RE CHEERY CITY CONTRACTORS LTD

HCCW 896/2003

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

COMPANIES (WINDING-UP) NO. 896 OF 2003

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J U D G M E N T

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1. This is an application by Cheery City Contractors Limited ("the Company") to adjourn a creditor's petition to wind up the Company for a period of three months, so as to allow the Company to seek the sanction of the court to a scheme of arrangement that has been approved by the statutory majority of creditors on 11 March 2004. The application is not opposed in principle by the petitioner, who is a former employee of the Company, but is opposed by the supporting creditor, China State Construction Engineering (Hong Kong) Limited ("China State"), on the ground that scheme is not viable and does not stand a realistic chance of being sanctioned by the court, notwithstanding the approval of the statutory majority of creditors. In the event that the court is of the view that the scheme is not viable, the petitioner seeks a winding-up order at this hearing. It is accepted by the Company that if its application for adjournment were refused, the Company would have no grounds to oppose the winding up as it is insolvent.

The background

2. I will first set out the relevant background matters.

3. The Company was incorporated in 1991 with a paid up capital of HK$1 million divided into 1 million shares of HK$1.00 each. It has since been carrying on business as a construction contractor and has accumulated experience in port works and site formation works. Its only two directors, Ho Siu Po ("Mr Ho") and Mui Wai Lin, are also the only shareholders, with Mr Ho holding 999,999 shares. The Company is not however in the List of Approved Contractors for Public Works and is not eligible to tender for government construction contracts.

4. China State was and is the main contractor engaged by the government for the infrastructure on two major construction works. One is Phase I of the Penny's Bay Infrastructure Development ("the Penny's Bay project"), which is part of the construction of the Hong Kong Disneyland. China State employed the Company as its marine works and dredging sub-contractor under a sub-contract made in January 2002 at a value of HK$103 million. The other project is the formation and associated infrastructure works for the development at Choi Hung Road and Jordan Valley ("the Jordan Valley project"). China State employed the Company as its earthwork sub-contractor under a sub-contract made in June 2002 at a value of HK$131.8 million.

5. On 31 December 2002, China State terminated the employment of the Company in the Jordan Valley project. The Company estimated that at the termination of the sub-contract, it had carried out works for about HK$6 million which has not been paid.

6. On 16 January 2003, China State terminated the employment of the Company in the Penny's Bay project. The Company estimated that at the date of termination, it had carried out works for about HK$43 million which has not been paid.

7. China State claimed that it had terminated both sub-contracts for cause. This is disputed by the Company. On 26 February 2003, the Company referred the disputes regarding the Penny's Bay project to arbitration. On 9 May 2003, the Company referred the disputes in respect of the Jordan Valley project to arbitration. On 7 July 2003, an arbitrator was appointed to arbitrate in the two references. After taking the steps of appointing an arbitrator, the Company has not progressed the arbitrations. To date, the Company has not served its points of claim.

8. On 15 August 2003, the Director for Legal Aid presented a winding-up petition against the Company on behalf of the petitioner, who had obtained an award against the Company for arrears of wages in the sum of HK$28,764.00.

9. On 11 September 2003, China State served a demand on the Company for HK$634,304.28, being taxed costs awarded against the Company in HCCT No. 7 of 2003, interest thereon and the taxing fee. The order for costs was made in connection with an injunction application by China State to remove the Company from the site of the Penny's Bay project. A further demand for debt claiming HK$2,200,135.09 was served on the Company by China State on 24 October 2003, being the amount paid as the main contractor to the Company's employees pursuant to section 43C of the Employment Ordinance, Cap. 57. China State filed a notice of intention to appear in the winding-up petition as a supporting creditor on 11 November 2003.

10. On 10 December 2003, China State wrote to the Company to put on notice that it has claims against the Company of HK$7,697,218.68 in respect of the Jordan Valley project (not including further claims for rectification works, damages as a result of blockage of site by the Company, prolongation and acceleration costs and liquidated damages) and of HK$22,474,778.98 in respect of the Penny's Bay project (not including further claims for rectification works, prolongation and acceleration costs, and exposure to liquidated damages under the main contract estimated to be HK$115,524,687.68). China State also informed the Company that the above claims would be raised against it as a counterclaim in the arbitration proceedings.

11. In respect of the arbitration for the Penny's Bay Project, China State has asserted that owing to the back-to-back nature of the sub-contract and the main contract, the arbitration with the Company cannot proceed until there is an arbitration between China State and the government after completion of the main contract works, which is estimated to be after mid April 2006. The Company however holds a different view and intends to submit the dispute on this as a preliminary issue for the determination of the arbitrator.

12. The petition first came on for hearing in October 2003. It was adjourned several times on the application of the Company, to allow the Company to file evidence on the progress of its attempts to restructure its debts and for a scheme of arrangement to be formulated and put to the creditors.

13. On 24 November 2003, the Company commenced HCMP No. 5133 of 2003, seeking an order that it be permitted to convene a meeting of creditors to consider and approve a scheme of arrangement. The hearing of the originating summons on 16 December 2003 was adjourned to 19 January 2004, with the solicitors of China State holding a watching brief. The adjournment was necessitated because the draft scheme documents were such that they would require rather substantial amendments before they could properly be put to the creditors as proffering an adequate explanation of the scheme of arrangement that the creditors were asked to consider. Revised draft scheme documents were submitted on 19 January 2004 to meet the specific queries raised by me on the first hearing, even then there were patent errors in the revised draft and the Company's solicitors were asked to submit a further revised draft for the consideration of the court. This was done on 21 January 2004 and I made an order without a further hearing for a meeting of the creditors to be convened to consider the proposed scheme.

14. The scheme documents were subjected to yet further amendments, even after the order convening the meeting was made and the scheme documents were despatched to the creditors on 10 February 2004. I understand the solicitors for China State had raised a number of queries with the Company's solicitors regarding the scheme documents served on them, and that would appear to be a reason why such further amendments were made. The draft amended scheme documents were then submitted by the Company to the court with an explanatory letter and directions were sought on the service of the amended scheme documents. They were given on 27 February 2004. The Company despatched a circular letter to the creditors dated 1 March 2004 giving an explanation of the amendments and enclosing a marked up copy of the scheme documents showing the amendments made with deletions and underlining.

15. The last hearing of the winding-up petition was on 19 January 2004. It was ordered that the petition was to be adjourned to 23 March 2004 to hear arguments on the Company's application for a substantial adjournment and to resolve the issue of the viability of the proposed scheme of arrangement.

16. At the creditors' scheme meeting held on 11 March 2004, China State was permitted to vote only HK$3,867,681.00 out of its claims in excess of HK$33 million, as the balance was set off by the Company against its claims in the arbitrations. The scheme was approved by a majority in number of creditors whose claims amounted to 82.85% of the value of claims admitted for voting.

The proposed scheme of arrangement

17. It would be convenient to summarise the terms of the proposed scheme of arrangement before I consider its viability and its prospects of being sanctioned by the court.

18. As at 31 January 2004, the Company has a total indebtedness of approximately HK$93.82 million. Financial creditors accounted for about 9% of the total indebtedness. Of this amount, preferential claims are approximately HK$1.46 million and the balance of HK$92.36 million is other unsecured indebtedness. Included in the unsecured indebtedness is the claim of China State estimated at HK$30.8 million odd, without taking into account the Company's claims against it, making China State the largest unsecured creditor. The Company is clearly insolvent. According to the unaudited management accounts as at 31 December 2003, it has net current liabilities in the region of HK$59.6 million and net liabilities of HK$49.9 million.

19. The investor under the scheme of arrangement, Concentric Construction Limited ("the Investor"), is a private company incorporated in Hong Kong in 1991 with a paid up capital of HK$3.8 million and since 1999 it has been engaging in construction works. It is looking for opportunities to be included in the List of Approved Contractors for Public Works. For this reason, the Investor is interested in the past job experience and reference of the Company, based on which the Investor hopes that it could meet the basic requirements and eventually apply to be included in the List of Approved Contractors for Public Works in the category of port works and site formation works.

20. On 19 November 2003, the Investor made an offer to take over the Company with HK$3 million ("the Scheme Investment") and on 21 November 2003 it entered into an escrow agreement with the Company and the escrow agent relating to the deposit of the Scheme Investment with the escrow agent. Under the proposed scheme, the Scheme Investment is to be utilised as follows:

(1) HK$1 million is to be applied to the settlement of the costs and expenses of the scheme administrators (HK$400,000.00), the escrow agent (HK$50,000.00) and a firm of consultants ("the Consultant") engaged by the Company to conduct the two arbitration proceedings against China State (HK$550,000.00); and

(2) the balance of HK$2 million (defined as "Scheme Cash" in the scheme documents) is to be applied to the settlement of firstly the claims of preferential creditors up to the statutory limit pursuant to section 265 of the Companies Ordinance, Cap. 32 in the aggregate sum of approximately HK$1.46 million, and then to the settlement of all other unsecured indebtedness estimated at HK$92.36 million on a pro rata basis.

21. Upon receipt of distributions from the Scheme Cash, the aggregate of all the unsecured debts of the Company as at the effective date of the scheme, which have been admitted by the Company in whole or in part, are deemed to be fully and finally discharged. The scheme will terminate on the date when all the Scheme Cash with interest accrued thereon have been paid and distributed to all preferential and unsecured creditors and the duties of the scheme administrators will cease upon the giving of a notice to all creditors to that effect. Any amount of the unsecured indebtedness which is not proved in accordance with the scheme or which is rejected, in whole or in part, shall be treated as wholly and irrevocably released, save and except that any unsecured creditor whose debts have been rejected by the scheme administrator or the adjudicator, in whole or in part, is at liberty to make any claim or counterclaim against the Company.

22. There are undertakings given by the Investor and the Company which do not form any part of the terms and conditions for the discharge of the unsecured indebtedness.

23. The Investor undertakes to advance interest free loans to the Company to meet disbursements relating to the two arbitration proceedings against China State until the conclusion thereof. Such disbursements do not, however, cover any legal costs for retaining solicitors or counsel or any security for costs. The Company has agreed with the Consultant that the latter will represent the Company until the conclusion of the arbitration proceedings at a fixed cost of HK$550,000.00 and that the Consultant will be entitled to a contingency payment at 20% of any amount that may be received by the Company from China State either as ordered in the arbitrations or through settlement of the proceedings.

24. The Company undertakes to pay and distribute to all unsecured creditors on a pro rata basis all monies to be received as a result of the two arbitration proceedings, except for any award of costs in favour of the Company (which would go to the Consultant), subject to deductions in respect of the loans advanced by the Investor for disbursements and contingency payment of 20% to the Consultant.

25. Upon the consent of the unsecured creditors to the scheme, the two shareholders of the Company have agreed to enter into a sale and purchase agreement with the Investor whereby each of them will transfer all the shares of the Company under his or her name to the Investor at the consideration of HK$1.00. In the alternative to this arrangement, and in the event that any shareholder is prohibited from transferring his or her shares to the Investor, subject to the scheme being sanctioned by the court, by a supplemental agreement dated 7 January 2004, the Company has agreed to restructure its share capital by an increase of 3 million new shares of par value of HK$1.00 each to the existing capital and issue the new shares to the Investor as fully paid up in consideration of the Scheme Investment. I should mention the alternative arrangement was necessitated because China State has obtained a charging order nisi on the 999,999 shares of the Company held by Mr Ho on 25 November 2003 and the order was made absolute on 16 February 2004. An appeal against the charging order absolute was dismissed on 16 March 2004.

The law

26. I turn to the law on the exercise of the discretion to adjourn a winding-up petition for the purpose of promoting a scheme of arrangement.

27. A creditor's petition to wind up a company is not ordinary litigation as the right of the petitioner to a winding-up order is a class right. The special considerations which apply require that the petition should be heard promptly. It is only in an exceptional case that a long adjournment will be granted as this is inherently undesirable (Re Esquire (Electronics) Ltd [1996] 3 HKC 309 at 312G to H). "Before the court would accede to any adjournment, even a short one, there has to be good reason for doing so, for example there are the makings of a viable scheme with evidence of adequate support (both in number and value) from the creditors" (Re Golden Dragon Land Development Ltd [1999] 539 HKCU 1).

28. The court's approach has most recently been expressed in the following manner by Rogers VP in Credit Lyonnais v. SK Global Hong Kong Ltd [2003] 4 HKC 104 at 113G to H:

"Whilst it is in the power of a court to adjourn winding-up proceedings, in order to enable a scheme of arrangement to be put in place, any such adjournment would generally only be ordered in the absence of opposition from the petitioning creditor. Even then that should only be done in circumstances where the court can see that there would be a realistic probability that a scheme of arrangement would be approved and can be sure that no prejudice will be occasioned as a result of the order made."

29. Mr Bartlett, who appeared for China State, accepted that the present hearing is not a "dry run" of the petition for sanction of the scheme under section 166 of Cap. 32, nor is the court charged with the exercise of the statutory jurisdiction under that provision at the present stage. He has asked the court to review the proposed scheme (and because of the manner in which the events have developed, the court is given the full details of the scheme in this instance) to ascertain its viability, so as to "weed out" at an early stage a scheme that is hopeless or which would stand no realistic chance of being sanctioned. I agree the court does have this "policing" or "gatekeeper" power, which may be exercised in a clear and compelling case, otherwise any proposed scheme of arrangement, regardless of its content, could with sufficient in-principle support of the creditors, bring about a substantial adjournment of the winding-up petition until the conclusion of the petition for the sanction of the scheme. I am therefore not concerned at this stage with whether there should be more than one class of creditors for the purpose of the scheme meeting.

The viability of the scheme and the prospects of obtaining sanction

30. The gravamen of Mr Bartlett's attack is that the scheme has hardly been presented in a manner with adequate disclosure and there is a real question if the creditors voting in favour of the scheme have fully appreciated the disengagement between the scheme and any monies that may be received by the Company as a result of the arbitrations or the relative benefits of the scheme in contrast to the liquidation scenario. Whilst the court has approached the granting of sanction on the basis that it would be slow to differ from the meeting as creditors acting honestly are "much better judges of what is to their commercial advantage than the court can be", this is premised on the assumption that they are "acting on sufficient information and with time to consider what they are about" (Re English, Scottish and Australian Chartered Bank [1893] 3 Ch 385 at 409). Thus, "it is essential to see that the explanatory circulars sent out by the board of the company are perfectly fair and, as far as possible, give all the information reasonably necessary to enable the recipients to determine how to vote" (Re Dorman Long & Co. Ltd [1934] 1 Ch 635 at 657).

31. I have recounted earlier the unsatisfactory way in which the scheme documents have been put together, necessitating the adjournment of the application to convene the scheme meeting and several rounds of amendments made thereto. Whilst it is apparent to the court, China State and the petitioner's solicitors that any recovery from the arbitrations and distribution of such proceeds do not form part of the scheme and that the admitted debts of unsecured creditors are fully and finally discharged with the distribution from the Scheme Cash, this has not been presented with sufficient clarity or emphasis in the scheme documents. Under the scheme, all admitted creditors' claims will be irrevocably discharged but they will only receive minimal compensation as stated below, referable to the valuation of the Company's goodwill or undertaking but without regard to any value of the Company's claims in arbitration. The court is particularly concerned that the "carrot" of recovery from the arbitrations as presented in the one-page analysis of liquidation and scheme scenarios (annexure D to the explanatory statement) might well have been used to entice creditors (only a small proportion are financial creditors) who have not undertaken a closer analysis of the scheme documents.

32. According to annexure D, under the scenario of the scheme of arrangement, after payment of preferential claims from the Scheme Cash, HK$534,954.67 would be available to pay unsecured claims (described as "ordinary claims" in the annexure) of HK$62,188,314.85; the latter figure is arrived at by deducting the claim of China State in the sum of HK$30,171,998.00, on the assumption that the Company is successful in the arbitrations. Leaving aside whether such an assumption should have been made (which is questionable), the dividend rate is presented as "0.86 per HK$100.00", which is actually 0.0086 cent in one dollar. The table went on to list an amount for debt recovered in the arbitration of HK$40 million less a consultancy fee of 20% giving a total dividend rate of 52.32 per HK$100.00. Although there is a footnote numbered 5 referring the reader to part 8 of the scheme and paragraph 3.26 of the explanatory statement "when considering this Analysis of Scenario", it is doubtful whether that would be sufficient to counter the impression conveyed in the analysis that the recovery from the arbitrations would be part of the scheme.

33. It is pertinent to note in this connection it was only in the last round of amendments on 1 March 2004 that paragraph 2.1(a) of the explanatory statement (which contained the "executive summary") was amended to delete the reference to the monies received in the arbitrations to correct any misleading impression that might have been conveyed in the earlier version that the arbitration proceeds would form part of the scheme. This particular amendment in the explanatory statement was not even mentioned in the covering circular letter of 1 March 2004 notifying the creditors of the changes made.

34. As for paragraph 3.26 of the explanatory statement, although this contained a sentence that the undertaking of the Company to distribute monies received from the arbitration proceedings will not form part of the scheme and any scheme debts admitted will be discharged upon payment of the Scheme Cash, this was given no prominence and the significance of this sentence would be buried in the small print of the document. Further, one is left in doubt as to the status of the undertaking of the Company, as it will "materialise only upon the awards of the [arbitration] Proceedings being made in favour of the Company" (paragraph 3.26 of the explanatory statement), and presumably would not arise if there should be a commercial settlement instead. There is also a question mark over the survival of this undertaking, as there is no express wording in the explanatory statement or the scheme of arrangement that the undertaking will survive notwithstanding that the scheme "will terminate on the date when all the Scheme Cash together with all interest accrued thereon have been paid and distributed to all Preferential Creditors and Unsecured Creditors" (paragraph 9.1 of the scheme of arrangement).

35. In the scheme of arrangement itself, there is no provision similar to paragraphs 2.1(a) and 3.26 in the explanatory statement. Paragraph 2.24 of the scheme of arrangement stated that the Company also undertakes to pay and distribute to the unsecured creditors all monies to be received, subject to the deductions detailed in part 8 of the scheme, as a result of the arbitration proceedings. Part 8 set out the undertaking given by the Company in detail. These provisions would appear to suggest that the Company's undertaking does form part of the scheme. To add to the confusion, paragraph 12.6 of the scheme of arrangement provided that in the event of a conflict or inconsistency between the terms of the scheme and the terms of the explanatory statement, the terms of the scheme shall prevail.

36. So much for the scenario for the scheme of arrangement as presented. I turn to the analysis of the liquidation scenario in the scheme documents.

37. In the liquidation scenario presented in annexure D, the only assets of the Company listed are cash at bank in the sum of HK$635,228.27. In the explanatory statement, it was stated that apart from the cash at bank, the Company owns landed property the current value of which is less than the debt to the mortgagee bank and shares in Cheery Hua (HK) Limited ("Cheery Hua") with a par value of HK$8 million and that such shares are "not worth any value". According to the audited accounts of the Company for the year ended 31 March 2003, it had accounts receivable of HK$3,715,078.00 due from Cheery Hua. The amount due was unsecured and interest free, and had fixed term of repayment. The auditors gave a qualified opinion on account of, inter alia, limited information pertaining to the Company's interest in associates, namely, Cheery Hua. The accounts receivable of HK$3.7 million were not dealt with in the unaudited management accounts for the period from 1 April to 31 December 2003, or in the explanatory statement. The dividend rate for unsecured claims given in the liquidation scenario in annexure D was nil. The total dividend rate was likewise nil, with an explanation in footnote numbered 3 that under the liquidation scenario, there will not be sufficient funds for the liquidators to pursue the arbitration proceedings to recover the debt of HK$40 million.

38. Mr Bartlett has queried whether the presentation of nil value for dividend rate is a fair one. No consideration would appear to have been given to the possibility that the liquidator of the Company might have assigned the cause of action of the Company in the arbitrations for valuable consideration. Notwithstanding the existence of a counterclaim in the arbitrations against the Company, I do not think the counterclaims of China State should have posed an insuperable difficulty for the liquidator to assign the chose in action in respect of the Company's claims (Baytur S A v. Finagro Holdings S A [1991] 3 WLR 866 at 871 to 872). It does not seem to me that the creditors have been given a fair picture here.

39. I am not satisfied that the creditors have been given sufficient explanation of the scheme of arrangement and its effects, and that they have been provided with adequate information to enable them to make a reasonable and informed decision in the particular circumstances as to how to vote at the meeting. For the above reason, I have come to the view that this is a clear case of there being no realistic prospect that the court would have sanctioned the scheme of arrangement.

40. I should add that Mr Bartlett has advanced other grounds to support his contention that it is unlikely that the scheme would receive the sanction of the court. He submitted that the scheme has infringed the principle that section 166 should not be used simply to provide an informal substitute for the liquidation process provided for elsewhere in Cap. 32 (Re Tillers Pty. Ltd [1970] 3 NSWLR 202; Re Island Air Pty. Ltd (1983) 7 ACLR 844 at 846-7; McPherson's Law of Company Liquidation by Andrew R Keay, 2001 ed., paras. 1.03 and 1.04). I have some doubts if the scheme has contemplated a process that is indistinguishable in substance from that prescribed by the statutory provisions for winding up. Here, the chose in action in respect of the Company's claim in arbitration does not form part of the scheme. Besides, the goodwill and past job reference of the Company could not have been disposed of in the same way if the Company should cease to be a going concern.

41. Mr Bartlett also submitted that the treatment of China State's claims under the scheme is extremely prejudicial in that it is placed in an invidious position as the scheme, once sanctioned and effective, will operate to fully discharge its claims unless they are rejected by the scheme administrators and yet China State will be fully exposed to the claims in arbitration to be pursued by the Company (notwithstanding that for the purpose of voting at the scheme meeting, China State's claims have been subjected to an "equitable set-off in respect of these mutual claims [in the arbitrations]" as notified by the letter of the chairman of the meeting dated 5 March 2004). It was contended that the dissimilarity of rights would have made it impossible for China State to consult with the other creditors. It seems to me it would be more appropriate to raise this at the stage of petition for sanction. I am not inclined to accept that the correctness of this contention is clearly made out at the present stage without fuller arguments.

Order

42. For the above reasons, I decline to grant a substantial adjournment of the petition as there is no realistic prospect that the court would sanction the scheme. The petitioner has indicated that it would seek a winding-up order if the adjournment should be refused. I order the Company to be wound up. There would be an order nisi that the costs of the petitioner and of China State are to be paid out of the assets of the Company.