XCHRX THE FUJI BANK, LTD. v. SANKO AIR-CONDITIONING ENGINEERING LTD. AND OTHERS

HCA1872/2001

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

ACTION NO.1872 OF 2001

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J U D G M E N T

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1. This is an appeal from the Order 14 judgment entered by the master in the court below against all the defendants in the full amount claimed by the plaintiff of some $1.5 million.

2. The claim by the plaintiff against the 1st defendant is as borrower in respect of alleged debt owing by the 1st defendant as a borrower. The claim is made against the 2nd to the 8th defendants as guarantors. What had happened is this : the 1st and 2nd defendants are associated companies and they were both customers of the bank. By a loan Facility Letter dated 6 October 1997 addressed to the 1st and 2nd defendants, the bank granted various facilities to the 1st and 2nd defendants on the terms set out therein. The terms included an overdraft of up to $1.5 million, a total overdraft for both companies and a total Trust Receipt ("TR") facility of up to $9 million. The interest provision, which is the most important provision for the consideration of this case, in relation to overdraft is HK Prime + 2.5% and for trust receipt is HK Prime + 1.25%. The security required under the facility included a cross-guarantee to be executed by the two respective borrowers for that $10 million total facility package, joint and several guarantees to be executed by the various guarantors and these are the 3rd to the 8th defendants and, lastly, a pledge of time deposit of not less than $2 million. Pursuant to the acceptance of the terms of the Facility Letter, securities of time deposit of $2 million in the name of the 2nd defendant as well as the guarantees by the 2nd to the 8th defendants were all given to the bank. In fact, I believe the 1st defendant also gave the guarantee under the cross-guarantee provision.

3. In support of this banking arrangement, of course, there were the various terms of conditions of the bank and there are three that are relevant. One and the most important is the guarantee indemnity conditions dated 8 October 1997; second is the general agreement on bank transactions dated 9 October 1997 and finally there is a charge on cash deposits dated 17 November 1997.

4. The facilities were used and they were used in this way : because of the two companies existing side by side, each of the company has a current account and under that current account, each of the company enjoys the overdraft facility. There was, in addition, of course the Letters of Credit but that does not concern us, and the TRs. Towards the beginning of January 1999 as a result of the downturn in the economy and the various contraction of business, the two companies found that they had to write to the bank to propose a new arrangement, namely to repay what was then outstanding by some proposed instalments over a period of one year. The then amount outstanding by 11 January 1999 come to something like $6.1 million. The document at page 70 the letter dated 12 January from the bank shows the breakdown of two trust receipts of the 1st defendant, totalling some $1.8 million, overdraft of the 1st defendant in the sum of $200 thousand odd and in relation to the 2nd defendant, four trust receipts in the sum of well over $2 million and overdraft of $1.28 million. Of the four trust receipts of the 2nd defendant, two are for sterling ￡46,000, the rest are in Hong Kong dollars. In addition, of course, there are some accrued interest on those outstandings. So the state of affairs as of the beginning of January 1999 when the two companies found themselves in difficulties in meeting the payments on the trust receipts was that they required the bank's indulgence or agreement to a proposed schedule to pay off these outstandings. It is important to note that in the letter dated 7 January, on page two under the schedule of the proposed payments by instalment, there was included under the schedule a set off of the fixed deposit of the $2 million. By a letter dated 12 January 1999 from the Fuji Bank to the two companies at page 70, it says :

"We refer to your letter dated 7-1-99 in which your proposed repayment schedule is unacceptable to us. We hereby inform you that the Banking Facilities granted to you under our Facility Letter to you dated 6-10-97 have been cancelled by our Bank with immediate effect. The outstanding debts under the said Banking Facilities become due immediately. We hereby formally demand from you the immediate payment of the following outstanding debts plus all accrued interest and other expenses or charges due to our Bank."

And then, it sets out in the table which I have indicated earlier the precise amount of the outstandings. Then the letter followed by saying :

"If the payment of the mentioned outstanding debts plus all accrued interest and other expenses or charges are not fully received within 7 days from the date of this letter, we will commence legal proceedings against you without further notice."

5. So, by that letter, the bank called in the loans and required within seven days for all outstandings plus interest to be paid by the two borrowers. It is interesting to note that the bank did not serve at that time or make any demand on the guarantors. There is evidence that the companies, through their officer, then talked to the bank's officer and said : "We've got your letter. We want you to set-off the deposit." and the evidence which seems to emerge from the affidavit is that the officer of the bank said : "I've to take instructions." That was the state of play as of January 1999. Repayments were regularly made by the two companies in the form of different payments and every time there was a payment it would seem that it was paid into the bank account of the borrower. Most of the payments, with the exception of one, were paid into the bank account of the 2nd defendant in which there was, of course, a large overdraft. I think there was one payment paid into the account of the 1st defendant's bank account in which there was also a substantial overdraft. There were some three payments made directly to the bank.

6. The position took a sudden confrontational role in the year 2001, some two years later when the bank said to the companies after a total repayments of some $3.5 million had been made by the two companies, that $1.5 million was still outstanding. There was a dispute as to how that was possible and the bank's case which is now clearly made before the court is that :

1. the bank did not set off the deposit immediately or at any time in early 1999 but only in 2001, some time more than two years later;

2. the bank had taken money that had been paid into the two bank accounts with the ODs and transferred such money from these accounts to pay off the TR transactions; and

3. the bank had been paying-off the TR interest first rather than the TR principals.

7. Proceedings thereafter were brought by the bank against all eight defendants for its claim against the 1st defendant as borrower and against the other defendants as guarantors.

8. On this appeal, a number of points have been raised as defences by Mr Au for the defendants. Mr Au at the main hearing yesterday and today was of course acting only for the 5th defendant but I think it could be said that as the appeals of the others are pending, his submissions insofar as they are applicable to the 5th defendant will certainly be applicable also to the other guarantors who are in similar position.

9. I have been greatly assisted by counsel on both sides. I am indebted to them for the very able submissions made to me and I hope that this judgment would take into account insofar as I could, the submissions made to me. I bear in mind, of course, that this is an Order 14 and that if I am going to grant leave to defend, I should not say too much or give too much details as to the merits of the case.

10. In broad outline, the points made to me by the defendants can be boiled down to three types of complaint. The first type is the complaint that there was no immediate set-off of the deposit. In order to understand the weight of that complaint, one has to look at the commercial reality of the actions taken by the bank. We have here a case where there are three interest elements. Under the OD there is the interest element of Prime + 2.5% together with the method of interest calculation on monthly basis, with monthly rest and compounded. The second regime of interest is under the TR with interest at 1.25% above Prime but no compounding. The third interest regime is under the deposit. Of course, interest rate on the deposit varied from time to time but I do not think it is in dispute that the interest payable on the deposit is Prime minus a spread. I would think it is not in dispute (although we did not go into any great detail) that the difference between the interest payable by the bank on the deposit would be at least 5, 6, may be even more percent less than the governing interest payable under the OD. Now, that large spread difference is commercially crucial to an understanding of the true nature of this case.

11. The first and the chief complaint of the guarantors and to a certain extent of the borrowers is that the bank, knowing of the inability of the borrowers to pay off the debt right away (and evidenced by their proposal for payment by instalments which was rejected) had deliberately chosen the most injurious way to continue the outstandings, that is to say by not setting off the deposit right away and thereby enlarging the exposure of the companies and the guarantors and to a certain extent also enlarging the exposure of the bank for these outstandings. The only benefit that can come from this arrangement, is to give to the bank for a long period of time a large unjustified interest spread because of the difference between the deposit interest rate and the OD interest rate. I think in summary form that is the complaint of the defendants to the non-setting off of the deposit in early 1999.

12. The second complaint is in relation to the payment made into the bank accounts which had large OD outstandings (close to the total limit of $1.5 million) and the complaint is that the bank had unilaterally and without mandate, just moved that sum out of the money paid in for the OD account to the TR account so as to benefit the bank, the reason being that the interest rate on the OD is higher and compounded as compared to the lower interest rate charged on the TR and that by taking money away from the OD account in the current account, the bank had again maximized the exposure of the borrowers and the guarantors.

13. The third complaint is that the bank when it applied the money pulled out of the current account from the money paid in, instead of paying-off the TR principal first discharged the TR interest and thereby further causing the borrower to suffer a higher liability.

14. I would dispose of the third question first. It seems to me that the bank has not done anything wrong insofar as it has transferred money to pay TR interest as opposed to the TR principal. I disagree with Mr Au that it is wrong. The allocation of the repayment first towards repayment of interest rather repayment of the principal is not unusual. But this is really a minor problem compared to the second question that was raised of the unlawful pulling out of money from the current account with the OD to pay-off the TR.

15. To my mind, the question is plainly arguable because that is the test here on an Order 14. As far as I can see, the bank has no justification to take money out of a current account where there was a large overdraft and allocate and transfer the money from the current account to the TR. Mr Lee said in submission that there was no appropriation by the companies and therefore it was open to the bank to appropriate the money received as part of the repayment to the TR account. The evidence before me suggests to me that the money had been paid in by the companies into the respective bank accounts and that there was appropriation by the companies to the OD accounts. It was not open to the bank to just take the money already appropriated to the OD accounts when they knew in the circumstances that it would maximise the exposure of all the defendants. So I think an arguable case had been made out under that head.

16. The first question and the principal argument of Mr Au is that there should had been, in early 1999, setting-off of the deposit, meaning of course the uplifting of the deposit and using the proceeds of the deposit with accrued interest to pay-off all the outstandings or as much of the outstandings as possible which would result in a gross reduction (probably right away the wiping off) of all the ODs and there would be a small balance left towards repayment of the TRs.

17. The case was argued on the basis by Mr Lee for the plaintiff that the banking documents do not impose any obligation on the bank to set-off and that the banking documents give the bank the right to pursue or enforce its securities at the time that the bank chooses. As a general rule, Mr Lee is correct in saying that the bank as a creditor, can enforce its security at the time of its choosing. But there is a parallel rule, which is that a bank as a creditor must not however do anything which is injurious to the interest of the sureties such as the guarantors. The case of Watts v. Shuttleworth was referred to in the judgment of the Privy Council in China and South Sea Bank v. Tan Soon Gin [1990] 2 WLR at page 56 and the following passage appeared at page 58G. It said this :

"Equity intervenes to protect a surety. In Watts v. Shuttleworth (1860) the creditor had covenanted to insure mortgaged goods and failed to insure. A surety was released. Pollock C.B. said at pp. 247-248 :

'The substantial question in the case is' whether the omission to insure discharges the defendant, the surety. The rule upon the subject seems to be that if the person guaranteed does any act injurious to the surety, or inconsistent with his rights or if he omits to do any act which his duty enjoins him to do, and the omission proves injurious to the surety, the latter will be discharged ... the rights of a surety depend rather on principles of equity than upon the actual contract."

And at page 60 after Lord Templeman said generally the creditor is not obliged to do anything and can choose the time of enforcement of the security, he said at page 60E :

"Applying the rule as specified by Pollock C.B. in Watts v. Shuttleworth 5 H. & N. 235, 247, it appears to their Lordships that in the present case the creditor did no act injurious to surety, did no act inconsistent with the rights of surety and the creditor did not omit any act which his duty enjoined him. The creditor was not under a duty to exercise his power of sale over the mortgaged securities at any particular time or at all."

18. The reference to the three situations of (1) creditor did no act injurious to surety; (2) creditor did no act inconsistent with the rights of surety; and (3) the creditor did not omit any act which his duty enjoining him to do, suggest that the Privy Council approved the principle that a creditor was entitled to do many things so long as they did not include the three acts that I have referred to above.

19. The question for this court is whether the admitted and deliberate failure to set-off in the circumstances fall within any of those three acts. Mr Au argues that they do or at least arguably they do. Mr Lee says to the contrary. I have to do the best I can in the circumstances, applying with some commercial common sense to what was happening at the time in early 1999. Now we are not dealing with security like a property or stock and shares which may rise or fall in value and therefore where the bank when it did nothing but in the meantime not injuring the security in anyway could not be said to be at fault. We are here talking about loans with applicable high interest rate which would be on-going and continuing vis-a-vis on the other hand a deposit which attracts a much much lower interest rate and that therefore every month if that situation is allowed to exist it will give to the bank a large interest spread and will give to all the defendants not just the borrowers but the guarantors an increasing exposure. It is in the context of that commercial setting that I have to consider whether it is arguable that the bank's action in not setting-off the deposit could be said to be injurious to the interest of the guarantors and that it was under a duty to act differently.

20. Speaking for myself, I must say that an arguable case has been well made out. We have here an exceptional situation, I agree. I have not seen any comparable case decided in Hong Kong of this unfair position of the difference in spreads which are knowingly taking advantage of by a bank. So I find that there is substance in the first point. The question however that is troubling the court is what would be the consequence of those two acts namely (1) the non setting-off in early 1999; and (2) the moving of the money from the current OD account to the TR account. Mr Au suggests that there is a possibility of those act being considered as repudiatory. I do not have any problem with that. However the problem is even if they were repudiatory there is not the material before me to suggest that the defendants had accepted the repudiation and that therefore that the contractual terms stop applying after January or February 1999.

21. The question depends on the law of surety. Does it provide a principle that these wrongful act will result in the total discharge of the guarantee or do they result in only a pro tanto reduction of the amount which the bank is able to claim under the guarantee? The case that was cited of Watts v Shuttleworth is a case where the whole security was discharged. Mr Lee suggests that that was because there is no question of pro tanto arising there and therefore pro tanto never come into the picture. I think that is probably correct and pro tanto was certainly not argued. The subsequent case of Wulff v. Jay (1872) LR 7 QB decided however that a pro tanto principle shall apply and therefore the court held in that case that the recovery was in an amount less the pro tanto reduction of the value of the property involved.

22. If I follow the principle of a total discharge and come to the view that it is arguable, then of course that would result in my giving unconditional leave to defend for the whole claim. If I agree with Mr Lee then of course the result would be I will only give credit for the pro tanto prejudice thereby giving to the plaintiff the balance of its claim. I find it an extremely difficult decision to make. I have however come to the view that the justice in this case calls for my giving unconditional leave to defend.

23. I put it on three basis. The first is that although there is little authority put before me and the authority put before me seems to suggest that a pro tanto principle is the governing principle, there is at least on analysis a probability (unfortunately due to time constraint the parties have not been able to put before me all the material they could, because the way the case developed this point was not properly argued until it was touched upon in the reply towards the end) that the true principle of equity is that in certain circumstances when there was an injury caused by the creditor that the whole of the security should be discharged. This sort of equitable principle would be salutary in discouraging a creditor from doing any injurious act because otherwise the pro tanto rule gives to the creditor the best of both worlds with the comfort that it can always fall back on the pro tanto basis. In the absence of fuller argument, I take the view that the point is arguable.

24. There are two other reasons that I should also give unconditional leave to the defend. It seems to me that in any event even on a pro tanto basis, a lot of credit would have to be given both on the set-off point as well as on the moving money out of the current account to pay the TR rather than paying-off the OD point. The calculation of such an exercise is going to be somewhat difficult and there are somewhat uncertain figures put before the court.

25. My third reason for deciding that it should be unconditional leave is that this is a case where I think the court ought to have the full exposure of a trial so that a bank can justify publicly why the interest spread should be an important consideration which had caused the bank to have taken the action it did. To put it another way, what was the justification for the bank taking the action it did in not setting-off right away and helping itself to money paid-in by transferring from OD accounts which probably exceeded the limit of $1.5 million to the TR accounts. I know the court is reluctant to rely on other reasons under Miles & Bill and I think this is the first time in my six or seven years sitting as a judge of the High Court that I have resorted to it. But this is a very unusual and exceptional case where I could see the huge injustice of the bank acting the way it did: injustice to the borrowers, injustice to the guarantors.

26. So my conclusion therefore is in relation to all the guarantors that unconditional leave to defend is given. The remaining question is whether a different result should apply vis-a-vis the borrower. I think this is an exceptional case where no costs is going to be increased by the borrower being also given leave to defend for the whole claim. I know that points can be made that the relation between the bank and the customer is a little different from the relation between the bank and the guarantor. But in the particular circumstance of the case it seems to me that all the defendants should be given unconditional leave to defend and I therefore so order.

27. The order of the Master therefore is reversed and the order of this court is that the appeal is allowed with unconditional leave to defend to all the defendants. So far as costs is concerned, I will hear the parties.