CIBA INTERNATIONAL LTD v. TUNG KA HUNG AND OTHERS

HCCW 1193/2002

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

COMPANIES WINDING-UP PROCEEDINGS NO. 1193 OF 2002

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D E C I S I O N

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1. This application for validation order has a chequered history. It came before me on 23 January and 4 March 2003. I need not repeat what I have said in my Ruling of 23 January 2003 and my Reasons for Ruling of 10 March 2003. For reasons set out therein, the application could not be finally disposed of at those hearings. Further evidence had been filed by parties since 4 March 2003 and the matter came back to me on 23 April 2003.

2. The following were relevant developments since 4 March 2003,

(a) the ex parte injunction obtained by the 1st Respondent against Heirlink in HCMP 927 of 2003 to restrain the latter from presenting a petition against Ratonal Industrial Limited ["the Company"] was discharged on 7 March 2003 upon Heirlink's undertaking not to file any petition based on the statutory demand of 7 February 2003.

(b) Heirlink served another statutory demand on 4 April 2003. The debt was stated to be $632,810.20 (instead of $1,188,275.40 in the first statutory demand).

(c) The application for striking out or stay of the petition was dismissed by Kwan J on 12 March 2003. The Petitioner was also ordered to pay security for costs in the sum of $150,000.00.

(d) Kwan J gave directions for the future conduct of these proceedings on 13 March 2003 including that it is to be heard with six sets of related proceedings before the same judge and there is going to be a further direction hearing on 7 May 2003.

3. In addition, without leave of the court, the parties issued two summonses returnable before me on 23 April 2003,

(a) The Petitioner issued a summons on 7 April 2003 asking for injunctive relief and discovery against the 1st and 2nd Respondents concerning their business activities including those of Ratonal Electronics Limited ["REL"].

(b) The 1st and 2nd Respondents issued a summons on 10 April 2003 asking for additional security for costs in respect of the summons of 7 April 2003 which had not been catered for (nor contemplated) under the order of Kwan J made on 12 March 2003.

4. Due to time constraint, I was unable to entertain these two summonses at the hearing of 23 April 2003. Since the hearing of 23 April 2003 was reserved for the disposal of the validation order application and judging from the substantial volume of evidence having been filed and the history of the matter, it was unrealistic to expect those two additional summonses to be heard together with the validation order application within the one day allocated for the matter. I decided that I should hear the application for validation order first. I saw no urgency in respect of the two additional summonses. The alleged diversion of business to REL has been detected by the Petitioner for quite some time and from what I was told on 23 April 2003, the Petitioner was more concerned about getting information as to the business of REL to enable them to assess the situation and to ensure proper accounts would eventually be rendered by REL on profits derived from business diverted from the Company. As it turned out, the hearing of the application for validation order ran beyond 4:30 pm. The two additional summonses have to be adjourned and I have given directions as to the further conduct of the same.

5. As regards the application for validation order, there is no dispute between the parties as to the relevant principles. In the context of the present application, an important consideration is whether the Company is insolvent. If the Company is insolvent, the basic principle is that the assets at the time of the commencement of the liquidation will be distributed pari passu amongst its unsecured creditors. In considering whether to make a validation order, the court must always do its best to ensure that the interests of the unsecured creditors will not be prejudiced. Further, it has been said that the desirability of the company being enabled to carry on its business was often speculative and the court must carry out a balancing exercise (see Denney v John Hudson [1992] BCLC 901 at p.904-5). In other words, for an insolvent company, the court must be satisfied that the transactions it proposes to sanction are likely to be profitable and therefore will increase the company's assets and therefore will be beneficial to the unsecured creditors (Re Fairway Graphics Ltd [1991] BCLC 468). I do not think the Court of Appeal in Re Parnip Investment Limited [1991] 2 HKC 272 laid down anything inconsistent with these principles.

6. Although the Petition is a contributory's petition, as I said in my Reasons for Ruling of 10 March 2003, the intervention of Heirlink as Supporting Creditor is significant in the context of this application. Unless I can be satisfied that the alleged debt due to Heirlink should not be taken into account in considering the solvency of the Company, the non-payment of such a debt is prima facie evidence of inability to pay debt when it was due.

7. Whilst Mr Lo (counsel for the Respondents) was correct in pointing out that the Petitioner could not rely on Section 178 (1)(a) of the Companies Ordinance because less than 3 weeks have elapsed since the service of the second statutory demand, this is by no means the end of the matter. Mr Lo accepted that the court could still come to a conclusion that the Company is unable to pay its debts if the overall picture justifies the same. He however submitted that on the material before the court, the Company should be regarded as solvent. In the alternative, even if the Company is insolvent, he urged this court to take the view that the continuation of the business of the Company is likely to be profitable and beneficial to the unsecured creditors.

Solvency of the Company

8. Though Mr Lo tried to persuade me that there is a serious dispute to the debt due to Heirlink, I am not convinced. Although there had been an assignment of the debts by Heirlink to Polyclad, the evidence clearly showed that Polyclad had re-assigned those debts back to Heirlink in February 2001. This is confirmed by a letter dated 6 March 2003 written on behalf of Polyclad to Heirlink. It was further confirmed in that letter that only partial payment in the sum of $555,465.20 had been received. Despite time being given to enable the Respondents to produce evidence as to payment of the balance, all that Mr Lo could rely upon is a facility letter dated 5 October 2000 from Fortis Bank to Grand Bond (Asia) Limited which made reference to letters of credit facility with Polyclad as one possible beneficiary. Even Mr Lo had to accept that this is not evidence of payment of the balance. He however invited this court to consider that there is a possibility that payment had been made. On the evidence before me, particularly in the light of the clear evidence from Heirlink and Polyclad as to the non-payment of the balance, I am unable to draw any inference from the facility letter of 5 October 2000 that payment had actually been made for the balance.

9. Mr Lo then submitted that even if the debts due to Heirlink were not fully paid, there is sufficient cash in the bank accounts of the Company to pay for the same. Perhaps in recognition of the weakness of their argument as to the dispute of the Heirlink debts, the Respondents reached an agreement with Heirlink in the afternoon of 23 April 2003. The terms of the agreement, as relayed to me by counsel, are as follows,

(a) in the event that a validation order is made, the Respondents undertake to pay $632,810.20 to Heirlink within 7 days of the order;

(b) in that event, Heirlink would not present a winding-up petition based on the second statutory demand and would withdraw the latter within 7 days after the payment of $632,810.20;

(c) After receiving the payment of $632,810.20, Heirlink would pay the 1st Respondent $100,000.00 by way of costs in HCMP 927 of 2003;

(d) Save as to (c), HCMP 927 of 2003 would be withdrawn by the 1st Respondent with no order as to costs;

(e) Heirlink would not oppose this application for validation order;

(f) Even if no validation order is granted, the Respondents would waive the benefit of the costs order made by me on 4 March 2003 against Heirlink. Heirlink and the Respondents would not ask for costs against each other for the hearing of 23 April 2003.

10. As a result of this agreement, Mr Raymond Lau (counsel for Heirlink) did not oppose the application for validation order.

11. It follows that if this court were to make a validation order, the Respondents would use the money in the bank accounts of the Company to pay $632,810.20 to Heirlink. Heirlink would then in turn pay a sum of $100,000.00 to the 1st Respondent by way of costs in HCMP 927 of 2003.

12. In my judgment, this agreement between Heirlink and the Respondents is in clear conflict with the fundamental precepts of winding-up of the affairs of a company in financial difficulties. As Ms Liu (counsel for the Petitioner) pointed out, it is a clear case of preference putting Heirlink in priority over the other unsecured creditors. Unless I can be satisfied that the Company is financially sound and solvent with sufficient resources to pay off all its creditors, I will not sanction such an agreement.

13. The payment of $632,810.20 to Heirlink will seriously undermine the cash flow position of the Company. According to the management account produced by the Respondents, as at 31 October 2002, the Company had cash in the sum of $1,410,924.00. By way of interim relief, a sum of $400,000.00 had been withdrawn. According to Exhibit "TKH-70" in the 7th Affirmation of Tung Ka Hung, as at 28 February 2003, the Company's bank balance was $1,130,601.68. If a payment of $632,810.20 were to be made, only a balance of $497,791.48 would be left in the bank accounts. Mr Navis Wong deposed in Paragraph 11 of his first affirmation as to the monthly expenses of the Company. It was about $300,000.00 per month. Although I was told that two staff had resigned since then, it did not significantly reduce the monthly expenses of the Company.

14. The management account shows that the Company owed its trade creditors $10,546,648.00 and in addition, there are current liabilities in terms of sundry accounts payable and accruals in the sum of $2,333,564.00. On top of that, there is an item called short term bank loan in the sum of $461,727.00. Mr Lo told me that was a hire purchase loan by Wing Hang Finance. According to the evidence of Mr Navis Wong, the instalment is $45,539.00 per month. There is also a mortgage loan of $1,237,654.00 with monthly instalment in the sum of $28,826.17.00. These two instalment payments were included in the $300,000.00 odd monthly expenses of the Company. The Respondents have not provided me with the up-dated information as to whether there has been any defaults in terms of these instalment payments. Exhibit "NW-20" suggests that there had been defaults regarding the Wing Hang loan.

15. It is not necessary for me to be embroiled in the dispute about whether the short term loan and a certain portion of the mortgage loan should be classified as current liabilities from accounting point of view. Section 178(1)(c) of the Companies Ordinance provides that in determining whether a company is unable to pay its debts, the court shall take into account the contingent and prospective liabilities of the company. In this connection, the observations of Nicholls LJ (as he then was) in Byblos Bank SAL v Al-Khudhairy [1987] BCLC 232 are pertinent,

"... If a debt presently payable is not paid because of lack of means, that will normally suffice to prove that the company is unable to pay its debts. That will be so even if, on an assessment of all the assets and liabilities of the company, there is a surplus of assets over liabilities. That is trite law.

It is equally trite to observe that the fact that a company can meet all its presently payable debts is not necessarily the end of the matter, because para (d) requires account to be taken of contingent and prospective liabilities. Take the simple, if extreme, case of a company whose liabilities consist of an obligation to repay a loan of ￡100,000 one year hence, and whose only assets are worth ￡10,000.00. It is obvious that, taking into account its future liabilities, such a company does not have the present capacity to pay its debts and as such it 'is' unable to pay its debts. Even if all its assets were realised it would still be unable to pay its debts, viz, in this example, to meet its liabilities when they became due. It might be that, if the company continued to trade, during the year it would acquire the means to discharge its liabilities before they became presently payable at the end of the year. But in my view para (d) is focusing attention on the present position of a company. I can see no justification for importing into the paragraph, from the requirement to take into account prospective and future liabilities, any obligation or entitlement to treat the assets of the company as being, at the material date, other than they truly are.

Of course a company's prospects of acquiring further assets before it will be called upon to meet future liabilities will be very relevant when the court is exercising its discretion: for example, regarding the making of a winding-up order or the granting of short adjournments of a winding-up petition."

16. Mr Lo urged me to have regard to the fact that apart from Heirlink, no other creditors appeared to be interested enough in these proceedings to take part therein. That may be so. But I do not think this court can disregard their interests in the exercise of the discretion in granting or refusing to grant a validation order. In Paragraph 9 of the 3rd Affirmation of Navis Wong, he referred to suppliers of the Company "pushing for payments and threatening to take legal proceedings against the Company".

17. The 1st Respondent had settled some of the indebtedness of the Company by his own resources. The total amount of such payments, according to exhibit "NW-11" in the 3rd Affirmation of Mr Wong, is $1,628,811.36. Even so, the Company still owes large amount of money to its trade creditors. Mr Wong also produced a deed of indemnity executed by the 1st Respondent in favour of a creditor Lee Tai Precious Metal Company Limited in respect of a debt of $167,880.00. That seems to be a compromise for payments to be made by instalments. Although I have no information as to the developments concerning this debt subsequent to this deed, this at least showed that the creditor had pressed for payment from the Company and the Company was prima facie unable to make payment in full after the debt had become due.

18. In paragraph 14 of my Reasons for Ruling dated 10 March 2003, I have alluded to my concern about the position of the large amount due to unsecured creditors. The Respondents did not produce detail information about these creditors and I simply have no means to be satisfied that their interests would be properly safeguarded if a validation order were granted. On the material before me, there is a high probability that the payment of $632,810.20 to Heirlink would prejudice the other creditors.

19. Further, in Paragraph 21 of the 4th Affirmation of Navis Wong, he deposed to the fact that liabilities of more than $700,000.00 is overdue and outstanding from the Company. An examination of the list exhibited as "NW-20" suggested that those were mostly expenses incurred after October 2002. Hence, this $700,000.00, or at least a large portion thereof, were not included in the trade debts of $10,546,648.00 set out in the management account.

20. Hence, the existing bank balance of $1,130,601.68 is not sufficient to pay off both the $632,810.20 due to Heirlink and the $700,000.00 odd liabilities incurred after October 2002, not to mention the pre-Petition indebtedness. There is a real likelihood that the Company would be wound up by one of its creditors, if not by the Petitioner.

21. On the whole, I have serious doubt about the solvency of the Company and on the existing material, even taking into account of the other current assets of the Company set out in the management account and disregarding the shareholders' loans which the Respondents agreed to defer, I am not satisfied that the Company is able to pay all its debts when they become due.

Profitability of the business

22. Mr Lo argued that even if the court is not satisfied with the solvency of the Company, it may still make a validation order if the continuation of the business of the Company is likely to be profitable and will thus increase the company's assets so as to be beneficial to its creditors. I have no quarrel with this proposition. But the question is whether there is sufficient evidence before me to warrant a conclusion that the continuation of the business of the Company is likely to be profitable. As reminded by Fox LJ in Denney v John Hudson [1992] BCLC 901, the speculative nature of the future profitability of a business is something I must bear in mind. In the absence of very cogent evidence pointing to the profitability of the business in the future if a validation order were granted, this court should be slow to conclude that the interest of the unsecured creditors would not be prejudiced.

23. In the present case, the Respondents have not produced any credible evidence to substantiate the profitability of the business. Mr Lo placed heavy reliance on the management account showing that the Company made a profit in the sum of $248,738.00 in the seven months prior to November 2002. He also referred to the 4th Affirmation of Mr Wong who deposed to the negotiations the 1st Respondent conducted with six regular customers of the Company. All it boils down to is that these customers indicated that they would be willing to place further orders with the Company and settle their outstanding debts to the Company if the latter could resume normal operation, including the operation of its bank account. Mr Wong made an estimate that the gross profit margin would be 15-20%. Turnover figures relating to these six customers between January and October 2002 were also given.

24. I do not regard these as sufficient to establish that the business would be profitable. In the past, the company had been running at a loss. According to the audited accounts of the Company, the business sustained a loss in the sum of $218,561.00 in the year ended 31 March 2000. For the next year, it sustained a loss of $3,249,137.00. By comparing the retained profits carried forward in the audited accounts for 31 March 2001 and the retained loss brought forward in the management account, between 31March 2001 and 31 March 2002, the business sustained a loss of $5,344,911.00. Mr Lo accepted these figures but he submitted that those poor results were the consequence of the wrongdoing and mismanagement on the part of Mr Wan who is in the same camp as the Petitioner. There are of course disputes of fact in this regard. However, Mr Lo told the court that the 1st Respondent assumed control of the Company in October 2001. Between October 2001 and March 2002, it would appear that the Company still suffered great loss in its business.

25. More importantly, the Respondents did not provide this court with any information as to the profitability of the business from November 2002 to now. As I mentioned in the course of arguments, given the Respondents' case that REL had been conducting the business for the Company to ameliorate the adverse impact of the Petition and they were quite willing to account such profit to the Company, the Respondents should provide information as to how much profit has been generated from such business albeit carried in the guise of REL. Notwithstanding my observation as to the lack of information on the profitability of the business since the Petition in Paragraph 15 of my Reasons of Ruling dated 10 March 2003, the Respondents chose to withhold such information.

26. Mr Lo submitted that it was difficult for the Respondents to produce concrete evidence as to profitability as the Company is still shouldering the adverse impact of the Petition. To some extent, I agree that the Petition must have some adverse impact on the profitability of the business. However, I do not think the Respondents can rely on this to absolve them from producing credible evidence to show that the continuation of business would be beneficial to the unsecured creditors. Without such evidence, it would not be right for this court to grant a validation order when it has serious doubt as to the solvency of the Company.

27. On balance, I do not feel able to conclude that the resumption of business by the Company would be profitable. This is particularly so in view of the very tight cash flow position and the serious doubts I have in respect of the financial viability of the Company. It follows that I cannot be satisfied that the grant of a validation order would not prejudice the interests of the unsecured creditors.

Result

28. For these reasons, the application for validation order must be dismissed. I will also make an order nisi that the Respondents shall pay the costs of the Petitioner regarding this application in any event. As between the Respondents and the Supporting Creditor, by reason of their agreement, there will be no order as to costs.