JENCO LTD. v. EASTERN FLOWER LTD. AND OTHERS

CWU No. 631 of 1996

IN THE SUPREME COURT OF HONG KONG

HIGH COURT

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D E C I S I O N

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1. This is an application on behalf of the Petitioner for the appointment of provisional liquidators and an application under Section 182 for validation of disposal of assets by the Company.

2. Before I proceed to the main part of my Decision, I would like to observe this, that this matter came before me for directions last year. Those directions were given. As often happens, they were more honoured in their breach than in their observance. The extent of the breach is that evidence was still being served, and I might say some of it relevant evidence, even after the Petitioner had made submissions to me on Tuesday which was the first day of this hearing. I have to say that certain aspects of the evidence are clearly wanting. This seems to me to be a symptom of, I regret, bad preparation because in some respects I had to ask for guidance as to where support for certain submissions was to be found in the evidence; after much scrambling through the bundles, that support was simply not there. This is a matter which in my view requires conclusion with some expedition. I am afraid that if the case is continued to be prepared like this, this Court cannot see its way to permitting flexibility in the preparation of the case because I regret some, at least, of those involved in the preparation have not demonstrated their capacity to be able to prepare the case properly and on time.

3. The history of this case goes back sometime but because this is a matter of an interlocutory nature and the evidence is by no means complete, it is important that I do not make findings of fact or indeed refer to too many of the facts unnecessarily.

4. The history goes back to the 1970s when there was a construction company by the name of "Hung Wan Construction Company". Eventually, that was formed into a limited company using the same name "Hung Wan Construction Company Limited". That seems to have been a profitable company. The profits from that company were put into a joint account. There were four major participants in that company, three of whom survive, the fourth unfortunately, having died and, it seems, prior to that had taken less and less part in the business.

5. The profits from the Hung Wan Construction Company Limited eventually found their way into the foundation for the "Eastern Flower Limited" which is the company in suit. That company is really a one item company. The one item being a plot of land which was bought in 1985 in Cameron Road, Kowloon and on which office premises were built, the finance for that coming from the dividends of the Hung Wan Construction Company Limited and from bank finance. Because of the nature of the business, however, the bank finance was soon paid off. The banking facilities which were originally taken up were extended in 1991 to provide facilities which covered the Hung Wan Construction Company Limited. It was thought judicious to do that at that stage because Hung Wan might need financial backing in order to show it was capable of fulfilling the regulations as to construction companies which could enjoy government contracts.

6. In addition to that, it seems that some of the profits from Eastern Flower Limited have been used for property investment in Australia, although little has been said about that in the evidence.

7. The present structure of the company took its final form in 1990. There seems to be confusion in paragraphs 32 and 35 of the Petition but there was no dispute that effectively there are 3 persons behind that company: a Mr. Yu and his interest in the company is held by the Petitioner; a Mr. Cheung and his interest is held by the 2nd Respondent company and a Mr. Kwan and his interest is held by his wife who is the 3rd Respondent. The 4th Respondent only holds a minor shareholding and there was never any management responsibility vested in the persons behind the 4th Respondent who were merely engaged in a minor role in the running of Hung Wan and, of course, the present company.

8. Although the Company, Eastern Flower Limited, and Hung Wan Construction Company Limited are separate companies, it should be noted that the shareholding is, I am told, identical in that the same parties own the same proportion of shares in each company. All that means is that there is a common shareholding; it does not make one company an associated company and certainly does not make one company a subsidiary company of the other. It does seem, however, that what happens in one company may be reflected, particularly as regards the management, in the other company.

9. In 1993, Mr. Cheung, who is the person behind the 2nd Respondent, introduced to Hung Wan Construction Company Limited the prospect of an investment in a building project in Shanghai called the Shanghai Scientific Centre Project. The total projected construction cost of that project is put in the evidence as having been approximately RMB180 million. Mr. Yu in his evidence says that it was his understanding that the contemplated capital outlay by Hung Wan was only RMB45 million, that is 25% of the total cost of investment. The remainder of the finance was anticipated to come from mortgages, pre-sale of the property and so forth.

10. The arrangement was that Mr. Cheung himself would have a 20% interest in the Shanghai Scientific Centre Project and one of Mr. Cheung's sons and one of Mr. Kwan's sons, who would be intimately involved in that project, would have 5% each.

11. For reasons which are partly in dispute and partly unnecessary for me to go into, it seems that at best it might be said that Hung Wan Construction Company Limited's interest in the Shanghai Scientific Centre Project has not been properly secured. Whether this was realised or not at the outset I do not know, at any rate once the matter was put in hand it became apparent that Hung Wan could not be a direct investor. Its investment has had to be made through a PRC company. On the petition it is to be alleged that that investment is an illegal investment but for the present purposes, I would ignore that allegation and deal with it simply on the basis that the best that can be said is that the investment in the Shanghai Scientific Centre Project is held by the PRC company on trust for Hung Wan. Whether that trust could ever be enforced is another matter.

12. What has transpired, however, is as set out in the Respondents' evidence that Hung Wan Construction Company Limited urgently needs $50 million for the Shanghai project and a total of some $100-$120 million are needed over the next 12 months.

13. Hung Wan Construction Company Limited also wishes to tender for government projects and those projects which have been referred to in the evidence are by no means small. I would say this, however, that it does appear to me that the construction business of Hung Wan in Hong Kong appears, at least in the past, to have been highly profitable. Hence, although there may be expensive projects in Hong Kong these might not be hazardous. I am not prepared to say the same about the project in Shanghai.

14. One of the difficulties that Hung Wan now finds itself in is that it is likely to be the case that it cannot satisfy the capital requirements for construction companies undertaking government contracts in Hong Kong. The reason for that is that the net current assets appear to have dwindled to a minus amount. Hung Wan's audited accounts are not in my view favourably impressive. They have had to be re-audited for reasons which I find do not inspire confidence in the first place. Even the re-audited accounts have discrepancies which have not been explained. I drew attention during the course of argument to the fact that I noticed that the deferred income in the 1994 accounts appeared to have been adjusted on a historical basis in the 1995 accounts. The best analysis that I can make of that is that there may have been an adjustment to the figure apportioned to "work in progress". Of course, when accounts are prepared, work in progress is often a matter of assessment and estimation. Hence, it could be said that the figure for work in progress is a figure which could be manipulated. Whether or not that has happened in this case, I know not. All I know is that after the accounts had been re-audited, there still seems to be a discrepancy between the same figure as appearing in one set of accounts as in another.

15. Be that as it may, when one turns to the final set of accounts for Hung Wan which are available and have been re-audited, one now sees that net current liabilities put at a figure of $1.721 million. Again without knowing more, it is quite possible that the reason for the dramatic drop in the net current assets over the years has been the Shanghai project.

16. It is often difficult to pinpoint what are the reasons for a breakdown in relationship. It does seem, however, that both these companies were effectively partnerships between three parties, certainly, as they have been carried on over the last 7 years. The Petitioner attributes the breakdown to what has been identified as the Chinese note. That is a document which was prepared by Mr. Cheung, the 2nd Respondent, and produced at a meeting between the Petitioner, Mr. Cheung and Mr. Kwan on the 15th February 1996. It is a document which in effect says to the Petitioner that instead of his shareholding being of some value it is of a negative value. It is a document which I do not propose to dwell on at any length, but it seeks to rely upon the fact that prior to Mr. Yu taking part in the original venture which resulted in the setting up of the Hung Wan Construction Company Limited, Mr. Cheung and Mr. Kwan had been working for nearly 5 years and receiving no salary. The calculation then goes on in a rather tenuous, to say the least, manner to capitalise that contribution and thereby to demonstrate that Mr. Kwan and Mr. Cheung were entitled to virtually the whole of the company and therefore the whole of the venture, whereas Mr. Yu owed something like $40 million once the dividend distributions had been taken into account.

17. It is not surprising that a document like that caused some consternation. Mr. Tang Q.C. on behalf of the Respondents says that that document was merely a tit-for-tat, the tat in this instance being Mr. Yu's dinner party at the Kowloon Tong Club at which it is alleged that Mr. Yu tried to instigate the exclusion of Mr. Cheung from the companies. I know not whether that is correct or not. There has been, no doubt as a result of current legal advice, a distinct attempt to dissociate the Respondents from this and indeed to play this Chinese Note down. However, it does not seem that all the legal advice which the Respondents received was of the same ilk because in letters of the 26th April of last year and 6th August of last year from the Respondents' solicitors, it seems as though it was still being maintained that this Chinese Note was valid.

18. It seems that, Mr. Yu has other matters of which he has, potentially at least, legitimate complaint. It seems that he has not had full access to the information as to the various companies' accounts and businesses. Mr. Cheung and Mr. Kwan's sons have been put on the board of Hung Wan Construction Company Limited whereas he has been removed from being the company secretary. He has been told that he is a non-executive director although it is quite clear that right from the outset he was intended to have an equal say in the running of the businesses.

19. Importantly, over the last 18 months or so, it seems that the income, which is primarily the rental income from the Company, has been directed into Hung Wan Construction Company Limited and, primarily, one would derive from that, for the Shanghai project. This matter, again, has not it seems been communicated to Mr. Yu immediately but knowledge of it has come to him rather later than the events and is certainly a matter over which he has had no control.

20. It is in dispute between the parties as to whether that income should have been so used. I find myself in this difficulty and this goes back to the complaint which I made initially, that I find the evidence totally unsatisfactory as to what has been termed the joint account. It seems that right at the beginning of the arrangements between the parties, going back to the 1970's there was a joint account and it seems that that joint account is still in the existence. How it has been used particularly in recent years and how it was intended to be used, I regret is not clear on the evidence. It has been suggested in the course of argument that effectively what happened was that dividends of the Company were declared, paid into the joint account and used for the purposes of Hung Wan Construction Company Limited. I find little support for such a sweeping description of the scenario in the evidence which has been filed today.

21. It does appear that over the years and at least up until 1995 the Hung Wan Construction Company Limited was making very substantial profits. In 1995, the profits went down from what had been $30 million in the previous year to $916,000.00. What need there was for money from the Easter Flower Company Limited, I know not. What is clear, however, is that the banking facilities that were arranged by the mortgage which Eastern Flower Company Limited had in 1991 had for the most part not been used by the Hung Wan Construction Company Limited. Indeed, the Hung Wan Construction Company Limited was until 1994 apparently able to distribute quite large amounts in dividends.

22. Come August 1995, it appears that $6 million was transferred from this joint account for use for the Shanghai project. In March of 1996 $1.79 million was transferred from Eastern Flower Limited to Hung Wan Construction Company Limited. The basis upon which that transfer was made, I know not. It does not appear to have been a declared dividend. It does not appear to have been a dividend paid into the joint account and then transferred to Hung Wan Construction Company Limited. The latest affidavit from Mr. Cheung merely states that it was transferred in March 1996 to and for the purpose of the Shanghai project.

23. Paragraph 4 of his 6th affirmation is perhaps more illuminating to this extent that there was a further payment of $7 million which, as far as I can see, was not known about by the Petitioner until the filing of this evidence. That payment was made in July/August of 1996. Mr. Cheung says that these transfers were made with the approval of all the shareholders and directors of Hung Wan and the Eastern Flower Limited except Mr. Yu and his nominees, and it is said that they were required for the Shanghai project and were so utilised.

24. When this matter came before me on the 5th December, it is said, although I did not keep a record of it, that counsel acting for the Respondents informed the court that rental income from Eastern Flower Centre for November 1996 had been paid into the bank account of Hung Wan and that the Respondents had undertaken to rectify the situation as soon as possible. This seems to be confirmed by paragraph 6 of Mr. Cheung's 6th affirmation where he says that the rental after September 1996 is "now" deposited in the accounts of the 1st Respondent.

25. It seems to me with all this in mind that the Petitioner has made out a prima facie case for winding up the Company. This was, it seems to me on the face of what I have seen, clearly a company which was in the form of a quasi-partnership. The purpose of it was to hold the Eastern Flower Centre and receive the rents. Mr. Tang Q.C. urged very strongly that this would be a case where the Court would order a buyout of shares. That may be the case or it might not. At this stage, it is too early to say. But it does seem to be a case where the trust and confidence between the partners has broken down. I see no prospect of it being repaired and I see it difficult for the arrangement as it existed in the past to continue unless there is a considerable change of heart.

26. The next question which I consider is whether the assets of the Company are in jeopardy. I take into account first of all that it seems that the Petitioner in the form of Mr. Yu has been excluded from management and clearly up until the presentation of this Petition, the funds of the Company have been pumped into Hung Wan Construction Company Limited and there is considerable cause for concern. Hung Wan Construction Company Limited has apparently a heavy financial outflow into a risky investment. It is at present in some financial difficulties as demonstrated by its own accounts. The Petitioner seems to have been excluded from control and has very little knowledge about what transpires within Hung Wan Construction Company Limited.

27. At the conclusion of the hearing on Tuesday evening, I suggested to the Respondents' counsel that the Respondents may like to think of proposals which could safeguard the Petitioner in view of the possibility of the investment which Hung Wan Construction Company Limited was making, going bad. Clearly there are difficulties with the Shanghai project . Clearly it is now costing in cash far more than was contemplated. It also seems that the prospect of a return from the Shanghai project is not anything like what it was once assumed to be.

28. Unfortunately, nothing concrete has been proposed and at the moment I cannot see a viable way of protecting the Petitioner's interest in the company and still allowing effectively what the Respondents wish to do which is to use their interest in the 1st Respondent as security to enable Hung Wan Construction Company Limited to carry on with the venture in Shanghai.

Further submission by counsel for the Respondents

29. At this stage of my decision, I was interrupted and proffered an undertaking by the Respondents. I do not find this undertaking satisfactory at the moment. I think that it verges on a potential reduction of capital. As I see the situation it is this. Unfortunately, the relationship between the parties has broken down. Although the Respondents have urged me that the support which is required for the Hung Wan Construction Company Limited should be confined to their construction business in Hong Kong, the difficulty with that is that one cannot divide the liabilities of the Hung Wan Construction Company Limited between those in Hong Kong and Shanghai. In effect even if the financial support, which at present appears is going to have to be very substantial, were given solely to the construction business in Hong Kong that would not safeguard the situation. It would only be necessary to prop up Hung Wan Construction Company Limited because all its other assets had been devoted to supporting the Shanghai project.

30. I do bear in mind that the decision in this case produces a hard result to the extent that it may give the Petitioner a considerable bargaining power, but those who produce documents such as that which has been called the Chinese Note live by the methods which they adopt and if it brings about a breakdown in the relationship between the parties, I regret they have to live with that and have to cope with it.

31. In my view, the assets of this Company have been put in jeopardy. They have been used in a manner which as I have indicated is unexplained and I consider it is right to appoint provisional liquidators.