for him by his assistant on 12th September and 22nd October 1986

97. The auditor testified that he issued the certificate after he had considered "the audited and unaudited accounts including the monthly accounts not just on one occasion but on various occasions" and had allowed more time to pass in order to determine whether the China market was really on the decline. Had he audited the accounts for the year ended 31st July 1986 before he certified his valuation on 27th October, the value of a class A share calculated on the same basis as he had employed in his valuation would have been 10.91% higher. Instead, as I have already observed, the valuation did not change from the figure that he gave on 15th September 1986.

98. On a full consideration of all the evidence before me and bearing in mind the factors that I have already outlined I have come to the conclusion that the auditor fell into error in making his valuation in that he

99. Applying the principles laid down in the authorities I have referred to I am satisfied that this is a proper case for the court to interfere. I therefore declare that the certified valuation of 27th November 1986 does not represent the fair value of a class A share in the company and that such valuation is not binding on the parties for the purposes of Article 25 of the Articles of Association. I also grant an injunction to restrain the defendants from acting on the valuation.

100. Both counsel appeared to argue the case on the assumption that, in the event that I found in favour of the plaintiff, I had power to make a declaration as to the value of a class A share or, alternatively, to direct that an enquiry should be carried out by a valuer to be appointed by the court. I have the gravest doubt that I have these powers. Since counsel did not address me on this aspect I will now call upon them to do so both generally and with reference to the case of Sudbrook Tradinq Ltd. v. Eggleton [1983] AC 444, an authority that was not cited in the course of argument.

(1)    [1983] 1 Ch.216

(2)    [1858] 53 E.R. 613

(3)    [1954] 1 Ch.409

(4)    [1971] 1 WLR 840

(5)    [1967] 1 WLR 506