CHAN KA CHING v. AJS CO

HCCW 10/2021 and HCCW 11/2021
(HEARD TOGETHER)

[2021] HKCFI 1947

HCCW 10/2021

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

COMPANIES (WINDING UP) PROCEEDINGS NO 10 OF 2021

_______________________

AND

     HCCW 11/2021

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

COMPANIES (WINDING-UP) PROCEEDINGS NO 11 OF 2021

________________________

________________

JUDGMENT

________________

1.  These are petitions presented by Chan Ka Ching (“the petitioner”) to wind up AJS Company Limited (“AJS”) and PAJS Company Limited (“PAJS”) (collectively “the respondents”) on the ground that the respondents are unable to pay their debts.

Background

2.  Prior to June 2019, the petitioner worked as a beautician in a beauty business called JS Marvelous, a company owned by Lau Sui (“Ms Lau”) and Lui Yuen Kei (“Ms Lui”). According to the petitioner, in October 2018, she was invited to become one of their business partners in setting up new beauty salons. Ms Lau and Ms Lui dispute this and have put forward a different account.

3.  The following is common ground:

(a)   AJS was incorporated on 28 November 2018 with a paid-up share capital of $10,000 divided into 10,000 shares of $1 each.

(b)   Since 2 April 2019, the shares have been held by 4 shareholders being Ms Lui (3500 shares), the petitioner (2500 shares), Ms Lau and Siu Lok Ting (“Ms Siu”) (2000 shares each) (collectively “the shareholders”).

(c)   PAJS was incorporated on 16 May 2019 and has the same shareholding and directorship structure as AJS.

(d)   Ms Lui, Ms Lau and the petitioner have been directors since the respective incorporations of the respondents and Ms Siu became a director in May 2019. The petitioner ceased to be a director on 23 December 2020.

4.  According to the petitioner, the shareholders agreed that each shareholder would contribute to the setting up costs of the new beauty salons by extending a shareholder’s loan to the relevant respondent in amounts proportionate to her shareholding therein and the profits would be distributed to the shareholders in the same proportions.

5.  While the respondents’ version of the ‘arrangement’ the parties reached is different, it is common ground that

(a)  the petitioner advanced $174,551.98 to AJS (“the AJS loan”) and $201,644.59 to PAJS (“the PAJS loan”) (collectively “the loans”);

(b)  each of the loans represented 25% of the total setting up costs of the relevant salon which reflected the petitioner’s shareholding in the relevant respondent;

(c)  Excel spreadsheets recording the monthly inflows and outflows were circulated to the shareholders on a monthly basis between June 2019 and July 2020 and net profits shown in the spreadsheets were distributed to the shareholders pro rata;

(d)  the petitioner received distributions totaling $477,177.36 from AJS and $345,455.12 from PAJS between June 2019 and July 2020; and

(e)  the relationship between the petitioner and the other 3 shareholders of the respondents deteriorated in about November 2020.

6.  It is the petitioner’s case that she was forced out of the respondents and pressured to resign but the other shareholders refuse to repay the loans. On 20 November 2020, the petitioner’s solicitors (“HW”) wrote to the respondents demanding repayment.

7.  On 23 November 2020, HW further alleged that the shareholders of the respondents were paid “monthly dividends” from the profits of the respondents and demanded payment of monthly dividends for October and November 2020 to the petitioner.

8.  Statutory demands were sent on 2 December 2020 to the respondents for repayment of the loans.

9.  The respondents’ solicitors (“TCW”) replied on 22 December 2020 stating that the distributions made to the shareholders in proportion to their respective shareholdings were advance bonus payments to be declared and that there was a consensus that the debts would be repaid by such advancement of bonus.

10.  The winding up petitions were presented on 6 January 2021.

The respondents’ case

11.  The respondents oppose the petitions on the ground that there is a set-off and/or a serious and genuine cross-claim.   

12.  It is now their case that the distributions made by the respondents are unlawful distributions contrary to the Companies Ordinance, Cap 622 (“the Ordinance”) because when they were made, there were no financial statements as required to be prepared by the Ordinance.

13.  On that basis, it was submitted that the petitioner is liable to repay those sums to the respondents and as the amount of the unlawful distributions exceeds the amount of the petitioning debts (i.e. the loans), the petitions should be dismissed.

14.  In any event, the respondents contend that during the period when the unlawful distributions were made, the respondents did not make any accumulated profits.

15.  Given the respondents’ submissions that the distributions were unlawful, it was acknowledged that their initial defence based on set-off was not sustainable and was not pursued.

Legal principles

16.  A cross-claim petition is regarded in the same way as a disputed debt petition. To successfully resist a cross-claim petition, the company has the onus of establishing that its cross-claim is genuine, serious and of substance. There must be supporting relevant details to demonstrate that the cross-claim is based on substantial grounds: see Re Sinom (Hong Kong) Limited [2009] 5 HKLRD 487 at §§11-12.

The respondents’ cross-claims

17.  The following issues arise:

(a)  whether, as a matter of fact, the distributions made to the petitioner are unlawful distributions in contravention of the Ordinance; and, if so,

(b)  whether the respondents have a viable and bona fide claim against the petitioner.

(a) Whether the distributions were unlawful under the Ordinance

18.  Factually, there is no dispute between the parties that distributions made to the shareholders between June 2019 and July 2020 were made based on the cash flow tables of income and expenses set out in Excel spreadsheets (“the cash flow tables”). 

19.  Part 6 of the Ordinance governs the distribution of profits and assets. For present purposes, the respondents invited attention to the following key provisions:

(1)  a company may only make a distribution out of the profits available for distribution, which are its accumulated, realized profits less its accumulated, realized losses: section 297

(2)  the amount of a distribution that may be made without contravening section 297[1] is determined by reference to the “financial items” as stated in the financial statements specified in Division 4: section 302

(3)  “financial items” means “all of the following - (a) profits, losses, assets and liabilities; (b) provisions; (c) share capital and reserves (including distributable reserves)”: section 290

(4)  the requirements of financial statements specified for the purposes of section 302 are set out in sections 304-306[2].

20.  The cash flow tables do not show assets, liabilities, provisions, share capital and reserves which are some of the components of “financial items” (as defined in section 290) “financial statements” must include[3]. The question whether or not there has been a contravention does not turn on whether the company making the distribution knew the facts or knew the legal rules: It’s a Wrap (UK) Ltd (In Liq) v Gula [2006] BCC 626 (“Wrap”) §43, per Chadwick LJ

21.  The respondents submitted that the legal consequence must be that the distributions were unlawful as they were made in contravention of section 297 of the Ordinance.

22.  Ms Tania Tse, counsel for the petitioner, disagreed with the respondents’ interpretation of the relevant sections of the Ordinance and specifically, section 306 (1) (b) which provides as follows:

“(1) If the distribution is proposed to be declared before any financial statements are laid before the company in general meeting … the financial statements specified for the purposes of section 302 are the company’s financial statements

(a) in the case of a listed company …

(b) in the case of any other company, that is necessary to enable a reasonable judgment to be made as to the amounts of the financial items.”

23.  Ms Tse submitted that if the legislature had intended to say that a financial statement must contain all the financial items in order to satisfy the formalities of the statutory requirement under the Ordinance, it would be more simple to say that the financial statement should state all the financial items rather than to say that they should be necessary to enable a reasonable judgment to be made as to the amount of the financial items.

24.  It is unclear what meaning the petitioner would attribute to section 306 (1) (b) as it stands since it is not open to the petitioner to rewrite legislation. It is entirely unhelpful to be critical of the wording of a statutory provision without clearly articulating an alternative interpretation of the wording as it stands.

25.  Moreover, it is incorrect to characterize the requirements of a financial statement for the purposes of sections 302, 304-306 as “formalities” once the underlying rationale[4] for regulating distributions of dividends is understood. In commenting on similar provisions under the English Act, Arden LJ highlighted the importance of the company’s accounts as the reference point for assessing whether there are profits available for distribution[5].

26.  In those circumstances, I am of the view that the respondents’ interpretation of the key provisions mentioned above is correct and that the distributions contravened section 297. Section 301 (1) (a) (ii) is thus engaged.

(b) whether the respondents have a viable and bona fide claim against the petitioner

27.  This issue involves the matters considered under the sub-headings below.

 (i) whether the petitioner is liable to repay the respondents

28.  This turns on whether section 301 (1) (b) is satisfied. It provides as follows

“(b) at the time of the distribution, the member knows or has reasonable grounds for believing that the distribution … is made in contravention of that section …

Where section 301 (1) (a) and (b) apply and if the distribution is made in cash, the member is liable to repay the distribution: section 301 (2).

29.  As Arden LJ (she then was) explained in Wrap at §18, it is a fundamental rule of English company law that the Companies Acts by implication prohibit a company from returning capital to shareholders except in one of the ways expressly permitted by the Acts. The underlying rationale for this rule is that capital constitutes the security for creditors. A distribution that is not paid out of profits available for distribution is paid out of the reserves that must remain available for the payment of debts. The claims of shareholders rank behind those of creditors. Any defence given to shareholders who receive a distribution paid in contravention of the Act detracts from the protection available to creditors.

30.  The core issue to be determined is the meaning of “knowledge” for the purposes of section 301 (1) (b). Wrap concerned the interpretation of section 277 (1) which provision is substantially similar to section 301 (1) and (2) of the Ordinance. As there are no Hong Kong authorities on section 301, Wrap merits close consideration since both parties rely on it.

31.  The issue on appeal in Wrap was whether “knowledge” required for the purposes of the UK Act is knowledge of (i) “the relevant facts constituting the contravention” or (ii) “those facts and in addition the fact that the Act was contravened”. The court unanimously held that (i) is the correct position as a matter of law.

32.  Section 277 (1) was designed to implement Art. 16[6] of the 2^nd EC directive on company law (“the 2^nd directive”). Under the Marleasing principle[7], the UK courts must interpret section 277 (1) in a manner that is so far as possible in conformity with the provisions and objectives of Art.16. That means that the court must find the meaning of Art. 16 and then see whether section 277 (1) can bear that meaning. For that purpose, the court may choose an interpretation of s 277 (1) which is not its natural meaning[8].

33.  Pausing here, it is fair to state that the purport of Art. 16 and section 301 is similar although differently expressed.

34.  Arden LJ held (at §2(D)) that on its true construction, Art. 16 means that a shareholder is liable to return a distribution if he knows or could not have been unaware that it was paid in circumstances which amount to a contravention of the restrictions on distributions in the 2^nd directive whether or not he knew of those restrictions. There is nothing in the wording or purpose of Art. 16 to oust the general principle that a person is deemed to know the law[9] given that the purpose of the provision is to support the maintenance of capital rule.

35.  Arden LJ went on to hold (at §2 (E)) that s 277 (1) of the UK Act, must be interpreted as meaning that the shareholder cannot claim that he is not liable to return a distribution because he did not know of the restrictions in the Act on the making of distributions. He will be liable if he knew or ought reasonably to have known[10] of the facts which mean that the distribution contravened the requirements of the Act.

36.  Thus, a shareholder will be liable if he has fact-based knowledge[11] that the distribution contravened the requirements of the Act. Such inferred actual knowledge is a form of actual knowledge. In that regard, all the company must prove is that the shareholders knew the facts constituting the factual position that the distributions were contrary to the Act[12].

37.  The court in Wrap thus rejected the shareholder’s central proposition that a shareholder must in all circumstances have knowledge of the requirement of the Act that the distribution contravened.

38.  Chadwick LJ put the issue as follows: is it necessary to establish that the member knows (or is to be taken to know) the legal rules and the consequences of those rules when properly applied to facts?

39.  As that question in Wrap did not arise in a purely domestic context (in that effect had to be given to the 2^nd directive), Chadwick LJ agreed with the reasoning and judgment of Arden LJ. Moreover, on the facts, the case was one of actual knowledge in that the directors making the distributions knew that the company was trading at a loss at the relevant time. For those reasons, the court did not consider it necessary to decide what meaning should be given to the words “has reasonable grounds for believing that …”.

40.  Nevertheless, Chadwick LJ observed[13] that had the question arisen in a purely domestic context, some support might be found in the authorities for the conclusion that knowledge of the facts alone is not sufficient: what is required is knowledge that, on those facts, the distribution does contravene one or other of the statutory provisions.

41.  He considered it was “by no means self-evident that they are to be equated with “constructive knowledge” if by that expression is meant knowledge which a person would have but for his negligence[14]”. He also proffered several alternatives regarding “knowledge” which the legislature has sought to describe in section 277 (1), namely, knowledge which the member has and knowledge which the member “must be taken to have” or, perhaps, “may reasonably be taken to have[15]” but considered it unnecessary to decide between those alternatives.

42.  I now turn to the parties’ respective submissions on the application of Wrap.

43.  The petitioner submitted that at all material times she was just a beautician, not a person equipped with the expertise to read financial statements, and did not have knowledge that the distributions were made out of amounts that were not available profits within section 297. They had been provided to her by Ms Lau, a person experienced in operating beauty salons on whose expertise the petitioner relied. Moreover, none of the other shareholders have repaid or been asked to do so and it is unfair for the petitioner to be so targeted.

44.  The petitioner referred to Wrap at §25 and submitted that the court should take into account circumstances that diminish a shareholder’s responsibility.

45.  Pausing here, I would observe that a person who chooses to conduct business through the medium of a company derives considerable benefits, not least in terms of limited liability. In turn, the Ordinance contain provisions designed to preserve capital so as to protect creditors.

46.  The respondents submitted that the law is as stated in Wrap and the principles to be applied are those set out in §36 above. Since the petitioner had the relevant facts in her possession, the distributions to her were unlawful.

47.  The 2^nd directive is not relevant when it comes to construing section 301 since EC directives have no application in Hong Kong. The respondents submitted that it would be ‘rational’ for them to apply in Hong Kong because what is at stake is the creditors’ interest. That appears to be a novel suggestion and one that I am not minded to accept, absent authority.

48.  Neither counsel addressed the court on whether the interpretation of Art. 16 had any effect or impact on the natural meaning of section 277 (1)[16]. Nor were counsel in a position to shed light on the provenance of section 301 (1) relevant to the proper interpretation of “knowledge”.

49.  In those circumstances, Wrap cannot be considered as dispositive on the issue of “knowledge” for the purposes of section 301 (1). In my view, it is a difficult matter for future determination by another court.  

(ii) whether, and to what extent, a declaration of dividends which exceeds the available profits for distribution is void

50.  In Ms Lau’s affirmation filed on behalf of AJS in opposition petition, management accounts for the periods 28 November 2018 to 31 March 2020 and 1 April 2020 to 30 November 2020 were exhibited to show that AJS made no accumulated profits at all.

51.  The petitioner’s stance is simply that in making monthly distributions to shareholders Ms Lau must have believed the respondents to have made profits each month as per the cash flow tables.

52.  The petitioner submitted that she is entitled to retain the distributions as they were only alleged to be in excess of the available profits of the respondents long after the same had been distributed to the shareholders. Further, a declaration of dividends which exceeds the available profits is not void, but the amount of the excess, if identified before payment, be payable, citing Re G & G Trading Limited (Company Registration No 0642120) HCCW 8/2016, [2018] HKCFI 192, §11.

53.  Re G & G concerned dividends declared by the company over several years based on audited statements. The petitioning debt was the unpaid dividends which the petitioner, a shareholder of the company claimed to be due but the company doubted their correctness.

54.  Factually, the case is distinguishable: here, the respondents are in breach of their obligations under the Ordinance as even now (almost a year after they should have been filed) no audited accounts in respect of the period from commencement of the business in November 2018 to 31 March 2020 have been filed. A draft of such accounts was circulated to shareholders on 20 November 2020 but no steps have been taken by the respondents to finalize and file those accounts.

55.  The company’s accounts are of critical importance for any dividend distribution: this is because, as earlier noted, the financial items that such financial statements must contain constitute the reference point for the distribution of dividends.

56.  On the facts as they stand, the petitioner can derive no assistance from Re G & G.

(iii) whether the amount of cross-claim exceeds the amount of the petitioning debt

57.  In the present case, the cash flow tables are not financial statements required to be prepared under the Ordinance. In the event of the respondents succeeding on the issue of ‘knowledge’, section 301 (1) the issue raised under this subheading becomes irrelevant.

58.  This issue arose out of the respondents’ evidence which referred to the purchase of beauty service packages by customers who pay in advance for a number of treatments over a period of time. The cash flow tables would record the price of a package in the month it was purchased but the fees from the actual service rendered to the customer would only be a fraction of the total package price.

59.  In §40 of her written submissions, the petitioner took issue with the respondents’ failure to state the actual income and/or the correct accrued profits in the cash flow tables which somehow meant that the respondents were unable to show that the cross-claim exceeds the amount of the petitioning debt. The petitioner’s reasoning (in §40) is not easy to follow.

60.  Be that as it may, in Allied Carpets Group plc v Nethercott [2001] BCC 81, the company sought repayment of dividends received by a former managing director on the basis that he held them on constructive trust for the company. The accounts (which the defendant had authorized) were based on a methodology that did not give a true and fair view of the items relevant to dividend distribution and so were not ‘properly prepared’ as required by statute. What the result would have been if the accounts had been rewritten to reflect the stated accounting policy was considered irrelevant.

(iv) whether the cross-claims are genuine

61.  The respondents exhibited management accounts dated 30 March 2021 which they caused to be prepared subsequent to the commencement of these proceedings.

62.  The petitioner submitted that the management accounts are largely inconsistent with the contemporaneous financial records (i.e. the cash flow tables) provided by Ms Lau. Several examples were highlighted: (a) expenses for the period increased from approximately $850,000 to $1.2 million; and (b) the revenue of AJS shown in the cash flow tables as approximately $2 million but was drastically understated in the management accounts as approximately $580,000.

63.  As to (a), the expenses shown in the management accounts include items that do not appear in the cash flow tables such as depreciation, MPF and penalty on MPF. As to (b), the difference of over $1.4 million, that is accounted for by the item “receipt in advance” under “current liabilities” of approximately $1.5 million which when added with the $580,000 figure total just over $2 million which is similar to that calculated from the cash flow tables.

64.  It would appear that the ‘discrepancies’ the petitioner highlighted are largely explicable and do not undermine the management accounts that have been professionally prepared.

(v) inability to litigate

65.  The petitioner submitted that apart from the respondents having to show that the cross-claims are genuine and of substance, they must also show that they have been unable to litigate them, citing Re Engineering Company Limited CACV 1896/2001, unreported, 20 February 2002 at §16 applying Re Bayoil SA [1999] 1 BCLC 62.

66.  The respondents have not initiated any proceedings against any of the shareholders. They rely on the factual matrix.

67.  In the respondents’ letter of 22 December 2020, there was no mention of the issue of unlawful distributions. That issue was not brought to the petitioner’s attention until 5 February 2021, approximately a month after the petitions were presented. Upon the presentation of the petitions, the respondents were not in any position to commence legal proceedings.

68.  The factual matrix in the present case is such that the respondents have provided an acceptable explanation why the unlawful distributions claims have not been litigated: but for the petitions, the issue of unlawful distributions might not have come to light.

69.  That aside, subsequent to Re SY Engineering, the English Court of Appeal in Popely v Popely [2004] EWCA Civ 463 had occasion to consider the question if inability to litigate should be part of the requirement in the principles established in Re Bayoil and concluded (at §§123-124 after reviewing other English authorities) that there was no absolute requirement although delay in the prosecution of the cross-claim could well throw doubt on the genuineness of the cross-claim: see Re Landune International Limited [2005] 4 HKLRD 46 adopting theEnglishapproach.

Conclusion on section 301

70.  Although what constitutes “knowledge” for the purposes of section 301 (1) (b) remains arguable for the reasons explained above, the respondents have raised a genuine and serious cross-claim. In my view, it is not a cross-claim that a court would strike out as unsustainable in law.

71.  It follows that the petitions fall to be dismissed.

Generally

72.  Whilst the respondents have raised an arguable defence to the winding up petitions based on unmet statutory demands, it is incumbent on the respondents (who have identified unlawful distributions made to all the shareholders) to take appropriate steps to recover all such unlawful distributions made to all the shareholders (including the petitioner) and to ensure that the respondents are compliant in every respect with the requirements of the Ordinance.   

73.  That the petitioner has grievances in the way she has been treated by the other shareholders is apparent from her affirmations, not to mention her allegations of misappropriation[17] of the respondents’ assets by Ms Lau and Ms Lui. If there has been unfairly prejudicial conduct on the part of the other shareholders, it is open to the petitioner (if so advised) to seek appropriate relief.

Order

74.  Accordingly, the petitions are dismissed.

75.  There is to be an order nisi that there be no order as to costs for these petitions.