PACIFIC DUNLOP GARMENTS LTD v. FUNDAMENTAL GLOBAL LTD AND OTHERS

CACV 184/2013

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF APPEAL

CIVIL APPEAL NO. 184 OF 2013

(ON APPEAL FROM HCA NO. 1655 OF 2008)

________________________

________________________

________________________

REASONS FOR JUDGMENT

________________________

Hon Cheung JA:

1.  I agree with the Reasons for Judgment of Kwan JA.

Hon Yuen JA:

2.  I agree with the Reasons for Judgment of Kwan JA.

Hon Kwan JA:

3.  This is the defendants’ appeal against the judgment of A Chan J handed down on 7 August 2013 after a three-day trial in June 2013.  The judge held in favour of the plaintiff that it had validly exercised the option to purchase a property situate at Jin Li Industrial Zone, Sanjiao Town, Zhongshan City, Guangdong, China (“the Property”).  He granted a declaration accordingly and ordered the agreement for the sale and purchase of the Property to be specifically performed, with damages for the breach of contract of the 1^st to 3^rd defendants to be assessed.

4.  We dismissed the defendants’ appeal with costs at the conclusion of the hearing.  These are the reasons for dismissing the appeal.

The background

5.  The relevant background matters may be set out as follows.

6.  The 1^st to 3^rd defendants are companies incorporated in the British Virgin Islands and used to own all the shares in Eunice Lingerie Ltd (“EHK”), which was in the business of manufacturing and sale of lingerie.  EHK has a wholly owned subsidiary in China, Eunice Lingerie (Zhongshan) Ltd (“EZS”), which owns the Property.  After the commencement of these proceedings, the shares of the 1^st to 3^rd defendants in EHK were transferred to the 4^th defendant.  The 4^th defendant was joined to be bound by the outcome of this action.  I will refer to the 1^st to 3^rd defendants collectively as “the defendants”.

7.  The plaintiff, which was and is in the business of production and distribution of garments, wanted to expand its manufacturing operations in China.  On 18 January 2006, the plaintiff and the defendants entered into an agreement entitled “Binding Heads of Agreement – Sale and Purchase of all of the Shares in Eunice Lingerie Limited” (“the Agreement”), by which the defendants agreed to sell to the plaintiff all the shares in EHK for $31.5 million.  Initially, the plaintiff had intended to purchase the Property but as this would attract tax liability the parties agreed on the sale and purchase of the shares to avoid the tax.

8.  By the Agreement, the plaintiff was to pay a non-refundable deposit on the signing of the Agreement and 12 non-refundable monthly instalments from March 2006.  The final instalment of $28.8 million was to be paid on 1 June 2007 or such later time as agreed by the parties.  It was provided that EZS should grant a licence to the plaintiff to occupy the Property from March 2006 to February 2007.  The parties also agreed they would use their best endeavour to sign an “official contract” by mid February 2006 or as agreed by both parties and the lawyer appointed by the defendants would arrange for the official contract.

9.  The provision of central importance to this action is clause 4 and it provided as follows:

“The Purchaser [i.e. the plaintiff] has the option to acquire all of the shares of Eunice Lingerie Ltd which owns all of the shares of Eunice Lingerie (Zhongshan) Ltd at the final installment of HK$28,800,000 on 1^st June 2007, or such later time if delays are caused by the Vendor [i.e. the defendants] in effecting the transfer of the said shares or the said Physical Property. Vendor will provide the necessary and reasonable warranties in such transaction including

…

· Eunice Lingerie Ltd and Eunice Lingerie (Zhongshan) Ltd are debt free and there are no outstanding charges or liens against these two companies at the transfer date. In case on the transfer date, it is discovered that Eunice Lingerie Ltd and/or Eunice Lingerie (Zhongshan) Ltd are not debt free, the Vendor will indemnify the Purchaser of the actual amount of the debt outstanding.

Should issues arise in transacting the shares which cause unacceptable risks to either the Purchaser or the Vendor, then both parties agree to transact to sale and purchase of the sale Property instead of the shares. The purchase price will be the same as the sale of shares.

…”.

10.  The plaintiff duly paid the deposit and the 12 monthly instalments and two further sums at the request of the defendants to top up the total amount paid prior to completion to 15% of the purchase price.

11.  A draft formal sale and purchase agreement prepared by the defendants’ solicitors was sent to the plaintiff on 15 February 2006.  Despite numerous chasers, the plaintiff did not respond to the draft until 23 May 2007 when it sent a revised draft to the defendants, by which it required a director of EHK and a director of EZS to provide a personal guarantee up to 100% of the purchase price to back up the warranties of the defendants in the Agreement.  This request for personal guarantee was turned down by the defendants.  It was apparently after the revised draft sale and purchase agreement was sent to the defendants that the plaintiff carried out the due diligence exercise for the purchase of the shares in EHK.  There were meetings and email exchanges on this between the plaintiff and the defendants from 1 June 2007.

12.  The plaintiff contended that the due diligence exercise identified “unacceptable” risks to it as the purchaser of the shares.  Accordingly, on 4 July 2007, it demanded that the transaction for the sale and purchase of the shares be turned into the sale and purchase of the Property, pursuant to clause 4 of the Agreement.  The defendants did not agree to this.  There were further exchanges between the parties during July to October 2007 in an attempt to resolve their differences.  On 29 August 2007, the defendants provided to the plaintiff a draft audited report of EHK covering the period from its incorporation in August 2002 to 30 June 2007 and the plaintiff raised a number of queries regarding the draft audited report.

13.  Eventually, the defendants caused their solicitors to write to the plaintiff on 20 October 2007 alleging that the plaintiff was in breach of the Agreement in failing to pay the balance of the purchase price.  The defendants gave the plaintiff one last opportunity to pay the outstanding consideration with interest on or before 8 November 2007, failing which the defendants would demand that the plaintiff should vacate the Property and return the same to the defendants and legal proceedings would be issued against the plaintiff for breach of contract without further notice.

14.  The plaintiff brought this action on 4 September 2008 seeking specific performance of the Agreement for the sale and purchase of the Property.

The judgment below

15.  At issue was whether the plaintiff was entitled to exercise the option provided in clause 4 of the Agreement to turn the sale and purchase of the shares into the sale and purchase of the Property.  This turned on whether there were “unacceptable risks to … the Purchaser” in the acquisition of the shares.

16.  The risks that were regarded as unacceptable to the plaintiff were set out in §27 of the judgment:

“(1) The draft auditor’s report of Eunice HK (for the period ending 30 June 2007) was heavily qualified by the auditors given the paucity of the information and documents made available to them.

(2) Incomplete accounting records of Eunice Zhongshan were provided by the Defendants to the Plaintiff.

(3) Eunice HK made shareholder’s loans to Eunice Zhongshan which were not registered with the Mainland authorities, in breach of foreign debt and foreign exchange rules in the PRC.

(4) Discrepancies in the book value of PP&E and buildings in the draft audited report of Eunice HK and audited report of Eunice Zhongshan suggested possible understatement of property value which may lead to extra income tax liability in the PRC.

(5) Eunice Zhongshan sold plants and equipments without reporting to the PRC tax authorities, resulting in potential tax liability.

(6) The Defendants’ failure and/or refusal to provide adequate warranties to the Plaintiff, limiting their cap on liability at HK$1 million and also refusing to provide personal guarantees – bearing in mind that the 1st to 3rd Defendants are BVI ‘shell’ companies.”

17.  On the question whether “unacceptable risks” are to be looked at subjectively, i.e. from the point of view of the plaintiff, or objectively against some kind of reasonable standard, the judge held on a proper construction that the phrase “unacceptable risks to … the Purchaser” has a subjective element, having considered these cases decided in New Zealand – Katz v Jones [1967] NZLR 861; North Shore Demolitions Ltd v McKay [1978] 1 NZLR 454; and Lerner v Schiehallion Nominees Ltd [2003] 2 NZLR 671.  Thus, whether the risks complained of were unacceptable was to be decided according to the subjective views of the plaintiff, subject to an implied term that the plaintiff must make its decision in good faith (§§46, 53 to 59 of the judgment).

18.  As to the next question whether the plaintiff, acting bona fide, had found there were unacceptable risks, the judge held that the heavily qualified draft audited report of EHK, coupled with the fact that the plaintiff had not been provided with all the books and records of EZS, led to the inescapable conclusion that the plaintiff had acted bona fide in taking the view there were unacceptable risks in acquiring the shares (§§61 to 63 of the judgment).

19.  Although the plaintiff had failed to pay the balance of the consideration on 1 June 2007, the Agreement was kept alive when the plaintiff exercised the option to turn the sale and purchase of the shares into that of the Property on 4 July 2007, as it was entitled to do under clause 4 of the Agreement. Accordingly, the judge found in favour of the plaintiff.

This appeal

20.  Mr Lawrence Ng[1] advanced three main arguments for the defendants in this appeal.

21.  Firstly, he contended that the judge was wrong in law in construing “acceptable risks … to the Purchaser” as referring to risks that are subjectively unacceptable to the plaintiff provided that the plaintiff had acted bona fide in making that decision.  He contended that the phrase should be construed to mean as comprising both an objective and subjective element, such that the option in clause 4 would be exercisable only if the risks are (1) objectively unacceptable and (2) subjectively unacceptable to the party exercising the option.  Alternatively, the assessment of risks should be purely objective.

22.  Secondly, irrespective of whether “unacceptable risks” were to be assessed bona fide subjectively, objectively, or otherwise, he argued that there were plainly no “unacceptable risks” – whether arising out of the personal guarantees, liability cap or the draft audited report of EHK – when the plaintiff exercised the option on 4 July 2007.  The heavily qualified draft audited report was provided to the plaintiff only on 29 August 2007, after the plaintiff had purported to exercise the option, and the judge should have excluded this from his consideration in deciding whether the plaintiff had validly exercised the option.  This turned out to be counsel’s main argument on appeal.

23.  Thirdly, he submitted that the plaintiff did not act bona fide in deciding there were unacceptable risks but had fabricated reasons to justify the exercise of the option.

Proper construction of “unacceptable risks … to the Purchaser”

24.  Mr Ng’s argument is that a subjective assessment of unacceptable risks should be discarded for it provides the plaintiff with an “unfettered route of escape from the contract, perhaps for completely unrelated reasons” (McMorland, Sale of Land, at p 143 §5.02, quoted in Lerner v Schiehallion Nominees Ltd §[32]).  He emphasized that contractual construction is an objective exercise in that it is concerned with what a reasonable person, armed with the knowledge of the parties to the contract, would understand the contract to mean.  A reasonable person with such knowledge would understand that the option to turn the sale of shares into a sale of the Property was not to be exercised lightly.  To allow the unacceptable risk to be assessed subjectively would be putting the threshold too low, even when that party was acting bona fide.  Unacceptable risks should be assessed objectively to ensure that only “objectively real and serious risks” would qualify, for the option to be exercisable.

25.  He took issue with what the judge said regarding the impossibility of an objective assessment in the present circumstances in §56 of the judgment:

“Different people or companies must have different attitude to risks taking. For a company, any risks taking decision must depend on a host of factors, e.g., financial ability, the return, the business plan and the ethos of the management. I simply cannot see how acceptability of risks can be assessed with a notional reasonable company. What are the attributes of this reasonable company? Is the court to assume that the management is conservative or adventurous or somewhere in the middle, and what does it mean when the management is neither conservative nor adventurous?”

26.  Mr Ng submitted there is no reason why an objective test could not be applied in this instance.  He said the test could be framed as whether a reasonable person, having all the attributes of the purchaser, e.g. financial ability, previous purchasing pattern, etc., would consider the acquisition of shares as unacceptably risky.

27.  Mr Ng further contended that the words “to either the Purchaser or the Vendor”, which followed the words “unacceptable risks” in clause 4, should have a neutral meaning and do not suggest whether or not the risks are unacceptable is to be decided subjectively by the party seeking to exercise the option.

28.  Lastly, he drew our attention to the fact that Lerner v Schiehallion Nominees Ltd, in which Potter J adopted an objective test regarding the words “satisfactory to the purchaser” instead of the middle road favoured by Moller J in North Shore Demolitions Ltd v McKay, was cited with approval by the New Zealand Court of Appeal in Arcadia Homes Limited (in liquidation) v More to This Life Limited & Anr [2013] NZCA 286 at §[69]. In Arcadia Homes, the court was concerned with the same standard form of agreement as in Lerner v Schiehallion Nominees.

29.  The relevant clause considered in North Shore Demolitions Ltd v McKay was that the agreement for the sale and purchase of a proposed subdivision of land was conditional on the county council approving the subdivision “on terms and conditions acceptable to the vendor”.  The middle road favoured by Moller J was similar to the approach advocated by the plaintiff here and accepted by the judge, namely, that whether the condition was acceptable was judged according to the personal views of the vendor but subject to an implied term he had to act bona fide in reaching that decision.  Moller J rejected the objective approach on the basis it did not give effect to the words “to the vendor” in the provision.

30.  Mr Jonathan Chang, who appeared for the plaintiff here and below, cited to us other authorities in support of the judge’s approach, apart from the New Zealand cases mentioned in the judgment.  I will mention two of them.

31.  In Meehan v Jones (1982) 42 ALR 463, the High Court of Australia considered a “subject to finance” clause in an agreement for sale and purchase of land, the condition was that the purchaser received “approval for finance on satisfactory terms and conditions”.  Gibbs CJ considered the subjective and objective tests (at 467) and expressed the view that the “natural effect is to leave it to the purchaser to determine whether or not the available finance is suitable to his needs”, as “such a condition is generally entirely for the protection of the purchaser, and it is the satisfaction of the purchaser, not that of some hypothetical reasonable man, that will satisfy the condition.  No doubt it may be implied that the purchaser will act honestly in deciding whether or not he is satisfied” (at 468 to 469).

32.  In Habton Farms v Nimmo [2004] QB 1, the provision considered by the English Court of Appeal was that the agreement for the purchase of a horse was “subject to veterinary inspection and approval of X-rays in the USA”.  The court considered the objective and subjective approaches (at §§22 to 32).  Clarke LJ was of the opinion that the natural meaning of the words construed in their context is that the vet’s inspection and the X-rays were to be satisfactory to the buyer and that the buyer could refuse to proceed provided he was dissatisfied with the vet’s report or X-rays and that his dissatisfaction was bona fide (at §33).

33.  The cases cited on both sides, although providing helpful guidance as to how the court should approach the task of construction, must be read with care, as the context in which the relevant phrase was construed in the decided cases is not the same as the present case.  Thus, in Lerner v Schiehallion Nominees Ltd, in coming to the conclusion that objective test should be adopted for the condition in the agreement, Potter J would appear to have been influenced to a large extent by another provision in clause 8.7(2) of the contract, which provided that “the party or parties for whose benefit the condition has been inserted must do all things which may reasonably be necessary to enable the condition to be fulfilled”.  Even before the judge considered the subjective or objective tests in §§[31] to [38] of the judgment, she already expressed herself in this way in §[29]:

“The purchaser must do all things reasonably necessary to enable the condition to be fulfilled (cl 8.7(2)). In the circumstances of this case that involved putting itself in a position to make a reasonable and fair decision as to whether a building report was necessary. A purchaser cannot simply claim that the building report is not satisfactory. That would be a subjective determination which the Courts have rejected. The purchaser must show he acted reasonably and fairly. He thus carries an evidential burden to satisfy the Court to that effect.” (Emphasis supplied)

34.  This foreshadowed the language Potter J used in rejecting the objective test in §[38]:

“A party will be bound by the contract to which he has committed unless on the basis of a fair and reasonable decision in terms of a condition subsequent inserted in the contract for the benefit of the party seeking to rely upon it, he is entitled to be relieved of his obligations under the contract.” (Emphasis supplied)

35.  In contending that the phrase “acceptable risks to …the Purchaser” should be construed as comprising both an objective and a subjective element, Mr Ng must have tacitly accepted that some effect must be given to the subjective element.  He introduced a co-existing objective element in an attempt to water down the subjective approach.

36.  In my judgment, the reasoning of the judge in §56 of his judgment quoted above is plainly correct.  Effect must be given to the clear wording of the provision that one is concerned with “unacceptable risks to …the Purchaser”.  I see no basis to water down the subjective element by grafting on to this an objective standard.  I reject the defendants’ arguments on this issue.

If there were unacceptable risks when the option was exercised

37.  I turn to Mr Ng’s main argument, which ran as follows.

38.  When the plaintiff purported to exercise the option to turn the sale and purchase of shares into the sale and purchase of the Property on 4 July 2007, the matters of concern raised previously by the plaintiff had by then been subsumed into just two issues – the provision of personal guarantees and a cap on liability.  So one should just focus on these two issues alone to see whether there were unacceptable risks, regardless of whether the risks were to be assessed objectively or subjectively.

39.  Regarding the personal guarantees sought by the plaintiff, he submitted that on the evidence, the plaintiff had accepted, or must be taken to have accepted, the risk that no personal guarantees would be forthcoming from the defendants.  The plaintiff knew that the defendants are shell companies before the Agreement was signed.  The need for personal guarantees did not occur to the plaintiff until midway through 2006.

40.  As to liability cap, he contended this was a red herring as the plaintiff knew that the defendants are all shell companies.  It would have made no material difference if the defendants’ liabilities were capped at the full purchase price as sought by the plaintiff, or at $1 million as suggested by the defendants.  Hence, the plaintiff’s inability to secure a higher liability cap could not have constituted an unacceptable risk on any view.

41.  The draft audited report, as mentioned earlier, was only provided to the plaintiff after it had purported to exercise the option, so that could not be taken into consideration as constituting an unacceptable risk.

42.  I would reject the contentions advanced by the defendants.

43.  As submitted by Mr Chang, it is important to consider the whole context of the exchanges between the parties from early June to 4 July 2007, which led to the request for personal guarantees and liability cap.  I do not propose to set out in detail the email exchanges mentioned in his submission but merely to summarise their effect.

44.  Whilst clause 4 of the Agreement provided a warranty of the defendants that EHK and EZS “are debt free and there are no outstanding charges or liens against these two companies at the transfer date”, the revised draft sale and purchase agreement sent by the defendants to the plaintiff on 23 June 2007 stated clearly for the first time that there was a “shareholders’ loan” owed by EHK to the defendants.  This came as a surprise to the plaintiff and it asked the defendants to clear the loan in advance of completion or else the defendants should provide a full indemnity in connection with it.  The loan also had potential tax liability implication, as the plaintiff pointed out to the defendants on 2 July 2007 and requested an indemnity for this potential liability as well.

45.  In the revised draft sale and purchase agreement sent by the defendants to the plaintiff on 23 June 2007, many of the warranties given by the vendor were qualified by the phrase “save and except as disclosed by the Vendors”.  However, to that date, little disclosure was made by the defendants to the plaintiff, not even a draft set of accounts were provided.  On 28 June 2007 and 2 July 2007, the plaintiff asked the defendants to expedite the provision of the accounts, otherwise the defendants should provide a full indemnity in connection with them.

46.  It was in the context that the plaintiff had no or little knowledge of the true financial position of EHK and EZS that it requested personal guarantees from the directors of EHK and EZS and disagreed with capping the defendants’ liability at $1 million.  As stated in the plaintiff’s email of 2 July 2007, “the parties need to understand that the manner in which this transaction [for the sale of shares] has been structured carries risks and little benefit to the prospective purchaser compared to a more transparent sale of real property”.  The plaintiff was understandably concerned with its lack of knowledge and information on the financial position of EHK and EZS and the associated risks, when it wrote to the defendants on 4 July 2007 stating that unless its stated concerns were addressed, they required the transaction to be restructured as an acquisition for the Property instead.

47.  The heavily qualified draft audited accounts provided to the plaintiff in August 2007 merely confirmed the plaintiff’s concerns which had been ventilated.

48.  It is correct that the judge’s reasoning and finding at §§61 to 63 of the judgment that there were unacceptable risks to the plaintiff in proceeding with the acquisition of the shares were focused on the heavily qualified draft audited accounts, coupled with the fact that the plaintiff had not been provided with all the books and records of EZS.  But his conclusion in §64 that “without an unqualified audited report, there was no basic assurance that the assets of the companies, or a significant part of them, had not disappeared or that there was no false accounting employed by the management of EZS” is undoubtedly correct and fully borne out by the evidence of the exchanges between the parties both before and after 4 July 2007.  There is no basis to interfere with the judge’s finding that there were unacceptable risks to the plaintiff in proceeding with the acquisition of the shares.

If the plaintiff had acted in good faith

49.  The defendants sought to overturn the judge’s finding of fact that the plaintiff had acted bona fide in taking the view that there were unacceptable risks in acquiring the shares.  I see no basis to interfere with that finding.  The matters relied on by Mr Ng (that the plaintiff’s main witness Robert Ng had lied in an affirmation in an unsuccessful attempt to join a third party in this action; that the plaintiff did not really want to acquire the shares after the Agreement was signed but was determined to hold on to the Property; that Robert Ng knew at an early stage in the event of an acquisition of the Property that the tax payable by the plaintiff would not be very high) were all matters expressly mentioned in the judgment and had been considered by the judge.  As the judge had said in §37 of the judgment, the way in which the plaintiff had conducted itself under the directions of Robert Ng is “not something to be proud of” but in a court of law, once an agreement is made a contracting party is entitled to take full advantage of its entitlements thereunder.

50.  For all the above reasons, the defendants’ appeal was dismissed with costs to the plaintiff.