TROPHY GOLD INVESTMENTS LTD v. MODERN CITY DEVELOPMENT LTD AND ANOTHER

HCMP 2161/2014

[2021] HKCFI 69

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

MISCELLANEOUS PROCEEDINGS NO 2161 OF 2014

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DECISION

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1.  This is the Petitioner’s (“P”) Summons filed on 20 December 2018 for adducing expert accounting evidence on 5 issues which grounded its unfair prejudice petition against the majority shareholder, the 1^st Respondent (“R1”), of the company in question, the 2^nd Respondent (“R2”). The Summons is opposed by R1.

2.  There is an unusual feature of this application, namely, P also asks for discovery to enable the expert evidence to be compiled. Para 2(a) of the Summons is formulated in wide terms: “The parties shall provide unrestricted access to the parties’ experts of all the books, records and documents in their possession, custody or power (whether in printed or digital form) in relation to the issues set out in paragraph 1 above”.  

Background

3.  The Company was incorporated in 2004 and its principal line of business was designing and selling footwear to consumers in the Mainland.

4.  From 2004 to around 2009, the Company conducted its Mainland operation through a company known as “QC”.  Since around 2009, QC was replaced by a wholly owned subsidiary of the Company known as “SBPRC”.  The Company, QC and SBPRC are referred to as the “Shoebox Group”. 

5.  P and R1 were and are shareholders of the Company :

(1)  R1 initially held 50% of the shares in the Company but, since September 2006, it has increased its shareholding to 95%. R1 is an indirect wholly owned subsidiary of Daphne International Holdings Ltd (“Listed Group”), which has been listed on the HKSE since November 1995;

(2)  P has held 5% of the shares in the Company since its incorporation.  P was and is represented by Ms Chan Lai Mei, who was employed by the Listed Group as a senior executive from January1996 to May 2007;

6.  All the directors of the Company were appointed by and said to represent R1.  These directors had or have also been executive directors of the Listed Group.

7.  P commenced these proceedings in 2014 seeking, inter alia, a buy-out order on the following grounds :

(1)  R1 and the directors had caused numerous unlawful and improper expenses and liabilities to be recorded in the Group Accounts so as to wipe out the significant profits made by the Shoebox Group.  As a result, the cumulative operating profits of the Shoebox Group from 2008 to 2015 had been understated by at least RMB1.43 billion (“Accounting Irregularity Ground”);

(2)  R1 and the directors had misappropriated substantial amount of funds from the Company and the Shoebox Group (“Misappropriation Ground”).

8.  There is much overlap between the 2 Grounds in that the alleged misappropriations, namely, (i) purported management fees; (ii) purported prepayments; (iii) purported sales to and purchases from subsidiaries; and (iv) purported payment to previous owners (collectively “Purported Expenses”)[1] in conjunction with purported provision for impairment, constituted alleged improper expenses and liabilities under Accounting Irregularity.

9.  The Purported Expenses and the Provision for Impairment are the subject matters on which P seeks to adduce expert evidence.

10.  P’s allegations concerning the Purported Expenses and Provision for Impairment had been helpfully summarised by Mr Wong, who appeared for P, which is adopted with modifications as follows :

(1)  Provision for Impairment: it is based on the “provision for impairment” entries in the Group Accounts from 2008 to 2015.  There was an increase in the amount of this entry from RMB5,609,007 in 2008 to RMB112,674,521 in 2015.  P’s case is that there was no justification for such drastic increase, given that Shoebox Group rarely sold its products below their purchase prices;

(2)  Management Fees: it refers to the RMB113,383,732 paid purportedly as “management fees” by Shoebox Group between 2013 and 2015 to the subsidiaries of the Listed Group in which the Company had no interest.  These payments were described in the Group Accounts as being made “in accordance with the service agreements as determined and agreed between the Company and the counterparties”, but no service agreement has been disclosed by R1.  There is also no explanation as to why such management fees were only charged for the first time in 2013 when the Company had been in operation since 2004.  Further, the Purported Management Fees had inexplicably increased threefold (from RMB15.5 million in 2013 to RMB51.4 million in 2015) during the time when the operation of Shoebox Group was reducing in scale;

(3)  Prepayments: it refers to the “rental prepayments” and “prepayments to suppliers” made by Shoebox Group, which amounted to RMB180,276,110 in 2013 and RMB204,035,332 in 2014.  A substantial part of the Purported Prepayments was made to companies in which the Listed Group or its directors (who were also directors of the Shoebox Group) were interested;

(4)  Sales to and Purchases from Subsidiaries: it refers to Shoebox Group’s sales to and purchases from unidentified subsidiaries of the Listed Group which amounted to, respectively, RMB591,373,511 from 2011 to 2015 and RMB3,322,452,245 from 2008 to 2015.  These transactions were conducted at undervalue and/or on favourable terms to the subsidiaries;

(5)  Payment to Previous Owners: it refers to a sum of RMB13,643,592 paid by Shoebox Group purportedly as “distribution to previous owners”.  During the relevant period, there were only 2 shareholders of the Company, namely, P and R1, and P has never received any such payment. 

11.  R1’s defence is that the Purported Expenses were all legitimate and there was no accounting irregularity.  In particular :

(1)  In respect of the Provision for Impairment, Prepayments and Payment to Previous Owners, R1 says that P had fundamentally misunderstood the relevant accounting entries in that they were “balance sheet items” or “balance sheet accounting treatment” (not “income/expenses items”) which did not “directly affect the Shoebox Group’s operating profit margin”;

(2)  As regards the Management Fees and Sales to and Purchases from Subsidiaries, R1 says that the former were paid in according to the terms of the relevant service agreements and the latter were transactions at arm’s length;

(3)  Further, in respect of all the Purported Expenses and the Provision for Impairment, R1 maintains that the relevant accounting entries had been audited by PwC.  In respect of each of them, PwC had “assessed the truth and fairness of the entries”.  In addition, (a) the Impairment was audited “in accordance with all applicable HKFRS issued by the HKICPA”; and (b) the Payment to Previous Owners was based on merger accounting under “Accounting Guideline 5: Merger Accounting for Common Control Combinations” published in November 2005 by the HKICPA. 

Accounting Treatment

12.  It can readily be seen from the parties’ cases summarised above that the issues of Management Fees and Sales to and Purchases from Subsidiaries involve largely factual questions and the legitimacy of those transactions.  I do not agree with P that the reference to PwC’s audit in the pleadings is sufficient to justify the admission of expert evidence.  The court must examine the substance of the dispute. 

13.  In respect of any suggestion that if P’s case is made out the court will require the assistance of accounting expert on the appropriate reversal to be made on the accounts and the like, I am inclined to accept the submission of Ms Lam, who appeared for R1, that those matters should be addressed if and when the court decides to grant the buy-out relief by way of setting the parameters of the valuation exercise: see Re LehmanBrown Ltd [2011] 5 HKLRD 668, CA, §41.  I note Mr Wong’s submission that LehmanBrown was a decision under a different context, but I do not believe that it detracts from the merits of the point.

14.  I turn to the 3 issues which may require expert evidence.  

15.  As for the Provision of Impairment, based on the evidence in opposition, Ms Lam explained that any indirect impact of excessive provision on the operating profit margin would have been reversed and reflected in the financial accounts for the following years.  This is because when the off-season inventories were subsequently sold and/or ultimately written off, the provision would have been applied to the resulting losses.  The net effect on the operating profit margin would be zero (if the estimated provision is the same as the resulting loss when the inventories were sold).

16.  In respect of the Prepayments, Ms Lam relies on the witness statement of Mr Cheung, the Vice President (Finance) of the Listed Group and a qualified accountant.  Mr Cheung challenges P’s allegation that the Company had suffered loss in the form of the loss of use of money and interest that could have been earned on the Prepayments as speculative and without basis.  No explanation or factual basis has been put forward to support why the Prepayments should not have been made in the first place.

17.  For the Payment to Previous Owners, Mr Cheung explained in his witness statement that there was no actual distribution made to the previous owners.  Rather, the amount represented the exchange rate difference between the Company’s payment of investment consideration and the capital injected by previous shareholders of the subsidiaries.  The amount was ultimately treated as a “merger reserve”, and reclassified from “retained profits” to a reserve account which formed part of the shareholders’ equity interest, and did not have an impact on the shareholders’ equity interest.

Analysis

18.  Properly understood, I do not believe that the Prepayments and Payment to Previous Owners involve accounting expertise to assist the court in its adjudication.  The former will turn largely on the existence and legitimacy of the Prepayments and the latter on whether payment was in fact made, contrary to R1’s case.

19.  Relating in particular to the Payment to Previous Owners, Ms Lam had demonstrated to the court with the Cash Flow Statements of Company for the years ended 31 December 2008 and 2009 that the recorded “Distribution to previous owners” of RMB13,643,592 should not be there (as contended by Mr Cheung) because it formed no part of the total recorded under Financial activities. 

20.  That leaves only the Provision of Impairment. Ms Chan, who is also a qualified accountant, in her evidence in reply to that of Mr Cheung merely pointed out that the latter had accepted that the difference between the opening balance and the closing balance of this item would be recorded in the income statement.  This effectively constituted an acceptance of P’s case that the Provision did impact on the debit to the income statement, and hence the profit margin of the Shoebox Group. 

21.  Ms Chan’s contention is not controversial in that it is accepted by R1 that the increase in impairment provision would be reflected in Operating (loss)/profit.  In the Financial Statements of the Company for the year ended 31 December 2015, that exercise can be seen under Notes 8 and 15.  However, as pointed out by Ms Lam, over the years there were increases as well as deceases in the provision according to the outcome of the eventual disposal of the aged stock. 

22.  On the evidence before the court, the primary issue here is a factual one concerning whether there should be any provision for aged stock.  Notwithstanding Ms Lam’s submission that the answer should determine this issue because there is no plea by P that the provision, if justified, was excessive, I am inclined to the view that the evidence may call for an examination by the court on the appropriate level of provision. 

23.  Mr Wong submitted that the court would require expert evidence on this issue of judgment by the auditor.  However, Ms Lam informed the court that, according to her instructions, there were established percentages for impairment under the accounting standards applied in Hong Kong.  Unfortunately, the matter was not addressed in the evidence (the burden of proof in this application must be on P).  On the other hand, the court has no reason to disagree with the suggestion.

24.  In the premises, I am not satisfied that the application for expert evidence is made out.

Discovery

25.  P complains that R1 had failed its duty to comply with the discovery order of the court.  However, R1 had filed an affirmation verifying its discovery and no specific discovery application had been made by P against it.

26.  It is accepted by P that without the discovery sought, it would not be appropriate to order expert evidence.  It seems to be a case of the cart being put before the horse.  The logical approach is for the relevant discovery to be obtained and considered before the time, costs and expenses are incurred for expert evidence.  The manner in which the discovery is sought lends weight to R1’s criticism that it is a fishing exercise.

27.  In any case, I do not believe that discovery application has been properly formulated and supported so that it may be adjudicated by the court: see Jade’s Realm Ltd v Director of Lands, unrep, HCA 1509/2012, 10 June 2014, §21.  Apart from such failures, I agree with Ms Lam that R1’s discovery affirmation is normally conclusive: see Hong Kong Civil Procedure 2021, vol 1, [24/7/1].

Disposition

28.  For these reasons, the Summons is dismissed. The parties had agreed that costs should follow the event.  I make an order that the costs of and incidental to the Summons be to R1, to be taxed and paid forthwith.