RE SOUTH CHINA STRATEGIC LTD

M.P. No. 2163 of 1996

Headnote

In a Petition to sanction a scheme of arrangement and reduction of capital and share premium account, the Scheme document contained a number of discrepancies and misleading statements in relation to the effect of the Scheme and, on the face of it, potentially permitted distribution of capital in circumstances that would be in breach of S.79B and S.79C of the Companies Ordinance. Moreover, the Scheme document and the Petition did not make clear the intention to eliminate the accumulated losses standing in the books of the company. Although creditors had consented to the reduction of capital they had not consented to a postponement of their debts.

Held :

1. The Reduction of Capital In a reduction of capital following Re Thorn EMI plc [1989] BCLC 612 the requirements are that

a) The shareholders are treated equitably

b) The reduction proposals are properly explained in the document summoning the meeting

c) the creditors are safeguarded

d) the reduction is for some discernible purpose

2. None of the above requirements were satisfied.

3. No explanation was made that (a) there were losses intended to be written off; (b) as to how the losses arose or (c) that they were permanent.

4. The creditors were not protected.

a) There were no sufficient assets of an immediate nature to cover the capital to be reduced and the liabilities with an adequate margin of safety.

b) The consents were not sufficient as the creditors did not consent to postponement to non-consenting creditors and the bank guarantee proposed was in the circumstances hopelessly insufficient

5. The Scheme of Arrangement To sanction a scheme of arrangement the Court needed to be satisfied inter alia that the provisions of the Statute had been complied with and that the arrangement is such that an intelligent and honest man might reasonable approve.

6. The statutory provisions were clearly not complied with.

7. The Scheme document did not explain the Scheme accurately and in particular there was an absence of proper explanation of past losses and the purpose of eliminating those losses was not explained.

8. If Schemes have not been clearly and properly explained in a simple way that shareholders can be expected to understand they will not be sanctioned by the Court.

9. The Petition In petitions the facts must be presented fairly, accurately and with candour. Petitions are not the place for persuasive advocacy. Dictum of Whitford, J. In Chevron Research Company's Extension 1975 FSR 1 adopted.

10. In the circumstances the Court was not prepared to make any order on the Summons for Directions.

M.P. No. 2163 of 1996

IN THE SUPREME COURT OF HONG KONG

HIGH COURT

MISCELLANEOUS PROCEEDINGS

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D E C I S I O N

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1. This is the resumed hearing of the summons for directions in a Petition to sanction a Scheme of Arrangement, confirm a reduction of capital and confirm a cancellation of a share premium account.

2. When this matter first came before me there were a number of points which I raised with counsel about the Scheme and the reduction of capital. High on the list was the fact that the Scheme was presented on paper and argued by counsel in Court to be a simple re-domicile. When the matter was examined, it emerged that the company had been making substantial losses and the Scheme involved the elimination of the existing capital of $189,042,522.00 and reinstatement of a paid up capital of a mere $1,000.00. The questions which I raised could not be answered at the time. Because of the seriousness with which I viewed the matter and the fact that it looked, from a scrutiny of what little of the accounts were available, as though the matter had not been fairly and properly presented, I indicated that if the company wished to pursue its application I would wish the services of an Amicus Curiae.

3. At the restored hearing, Mr. Winston Poon Q.C. appeared as friend of the Court and I am greatly indebted to his careful and thorough assistance in the matter. As a result of the further consideration of the application, I have no hesitation in saying that the manner in which the Petition has been presented and the order on the summons for directions has been sought was in many respects an affront to the Court. It is such that no order could possibly be made, in my view, on the Petition and indeed the order sought on the summons for directions could not be made either. In view of the importance of schemes of arrangement and, in particular, the proper regulation of reductions of capital I have adjourned this matter into open court to give this Decision.

4. The purpose of the reduction of capital is set out in the Petition as being to give effect to the Scheme. The Scheme was, on the face of the Scheme document, a scheme to enable what is termed the emigration of the Company. The Company is a Hong Kong company and its shares are quoted on the Hong Kong Stock Exchange. The Scheme, if implemented, would involve the creation of an overseas holding company whose shares would likewise be quoted on the Hong Kong Stock Exchange but the Hong Kong company's shares would be cancelled and, as I have indicated, the capital would be reinstated to the amount of $1,000.00.

5. Frequently, such schemes of arrangement are effected by cancelling the old shares in the Hong Kong company and by re-issuing them to the same amount to the new overseas holding company. This device saves stamp duty because it saves the duty payable on transfer of shares. The device, presumably, cannot be used in the present instance because there is insufficient capital in the company.

REDUCTION OF CAPITAL

6. I propose to consider the matter in three aspects and the first is the question of the reduction of capital. When a company has passed a resolution to reduce share capital, it then has to apply, under section 59(1) of the Companies Ordinance, for confirmation by the Court of that reduction. The principles under which the Court operates in deciding whether to confirm a reduction have been summarised in many cases perhaps most conveniently in Re v. Thorn EMI plc [1989] BCLC 612. At p.616 Harman J. said:

"The requirements are that shareholders are treated equitably, that the reduction proposals are properly explained (that means in the circular summoning the meeting), that the creditors are safeguarded and that the reduction is for a discernible purpose. "Discernible" means, in my view, something which is demonstrated by evidence to the Court and is something sufficiently solid and near in expectation to be a real prospect."

Proper Explanation

7. Taking those matters in turn, I first of all consider whether there was a proper explanation of the reduction of capital and the reasons therefor to the shareholders when they held their meeting. In that aspect I have to consider the Scheme document which has been exhibited and had been sent to the shareholders. The importance of the scheme document and its accuracy has been emphasized on a number of occasions see e.g. Buckley on the Companies Acts. The importance of the accuracy of the scheme document cannot be over-emphasized. The documents are usually in a standard format but they are the only material which the shareholders and their advisers will have at their disposal. If they do not accurately portray the underlying facts, the shareholders and their advisers will be misled. Indeed, it is probably fair to say that it is quite likely that the shareholders and their advisers will decide as to whether to attend and how to vote at a meeting not at that meeting but prior thereto. Indeed they will probably decide whether to attend that meeting largely on the basis of the information provided by the company in the scheme document. It can also be said that frequently they will not attend the meeting but that is by the bye and one hopes that before proposals are put to company meetings they are properly formulated and presented.

8. The first aspect in respect of the Scheme document which I consider has to be mentioned is this: there is a very little reference in the Scheme document to the losses which the company has suffered. By ferreting around various parts of the document, it is possible to discern indications that there have been losses and indeed it was partly a reference, for example on p.30 to accumulated losses attributable to the company and its subsidiary of $67m, that alerted me to the fact that there were or might have been such losses. I have to say, however, though that one of the difficulties in this case is that proper accounts have been difficult to track down. In the Scheme document the accounts, in so far as any are presented, are group accounts. This may satisfy the requirements of the stock exchange and the SFC who may for very valid reasons require the group position to be made clear to the shareholders, however, when it comes to matters of company law and in particularly the importance of individual company solvency and when it comes to consideration of creditors, the company's own accounts are what matter. Initially, in the affidavit supporting the Petition and seeking the directions, again, there was no mention of losses.

9. Still today, the question of losses has not been properly explained. The accounts produced have been minimal and there have been no adequate explanations. It does seem that the accumulated loss is $88 million. Furthermore even now, there is no indication in the evidence as to whether the loss is a permanent loss. Without a description as to the loss and the circumstances of it, it is impossible to form any conclusion on that. As has been pointed out in, for example at p.179-180 of Buckley on the Companies Acts 14th Edition such proof is a requirement. The reason for this is clear. The nature of the loss and whether it is permanent affects both any safeguards for creditors which the Court may require and also the Court's duties under Section 59(2).

Protection of Creditors

10. The next matter to which I would draw attention is the question of safeguarding the creditors. This is a highly important matter in a reduction of capital and is probably the overriding factor which is in the Court's consideration in deciding whether or not to approve a reduction. In the present case, it is clear from such accounts as have now been exhibited that there are net current liabilities totalling over $13m. There are long term liabilities totalling more than $66m. There are contingent liabilities in respect of a guarantee totalling more than US$71m and there are to be expected to be further contingent liabilities to employees and the landlords and other current running costs of the company which there has been no attempt to identify.

11. Generally speaking, in a reduction of capital the Court looks to see whether there are sufficient assets of an immediate nature which would cover both the capital to be reduced and the liabilities of the company with an ample margin of security. If there are not, the Court must be cautious.

12. As has been set out in, for example Atkin's Court Forms the standard procedure is that either a bank guarantee should be provided to cover all the liabilities of the company or else the creditors should not only consent to the reduction of capital but they should also indicate their willingness to postpone their claims to those of the non-consenting creditors.

13. In this instance, the consents to the reduction have been given by some of the creditors. The consents have been exhibited. But the creditors have not consented to the postponement of their debts to the non-consenting creditors. The company has offered to provide a guarantee in the sum of some $1.3m. This would cover the non-consenting creditors but in view of the absence of consent to postponement by the remaining creditors, this offer is wholly insufficient.

14. I would mention, however, that this offer to provide a guarantee only came after the last adjournment, when it was becoming apparent to the petitioner and its advisers that the difficulties presented by this Petition were not unnoticed.

Discernible Purpose

15. Lastly, turning to the discernible purpose it seems to me that again giving a fair reading to the Scheme document, which was the only information given to the members of the company, the purpose for the reduction of capital was hidden. The discernible purpose on the face of the document was merely the emigration of the company. The real purpose seems to me to have been to reduce the capital and write off the losses in the process.

16. In the circumstances, it seems to me that it would be impossible for me to grant an order on this reduction of capital as sought on the summons for directions, namely that section 59(2) of the Ordinance should not apply and that there should be no advertisement for creditors. But if I go further, on the present documentation and having seen the manner in which the matter was presented to the shareholders, I do not see any way in which the Court could ever sanction this reduction of capital.

THE SCHEME OF ARRANGEMENT

17. I turn next to the question of the Scheme of Arrangement. Buckley sets out the functions of the Court as follows:

"In exercising its power of sanction the Court will see, first, that the provisions of the statute had been complied with, second, that the class was fairly represented by those who attended the meeting and that the statutory majority are acting bona fide and are not coercing the minority in order to promote interests adverse to those of the class whom they purport to represent, and thirdly, that the arrangement is such as an intelligent and honest man, a member of the class concerned and acting in respect of his interest, might reasonably approve." See p.473-474 5th Edition."

Compliance with Statutory Provisions

18. Turning to the Scheme document, one matter which causes considerable concern is that in para. 1E of the Scheme, it is said that:

"On the Effective Date, the balance of the credit arising in the books of account of the Company as a result of the reduction of its share capital referred to above, together with the credit arising in the books of account of the company as a result to the cancellation of its share premium account, will be credited to a reserve account in the books of account of the Company which reserve account will be distributable subject to any restrictions or conditions imposed by the Court to protect the interest of the creditors of the Company."

19. It seems to me that in view of the state of affairs of the company with its accrued losses, any such distribution would clearly fall foul of section 79B and section 79C of the Companies Ordinance. The Court could not approve a Scheme in circumstances such as these which contained such a statement. It is idle to argue that in practice there was no intention to make any such distribution. If there were no such intention the statement should not be there.

20. The next matter which is perhaps an unintentional slip is under clause 2 of this Scheme. Having provided for the issue of new shares in the company which is referred to as SCSI being the overseas company, the document then says: "fractional entitlements will not be allotted but will be aggregated or retained for the benefit of SCSI." This, it seems to me, would involve, if the Scheme be carried out, the company holding its own shares and that is, of course, not permissible under the companies legislation.

21. It is also to be noted, however, that this wording does not accord with what is in the rest of the Scheme document and, for example, the explanatory statement on p.5 where it says "that fractional entitlements to SCSI shares will not be issued to shareholders of scheme shares but will be aggregated and sold for the benefit of SCSI." That is repeated in other parts of the document.

Proper Explanation of Scheme

22. When I turn to the requirement as to whether the Scheme has been properly explained such that an intelligent and honest man as a member of the class might have approved it, it seems to me that again there is a lapse.

23. First of all in the Scheme document there is no proper mention of the losses or of the real purpose behind this reduction of capital albeit the Scheme will also involve a re-domicile.

24. At best the question of distributable reserves which are referred to and contained in clause 1E of the scheme could be said to be misleading.

25. One other point has emerged during the course of the hearing and that is the way the Scheme will operate. In clause 2 of the Scheme, it is said that "In exchange for and in consideration of the cancellation and extinguishment of the Scheme shares, and in exchange for allotment of shares in South China Strategic BVI to SCSI, on the Effective Date, SCSI shall issue new SCSI shares, credited as fully paid, and the Company shall procure the transfer at its expense of SCSI shares to the persons who are holders of Scheme Shares (as appearing in the register of members of the Company at the Record Time)....."

26. The way the Scheme is explained to work at page 41 of the Scheme document is that it will not be the Company which procures and transfers at its expense the SCSI shares but that the SCSI shares will be issued to the scheme shareholders. This is emphasised by note(1) on page 42 of the Scheme Document. The net effect to the shareholder might be the same but the legal effect of the requirement seems to me to be different.

27. There are other minor points which have been raised on the wording of the Scheme document and its relation or otherwise to the explanatory memorandum. It seems to me that really what has probably happened in this case is that the Scheme document was a copy of, or taken in large part from, a previous scheme and it may well be that the meaning of some of the wording was not appreciated but simply copied through. The importance of making sure that the explanatory memorandum ties up with the Scheme of Arrangement and that the Scheme of Arrangement says exactly what is intended to be said, cannot be over-emphasized. It is pertinent to mention at this stage that once a scheme is sanctioned under the provisions of the Ordinance, it is the scheme which is effective and is binding upon the company, the members and, indeed, the creditors. If schemes have not been clearly and properly explained in a simple way that shareholders can be expected to understand they will not be sanctioned by the Court.

THE PETITION

28. Before concluding I should also refer to the Petition. The Petition should make the purpose of the application clear. It should draw the Court's attention to all material facts. It seems to me that when the Petition is examined, the purpose of the reduction is very far from clear. The Company is at present suffering losses which it can not clear. It is, as I have indicated, now quite clear that it is the intention of the reduction of capital to cancel out those losses. In my view, it is quite wrong for the Petition to be presented without making that clear.

29. I wish to leave those responsible for applications such as this in no doubt that in cases such as this where petitions are presented with a view to reduction of capital and approval of schemes of arrangements, matters must be presented fairly, accurately and with candour. On most occasions, there will be no opposite party to test the petitioner's case. It is not for the Court to take up the cudgels and undertake microscopic examination of footnotes to see whether matters have been hidden in corporate documentation which could best be described as masterpieces of obfuscation in need of lengthy consideration if they are to be understood and their secrets revealed. In Chevron Research Company's Extension [1975] FSR1 Whitford, J. approved counsel's submission that petitions are not the place for persuasive advocacy, the facts must be stated. I would add to that that all relevant facts must be stated.

30. As was drawn to my attention at the conclusion of this hearing, the duty on those involved in the presentation of a petition continues long after the reduction is sanctioned. The liquidator, should the company be misfortunate enough to have a liquidator appointed, could potentially challenge a reduction of capital. Legal advisers may be liable for losses to the company. They might even be made liable for losses to the company after takeover if new owners and management of the company were to take the company over. But over and above that, there is the consideration that the Court must be vigilant to protect creditors and those who present petitions for reduction of capital must take all proper care in their presentation.

31. I therefore refuse to make any order on the summons for Directions.