XCHRX RE LINFA INDUSTRIAL CO. LTD.

HCCW 1047/1999

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

COMPANIES (WINDING-UP) NO. 1047 OF 1999

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D E C I S I O N

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1. This is an application for `anticipatory' validation orders, so that in the event that orders to wind up these two companies are made on the petitions presented to Court by a creditor, payments made into or out of the bank accounts of the companies in the ordinary course of business would be not avoided under s.182 Companies Ordinance.

2. The petitions against these two companies ("the Companies") are based on statutory demands which have not been met. The demands are for repayment of, amongst other things, amounts owed by the Companies as guarantor of other companies in a group, headed by Wah Lee Resources Holdings Ltd ("Holdings"), to which both these Companies belong ("the Group"). Holdings is incorporated in Bermuda and is listed in the Stock Exchange of Hong Kong. There is a petition to wind up Holdings to be heard in Bermuda on 14 January 2000. It is common ground that the financial position of the Companies stands or falls with that of the Group.

Principles

3. It is well-established that the onus is on the applicants to persuade the court to exercise its discretion to make such an order.

4. Before the Court would make an order, there must be credible evidence that either:

(a) the Companies are solvent and able to pay their debts as they fall due, or

(b) that the order, whether it relates to a particular transaction or a series of transactions, would be for the benefit of the Companies' creditors as a class (Re Fairway Graphics Ltd [1991] BCLC 468). Where a company seeks to carry on trade (as in the present case), the Court must be satisfied that the transactions are likely to be profitable and therefore would increase the Companies' assets, so as to benefit the creditors (Fairway Graphics, 469).

Solvency considerations

5. Dealing with the first aspect, it would appear that the financial position of the Group is weak, and as noted above, the position of these Companies stands or falls with that of the Group as a whole.

6. No audited or draft accounts for the Group for the last financial year, ending 30 June 1999, have been exhibited. In August 1999, Holdings appointed KPMG to perform a preliminary independent business review ("the KPMG Review"). The KPMG Review ("WHC-8", Wong Hei Chiu III) dated 13 September 1999 stated as follows:

"The current financial position of the Group is extremely weak. All bank facilities have been exhausted, outstanding trade debtors have increased considerably, and the Group is not in a position to meet its financial obligations when they fall due. Therefore, without the support of its lenders, the directors will have little alternative but to declare the Group insolvent and to invite its creditors to appoint a liquidator"

7. It reported that the future recovery of the Group was reliant on the following Critical Success Factors:

- the successful collection of debts for air-conditioners sold by the Group on the Mainland;

- a successful outcome of compensation negotiations with Mitsubishi Heavy Industries for allegedly faulty air-conditioners which the Group had sold on the Mainland;

- sale of investment properties in Hong Kong;

- restructuring of bank debt ($273m as at 24 August 1999, of which $207m was unsecured);

- rebuilding of the core business; and

- equity investment from a new investor.

8. The Companies do not take issue with the factual matters reported in the Review, nor do they dispute that the above factors were critical. However they say that steps are being taken to "rebuild the companies, rebuild its business, reduce the running costs and expenses of the Group, to generate cash flow and to raise funds for the repayment of the indebtedness".

9. I shall examine each of the Factors and the steps taken in turn.

Trade receivables

10. First, it would appear that the collectibility of trade debts on the Mainland is critical. The consolidated balance sheet set out at paragraph 4.1 of the Review showed a substantial increase in trade receivables from $75m. as at June 1998 to $344.5m. as at June 1999. This constituted more than 66% of the total assets. It would appear that there have been problems with collecting because of complaints about faulty air-conditioners, inability of wholesalers to sell their stock and the economic situation on the Mainland.

11. The Review contained a Re-Cast Financial Position of the Group to allow for 100% provisioning against trade receivables older than 90 days, receivables relating to faulty Mitsubishi goods and damaged stock held on the Mainland. After re-casting, the amount of trade receivables is substantially reduced by $217.9m to only $126.5m, and stock reduced by $6.7m. to $32.8m.

12. The effect of that is the Group has negative net assets of $60.4m. (paragraph 4.10, Review).

13. In answer to this, Mr Wong the Financial Controller of the Companies only asserts that "we consider that it [the Group] has reasonable prospects of collecting the money in the above two provisions". However, there is no evidence of facts in support of Mr Wong's opinion that those prospects are reasonable.

14. There is no evidence that any progress has been made in collecting the trade receivables since September 1999, even though special teams have been set up for the purpose. There is no evidence that any or any appreciable amounts have been collected at all. Indeed the evidence appears to show that the efforts have been unsuccessful: Mr Wong in his 3rd Affirmation says that November - February is the "low season" and "it is difficult to collect debt in these months".

15. It would therefore appear that at present, the financial position of the Group is as per the Re-cast Financial Position, i.e. that the Group has a negative net asset position of more than $60m.

Compensation from MHI

16. Secondly, there is the question of compensation from Mitsubishi Heavy Industries. Mr Wong says that the loss and damage suffered by the Group by reason of faulty air-conditioners was about $21m.

17. According to the Review, management had informed KPMG that Mitsubishi had verbally agreed to reimburse the Group, and accordingly there was a forecast in the Review that $20m would be received by November-January 2000.

18. However, there is no evidence that this alleged "verbal agreement" is being performed by Mitsubishi and there is no evidence that this payment is forthcoming. On the contrary, it would appear from a letter dated 29 November 1999 to Holdings from the Group's American attorneys ("WHC-11") that litigation has to be resorted to. Whilst the attorneys have given an opinion that there is a "reasonable chance to prevail", the attorneys are still in the progress of reviewing the file on the matter, and according to Mr Wong's 3rd Affirmation, he has been given to understand that a result may be obtained within 4-6 months. Clearly therefore, the prospect of receiving that amount in the short term, as per the Review, has dissipated.

Sale of properties

19. A number of properties held by the Group in Hong Kong have been sold or are in the process of being sold. This is in accordance with the recommendations in the Review.

20. However there is no evidence that there are any net proceeds arising from the sales, although the mortgagee bank debts would have been reduced by $17.5m. being the total sale prices of the properties so far sold. I have also noted that through the sale of optical disk equipment, the Group has received $5m. as down payment and would be receiving $625,000 per month for the next 8 months. However, this is a relatively small amount compared to the Group's liabilities.

Restructuring of bank debts

21. In September 1999, Deloittes was appointed to devise a restructuring plan. This was unsuccessful.

22. More recently, in December 1999, Pacific Challenge Capital Ltd was appointed to advise on debt restructuring. A proposal has been presented to all creditor banks proposing that the unsecured portion of the bank debts ($207m. as at August 1999) be discharged upon payment in cash of 20% of the amount, with the balance being waived.

23. The 11 creditor banks were approached by asking them to opt either to wind up Holdings or to agree to the adjournment of the petition against Holdings scheduled for 14 January 2000. Out of 11, 4 banks (comprising 18% of total outstanding amounts) have agreed to support an adjournment of the petition, 2 banks (KBC and Belgian) have required an improvement in terms and 3 banks (comprising 49% of the total outstanding amounts) have indicated that they wished to proceed with winding up. Two have not responded.

24. That cannot be said to be a very encouraging response. Even for those banks who have agreed to support an adjournment, it is no more than an indication that these banks are prepared to give time beyond 14 January. There is no real evidence at present that the banks are prepared, or even inclined, to agree to a debt restructure along the lines proposed by Pacific Challenge.

Rebuilding the core business

25. In this respect, Mr Wong says that the Group is changing its business from the import of air-conditioning, audio-visual and photographic products to the Mainland to export of photographic products, which he says has a high profit margin of some 10%.

26. The export business represented only 4% of the Group's sales in 1999. But Mr Wong says that the Group now "has about 60 to 70% export nature of business to South East Asia, Middle East and South Africa".

27. Even assuming that this means that 60-70% of the Group's business is now in export, no turnover or volume of sales has been disclosed, and as Mr Kenneth Ng, counsel for the petitioner, has pointed out, according to the Review, the margin of 9.9% is gross - there is no evidence of what the net profit margin is. As such, it is not possible for the court to know, in terms of funds, what sort of income this type of business is bringing into the Group and whether it could carry the expenses of continuing the business, even with the reductions in staff and expenses.

28. The same lack of evidence is apparent for the other field of endeavour that Mr Wong says the Group is now developing, i.e. e-commerce.

29. The Group ought to be in a position to adduce evidence in support of its case that these new businesses are bringing new profitability to their finances, but no hard facts are given. In the absence of such evidence, one cannot see how these Companies can discharge the onus that they bear in this application.

New investor

30. Finally, it would appear that despite endeavours made to find a new investor since September 1999, there is no evidence that any interested party has emerged.

31. Mr Wong also says in his affirmation that Pacific Challenge is arranging for fund raising, such as share placement, rights issue, etc. However, no evidence is provided as to the likelihood of success of such a proposal, nor indeed are any details given of such a proposal at all.

32. In the circumstances discussed above, it is difficult to see how the Companies can suggest (if they do) that the validation orders should be made because the Companies are solvent and able to pay their debts as they fall due. Indeed the evidence suggests that the Companies themselves accept that their solvency depends on their being able to restructure the debts (paragraphs 8, Wong I).

Must benefit creditors as a class

33. If the Companies are not solvent, then they should be allowed to carry on trading only if the transactions contemplated are for the benefit of the creditors as a whole. However, the Companies' application for validation is simply to continue trading generally - not just to participate in certain profitable transactions. There is no evidence to show that general day-to-day trading would be of benefit to creditors.

34. Accordingly, taking all the above factors into consideration and in the exercise of my discretion, I have to dismiss the applications as the Companies have failed to satisfy me that either (a) they are solvent and able to pay their debts as they fall due or (b) that continued day to day trading in the present circumstances would be for the benefit of all creditors.

35. As a matter of completeness, I should note that Mr George Chu, counsel for the Companies, had asked for anticipatory validation of payments out of the bank accounts of employees wages on the basis that they would be preferential debts in the event of winding-up anyway. However, it would appear that the extent of preferential payments under the Companies Ordinance is quite limited, and there would be the further difficulty posed of double preferential payments if, on winding-up, the employees claim statutory entitlement to another round of preferential payments. That would not be to the benefit of other unsecured creditors.

36. Finally, I would note that Miss Tsui of the Official Receiver's Office, whose interest lies in preserving the assets of the Companies, supports the Petitioner's position in opposing the applications for validation orders.

37. In the light of the above, I have to dismiss the applications of both Companies. I make an order nisi that the costs of the applications follow the event, i.e. that they be borne by the Companies.