OSMAN MOHAMMED ARAB AND WONG KWOK KEUNG, THE JOINT AND SEVERAL LIQUIDATORS OF KAM TOYS & NOVELTY MANUFACTURING LTD (IN CREDITORS’ VOLUNTARY LIQUIDATION) v. CASHBOX CREDIT SERVICES LTD

HCMP 1908/2016

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

MISCELLANEOUS PROCEEDINGS NO. 1908 OF 2016

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J U D G M E N T

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1.  By an Amended Originating Summons (OS) filed on 18 January 2017 the Applicants seek a declaration that the amount of HK$19,287,000 paid by the Company to the Respondent on 9 January 2014 (Payment) constituted an unfair preference contrary to ss.266 and 266B(1) of the Companies (Winding Up and Miscellaneous Provisions) Ordinance, Cap 32 (Ordinance) and is void, and for a consequential order for payment of that amount to the estate of the Company.

Issue

2.  The statutory framework applies to unfair preference claims and the elements which have to be established in such claims were discussed and set out in Re Aloha Coffee Co Ltd (in liq) [2013] 1 HKLRD 356 at §§5-7.

3.  The issue in this case is whether the Applicants can establish the fact that in deciding to make the Payment the Company was influenced by a desire to “prefer the Respondent” (I use this as a short form for “putting the Respondent into a position which, in the event of the Company’s insolvent liquidation, would be better than the position it would have been in had the Payment not been made”), which is one of the elements required to be proved in making good the Applicants’ case.  

4.  There is also an issue on whether the Company was insolvent at the time of the Payment.  However, as analysed below, this dispute has no merit. 

Background

5.  The background facts are largely uncontroversial and based on the documents before the court.

Creditors’ voluntary liquidation

6.  On 6 March 2014, the sole director of the Company, Mr Lee Yuk Shan (LYS), passed a written resolution to put the Company into creditors’ voluntary winding up pursuant to s.228A of the Ordinance (voluntary winding up in case of inability to continue business).

7.  Shortly before the liquidation, on 28 January 2014, 3 of the Company’s 4 directors, namely, Mr Lee Kwan Wah (LKW), Lee Yue Wah (LYW) and Mrs Lee Tsui Lai Ling (LTLL) resigned from the board, leaving LYS as the sole director.  LKW and LYW are brothers.  LTLL is the wife of LKW, and LYS is his son. 

8.  The Company’s shareholders as at the date of commencement of liquidation were LKW (80%), LYW (10%) and LTLL (10%).

Insolvency

9.  There can be no real question that at the time of the Payment the Company was insolvent based on the Cash Flow Test.  The evidence demonstrates that the Company had not been in a position to pay its debts for some time before the Payment was made.

10.  As at 26 July 2016, the Applicants had received 109 proof of debt claims amounting to HK$267,397,287.08 from various creditors, including trade creditors, and outstanding salaries and remuneration owed to 37 employees.

11.  The Company’s trade debts almost entirely pre-date the date of the Payment.  Many of these debts go back to 2012 and 2013, with the earliest dates from October 2011 (from June Just Printing Co Ltd with a claim of HK$2,323,916.84).

12.  At the time of the Payment, there were 2 High Court actions brought against the Company by 2 trade creditors (both of whom had subsequently lodged a proof of debt in the liquidation) – HCA 2019/2012 issued on 30 October 2012 by Chan Chi Leung trading as Hang Cheong Plastic Moulding Fty; and HCA 1348/2012 issued on 31 July 2012 by Winner Printing & Packaging Ltd.  There were also 2 District Court actions apparently brought by trade creditors (which have not lodged any proof of debt), Jobkey Paints & Chemicals Ltd (DCCJ 3790/2012) and GPI International Ltd (DCCJ 3538/2002). Shortly after the Payment and just days before the commencement of liquidation, on 28 February 2014 another one of the Company’s trade creditors (which subsequently lodged a proof of debt), Art’s Printing Co Ltd, issued DCCJ 759/2014 against the Company.

13.  The fact that the majority of the directors of the Company had resigned their position on the same day shortly after the Payment speaks volumes.  Clearly, they were abandoning a sinking ship.  That is fortified by the decision of LYS to put the Company into creditors’ voluntary winding up.  The Statement of Affairs submitted by LSY as at 6 March 2014 shows that the Company had a total estimated deficiency (liabilities exceeding assets) in the sum of HK$112,575,902 (at book value) or HK$194,754,072 (with estimated realisable value used for the assets).  Common sense dictates that the Company could not have got into such a dire financial position within a short period of time. 

14.  The Respondent adopts a technical and, with respect, unrealistic approach to the evidence of insolvency.  It was argued that there is no evidence of, eg, the Company’s management accounts, cash flow statements or information on the liquidity of its assets, and therefore the insolvency of the Company cannot be proved.  I disagree.  The proof of insolvency is not a mechanical exercise.  The court is entitled to draw an inference based on the evidence. 

15.  I regret to say that the approach taken by the Respondent is unhelpful.  It added to the costs of litigation, prolonged the hearing and increased the burden on the court. 

Black’s Link Property

16.  At the time of the Payment, the Company owned a property in Black’s Link (Black’s Link Property).  That property was subject to an “all moneys” first legal charge (First Legal Charge) dated 30 January 2013 in favour of Lei Shing Hong Credit Ltd (Lei Shing Hong) and an “all moneys” second mortgage (Second Mortgage) dated 30 September 2013 in favour of Success Full Finance (HK) Ltd (Success Full).

17.  The Company entered into a provisional sale and purchase agreement to sell the Black’s Link Property for HK$300 million on 15 November 2013.  The deposit from the sale in the sum of HK$30 million (Deposit) was paid to Messrs Tony Kan & Co (TKC), the Company’s solicitors, in 2 tranches by 29 November 2013.  According to the provisional agreement, the Deposit was paid to TKC as stakeholder and it might be released to the Company provided that the balance of the purchase price was sufficient to discharge the mortgages.  The sale was completed by assignment dated 18 February 2014 with both the First Legal Charge and the Second Mortgage discharged on the same date.

Taikoo Shing Property

18.  LKW and LTLL were the joint owners of a property in Taikoo Shing (Taikoo Shing Property).  That property was also subject to an “all moneys” first legal charge dated 6 June 2013 in favour of Lei Shing Hong and an “all moneys” second mortgage dated 30 September 2013 in favour of Success Full.

19.  The husband and wife entered into a preliminary sale and purchase agreement to sell the Taikoo Shing Property for HK$22 million on 1 December 2013.  The sale was completed by assignment dated 16 January 2014.

Loan agreement with the Respondent

20.  According to the evidence of the Respondent’s director, Mr Mok Ka Fai (Mok), in early December 2013 the Company was introduced to the Respondent, a licensed money lender, by Ms Winnie Chan of Cyber Link Consultants Co (“Cyber Link”), an agent of the Respondent.  Mok met with LKW and LYS, who asked (on behalf of the Company) to borrow HK$19 million (Loan) for no more than a month.  According to Mok, he was told that :

(a)  TKC was holding the Deposit;

(b)  The Company needed to use HK$16 million of the Loan to partially pay off its debts to Lei Shing Hong, and the balance of the Loan would be used as working capital;

(c)  The balance of the Company’s debts to Lei Shing Hong would be paid off upon completion of the sale of the Black’s Link Property (Completion);

(d)  Lei Shing Hong had agreed to release the Deposit to the Company subject to two conditions: (i) it would be paid HK$16 million immediately; and (ii) the balance of the Company’s debts to it would be paid off upon Completion; and

(e)  LKW was reluctant for the Company to execute a new mortgage over the Black’s Link Property in favour of the Respondent.

21.  Later, the Loan was agreed.  It would be drawn down in 2 tranches – HK$3 million on 23 December 2013 and HK$16 million on 30 December 2013.  The Loan, together with the interest of HK$287,000 (at 36% p.a.), would be repaid in full on 13 January 2014.  The following documents were made :

(a)  On 20 December 2013, the Company issued a directors’ resolution approving a letter of authorisation to TKC (Letter of Authorisation) by which TKC were instructed to make the Payment from the Deposit to the Respondent and the balance of HK$10,713,000 be paid to the Company;

(b)  According to the Letter of Authorisation, these payments were to be made “within 2 working days after your firm have received confirmation from the existing mortgagees of the above property that the balance of purchase price payable by the purchaser … is sufficient to discharge the existing legal charges and mortgages on completion”;

(c)  By a letter dated 23 December 2013, TKC confirmed to the Respondent that it had received and would act in accordance with the instructions contained in the Letter of Authorisation;

(d)  On the same day, 23 December 2013, the Company entered into a Loan Agreement (Agreement) with the Respondent.  It was a condition precedent that the Company must provide, 2 days prior to the date of drawdown, ie, by 21 December 2013, all the documents listed in Schedule II, including (i) an “all monies” third legal charge on the Taikoo Shing Property (Third Legal Charge); (ii) an Irrevocable Power of Attorney (POA) duly executed by LKW and LTLL authorising the Respondent to settle the Taikoo Shing Property in case of the Company’s default on the Loan; and (iii) a Personal Guarantee to be executed by LKW and LYS to jointly and severally guarantee to the Respondent the due and prompt performance of the Agreement (Guarantee);

(e)  Schedule III of the Agreement provided that the Loan would be advanced in 2 tranches payable to the Respondent’s solicitors, Messrs Darin Leung & Partners (DLP) – HK$3 million on the date of the Agreement (23 December 2013) and $16 million on 30 December 2013;

(f)  Schedule V of the Agreement stipulated that the date of repayment for both tranches was 13 January 2014, and that the total interest payable upon repayment of the Loan would be HK$287,000;

(g)  On 23 December 2013, the Third Legal Charge, the POA and the Guarantee were all executed.

22.  The Respondent transferred the 1^st tranche of HK$3 million to DLP also on 23 December 2013.  On the same day, DLR issued 2 cheques in the respective sum of HK$285,000 and HK$190,000 (HK$475,000 in total) to Cyber Link.  It appears from a Notice of Drawing, which differed from the version in Schedule III(2) of the Agreement, that the 1^st cheque was for “commission fee” and the 2^nd was “set up fee”.

23.  On the same day, DLP also issued a cheque in the sum of HK$2,514,000 (after deducting from HK$3 million, the sum of HK$475,000 and another sum of HK$11,000 as DLP’s fees) to the Company, which was deposited into its bank account the next day.

24.  On 30 December 2013, the Respondent paid the 2^nd tranche of HK$16 million to DLP, and on the same day DLP issued a cheque for the same amount to Lei Shing Hong, which was deposited into its bank account on that day.

25.  On 8 January 2014, TKC sent a letter to the Respondent enclosing a cheque for the Payment, which was deposited into its bank account on the next day.  The balance of the Deposit (HK$10,713,000) was paid to the Company also on 8 January 2014.  The Loan was therefore repaid (with interest calculated in full up to 13 January 2014) 5 days before the due date for repayment, and without any interest deduction for early repayment.

Completion

26.  There is an undated Statement of Account issued to the Company by TKC (it was probably issued around the time of Completion on 18 February 2014) according to which, from the balance of purchase price of HK$270 million, HK$238,802,148.78 was paid to Lei Shing Hong to settle the First Legal Charge (counting the HK$16,000,000 paid on 30 December 2013, Lei Shing Hong was paid a total of HK$254,802,148.78), and HK$28,477,260.00 was paid to Success Full in settlement of the Second Mortgage.  The balance, less costs, disbursements and legal fees, paid to the Company was HK$2,449,933.76.

Respondent’s case

27.  The Respondent says that the Loan was a commercial transaction entered at arm’s length.  It had no reason to believe that the Company had “preferred it” in making the Payment, and there is no reason to believe that was the case. 

28.  Mok’s evidence is that in addition to the Third Legal Charge, the POA and the Guarantee, the Loan was secured by the Deposit held by TKC and the undertaking (it was in fact a confirmation) by that firm to make the Payment to it.

29.  I shall deal with the Applicants’ case in the analysis below.

Analysis

30.  What is known about the Loan has been set out above.  Both sides are blaming the other for not adducing any evidence from LKW or LYS to provide further information on why the Loan was necessary.  The evidence is that the Applicants had tried to meet with LKW but to no avail.  I do not believe that it is right to criticise them in this regard, although it may be said that they could have tried harder to obtain further information about the Loan given the unusual circumstances (see below).  On the other hand, under the adversarial system Respondent is entitled to put the Applicants to prove their case.

31.  One of the 2 arguments advanced by the Applicants in support of their case is that the Loan was not a genuine commercial transaction.  Mr Hughes, appearing for the Applicants, suggested that the Loan bore the hallmark of a “side deal”.  There is considerable force in the submission. 

32.  Most importantly, the Loan (or the lion part of it) was required to secure Lei Shing Hong’s consent to the release of the Deposit.  I agree with Mr Hughes that the simple solution would be for the Company to reach an agreement with Lei Shing Hong for the latter to provide the confirmation (that the balance of purchase price was sufficient to pay the First Legal Charge) required to release the Deposit on condition that HK$16 million thereof be paid to it.  It would have been a solution which cost nothing.  Instead, the Company took the course of borrowing a very expensive short term loan from another lender, with 2 directors having to provide their personal guarantee.  It is difficult to see any sense in that decision by the Company. 

33.  If one looks into the details of the Loan, the situation becomes more inexplicable.  On any objective appraisal, the Loan was pretty much a no risk transaction for the Respondent.  The entirety of the repayment was secured by the Deposit which was held by professionals who were under instructions to pay the Respondent.  The very high cost of the Loan is therefore quite surprising, and reasonable businessmen would not normally agree to the same. 

34.  Mr Ho, appearing for the Respondent, was unable to explain these unusual features of the Loan.  There are other matters which also cast doubt on the true nature of the Loan, eg, there was no reduction of interest despite the early repayment.  

35.  However, the suspicious nature of the Loan does not turn the Payment into one made under the influence of a desire to prefer the Respondent.  I turn to the Applicants’ 2^nd argument.

36.  Relying on Mak’s evidence that he believed that the Payment was made to protect LKW and LYS from being personally liable for the Loan under the Guarantee (such evidence is, in my view, consistent with the natural inference from the evidence before the court), Mr Hughes submitted that the Company’s desire to protect its directors and its desire to put the Respondent in a better position in a liquidation scenario went hand-in-hand and are indistinguishable.

37.  To assess the merits of this argument, I need to look closely at the requirement that the Payment was influenced by a desire to prefer the Respondent.  I have been referred by both counsel to the much quoted dicta of Millet J (as he then was) in Re MC Bacon Ltd [1990] BCLC 342 at 335e to 336d, where the learned Judge explained the difference between the old and the new test :

“This is a completely different test. It involves at least two radical departures from the old law. It is no longer necessary to establish a dominant intention to prefer. It is sufficient that the decision was influenced by the requisite desire. That is the first change. The second is that it is no longer sufficient to establish an intention to prefer. There must be a desire to produce the effect mentioned in the subsection.

This second change is made necessary by the first, for without it it would be virtually impossible to uphold the validity of a security taken in exchange for the injection of fresh funds into a company in financial difficulties. A man is taken to intend the necessary consequences of his actions, so that an intention to grant a security to a creditor necessarily involves an intention to prefer that creditor in the event of insolvency. The need to establish that such intention was dominant was essential under the old law to prevent perfectly proper transactions from being struck down. With the abolition of that requirement intention could not remain the relevant test. Desire has been substituted. That is a very different matter. Intention is objective, desire is subjective. A man can choose the lesser of two evils without desiring either.

It is not, however, sufficient to establish a desire to make the payment or grant the security which it is sought to avoid. There must have been a desire to produce the effect mentioned in the subsection, that is to say, to improve the creditor’s position in the event of an insolvent liquidation. A man is not to be taken as desiring all the necessary consequences of his actions. Some consequences may be of advantage to him and be desired by him; others may not affect him and be matters of indifference to him; while still others may be positively disadvantageous to him and not be desired by him, but be regarded by him as the unavoidable price of obtaining the desired advantages. It will still be possible to provide assistance to a company in financial difficulties provided that the company is actuated only by proper commercial considerations. Under the new regime a transaction will not be set aside as a voidable preference unless the company positively wished to improve the creditor’s position in the event of its own insolvent liquidation.

There is, of course, no need for there to be direct evidence of the requisite desire.  Its existence may be inferred from the circumstances of the case just as the dominant intention could be inferred under the old law.  But the mere presence of the requisite desire will not be sufficient by itself.  It must have influenced the decision to enter into the transaction.  It was submitted on behalf of the bank that it must have been the factor which ‘tipped the scales’.  I disagree.  That is not what sub-s (5)[1] says; it requires only that the desire should have influenced the decision.  That requirement is satisfied if it was one of the factors which operated on the minds of those who made the decision.  It need not have been the only factor or even the decisive one.  In my judgment, it is not necessary to prove that, if the requisite desire had not been present, the company would not have entered into the transaction.  That would be too high a test.”

[emphasis added]

38.  According to the Oxford Shorter English Dictionary, 6^th edn, desire means long for or want earnestly.  I can certainly accept that in making the Payment so as to release LKW and LYS from the Guarantee it would have been plain to the directors of the Company, given its financial circumstances, that the Payment would result in improvement of the Respondent’s position in the event of an insolvent liquidation.  It must be a natural consequence of the Payment.  However, I struggle to see how or why the directors would have desired (or positively wished for) that consequence. 

39.  All the indications from the evidence suggest that the Company was badly insolvent.  The directors were probably indifferent as to which of the Company’s creditors would be better off in the event of liquidation.  There is no evidence of any non-commercial relationship between the Company or its director(s) and the Respondent or its controller(s).  I see no valid reason to believe that the decision to protect LKW and LYS from the liabilities under the Guarantee was in part influenced by a desire to prefer the Respondent. 

40.  In short, I am unable to see any evidence to support the inference of a desire on the part of the directors to improve the position of the Respondent in the event of the Company’s insolvent liquidation. 

41.  Finally, I do not believe that the quality of this 2^nd argument is improved by considering it in conjunction with the suspicious circumstances of the Loan (the 1^st argument of the Applicants).  The court should not enter into the realm of speculation.

Conclusions

42.  By reason of the above, the OS must be dismissed.  I make an order nisi that the Respondent is to have 2/3 of its costs of these proceedings paid by the Company, to be taxed if not agreed.  The 1/3 deduction is to reflect the unmeritorious arguments over the insolvency of the Company. 

43.  I regret to say that the CJR has not, as far as I can see, achieved the desired result, it is the duty of the court to encourage a real change of litigation culture.  Bad arguments result in waste of time, costs and resources of the court.  The best, and perhaps the only effective, way to discourage such arguments is an appropriate costs order. 

[1] The equivalent of s.50(4) of the Bankruptcy Ordinance, Cap 6.