RE LIPPO CHINA RESOURCES LTD

1997, No. MP 4195

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H E A D N O T E

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Company - reduction of capital by way of cancellation of share premium account

Principles set out in Re Ratners Group plc (1988) BCC 293 and Re Thorn EMI plc (1988) 4 BCC 698 apply

Need to safeguard creditors - form of undertaking - in the usual case limited to safeguarding existing and not future creditors

Discernible purpose - "goodwill" arising on consolidation - setting off against reserves - Statement 2.204 of the Exposure Draft of the Hong Kong Society of Accountants

1997, No. MP 4195

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

MISCELLANEOUS PROCEEDINGS

Reasons Handed Down : 30 December 1997

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R E A S O N S

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1. This is a petition by Lippo China Resources Limited ("the Company") for confirmation by the Court of a reduction of capital. Under the special resolution passed to reduce capital, the entire amount standing to the credit of the share premium account of the Company as at the close of business on the first day immediately preceding the day on which this petition is heard is to be cancelled. At the hearing, an order was made confirming the reduction. In view of the absence of any Hong Kong decision on the subject of a reduction of capital by way of cancellation of the share premium account, it would be desirable for the reasons to be fully set out and I do so below.

The facts

2. The present authorised share capital of the Company is HK$2,800,000,000 divided into 5,600,000,000 ordinary shares of HK$0.50 each. As at the date of the petition, there were in issue 3,066,996,246 ordinary shares of HK$0.50 each in the Company fully paid or credited as fully paid. At as 1 December 1997, there was standing to the credit of the share premium account of the Company the sum of HK$849,148,516.43. This has arisen as a result of various issues of shares by the Company at a premium. At a duly convened EGM held on 2 December 1997, a special resolution was duly passed in accordance with section 116 of the Companies Ordinance to effect the reduction in capital. Accompanying the notice convening the meeting was a Circular which, inter alia, set out the reasons for the proposed cancellation of the share premium account.

3. The Company is part of the Lippo Group. Through a wholly-owned subsidiary, Lippo Limited, the ultimate parent, holds approximately 54.2% of the issued capital of the Company. The Lippo Group was recently re-organised through the implementation of what is referred to as the Composite Agreement and the J V Co. Agreement both dated 18 June 1997 and completed on 2 September 1997. The implementation involved the acquisition by the Company from Lippo Limited of a 50% shareholding interest in Lippo CRE (Financial Services) Limited ("the Acquisition") which held an approximate 60.6% shareholding interest in the HKCB Bank Holding Company Limited ("HKCB Holding"). After the completion of the Acquisition, the Company and China Resources Enterprise Limited, being the two 50% shareholders in Lippo CRE (Financial Services) Limited entered into a shareholders agreement under which the Company is entitled to appoint a chairman resulting in its having a casting vote at shareholders in directors meetings. Lippo CRE (Financial Services) Limited is now treated as a subsidiary of the Company with the consequence that its interest in HKCB Holding had been consolidated into the accounts of the Company. As a result, the consolidated net asset value of the Company was reduced by approximately $676 million representing the value of the goodwill arising in the consolidated accounts of the Company as a result of the Acquisition.

4. The reduction in capital involves the elimination of the value of the goodwill arising on the consolidation as a result of the Acquisition against the reserves of the "Group". It is to be noted that for the purposes of the reduction of capital, "Group" means the Company and its subsidiaries only. Together they form a sub-group of the Lippo Group. The reduction is effected at the level of the sub-group rather than of the Lippo Group as such and it is important to have this distinction in mind when considering the reduction. It is also proposed that the remaining balance standing to the credit of the reserve account will be applied towards capitalisation issues in the future and/or eliminating the value of the goodwill on consolidation which is expected to arise as a result of future acquisitions by the Group.

The applicable principles

5. The principles upon which a court would confirm a reduction of the share premium account were enunciated by Harman J. in Re Ratners Group plc (1988) BCC 293 and reiterated by him in Re Thorn EMI plc (1988) 4 BCC 698. They are that :

(1) the shareholders are treated equitably;

(2) the reduction proposals are properly explained (that means in the circular summoning the meeting);

(3) the creditors are safeguarded; and

(4) the reduction is for a discernible purpose.

6. The first two requirements are unquestionably satisfied in the present case : the reduction does not alter the rights of the shareholders and the reduction proposals are properly explained in the Circular.

7. Safeguarding creditors

8. As regards the safeguarding of creditors, this means that the money cannot be applied in any way which would be detrimental to them. Subject to appropriate undertakings on the part of the Company (as to which see below), a creditor is not affected by the application of the credit thrown up on the reduction of the share premium account to set off goodwill in the consolidated accounts. As Harman J. explained in Re Thorn EMI plc (supra), a creditor is a creditor of a particular company and he is not in any proper sense of language a creditor of the group and the consolidated accounts which purport to be the accounts of the group if it had been (which it was not) a single company, have no bearing whatever on the creditor's position.

9. I now turn to the question of undertakings. It is part of the Order made on 15 December 1997 on the summons for directions that the Company by its leading counsel undertakes

"... forthwith upon the proposed cancellation of the share premium account taking effect, an amount equal to the credit arising therefrom will be credited to a special capital reserve in the books of account of the Company for the purpose of setting off goodwill arising in the consolidated accounts of the Company and its subsidiaries and that such special capital reserve (a) shall not be treated as realised profits, and (b) shall be treated as an undistributable reserve of the Company for the purposes of Section 79C of the Companies Ordinance (or any statutory modification or re-enactment thereof) for so long as there shall remain outstanding any debt of or claim against the Company which, if the date on which the proposed cancellation of the share premium account becomes effective were the date of the commencement of the winding up of the Company, would be admissible to proof in such winding up and the person entitled to the benefit of such debt or claim shall not have agreed otherwise, PROVIDED THAT (i) the Company shall be at liberty to apply the special capital reserve for the same purposes as a share premium account may be applied; and (ii) the amount standing to the credit of the special capital reserve may be reduced or extinguished by the amount of any increase, after the cancellation of the share premium account taking effect, in the paid up share capital or the amount standing to the credit of the share premium account of the Company as a result of the payment up of shares by the receipt of new consideration or the capitalisation of distributable profits."

10. This undertaking is in the form set out in 9 Atkin's Court Forms 1995 Issue 97, footnote 4 which is described as "the usual form of undertaking". The part preceding the proviso is based on the actual undertaking given in Re Grosvenor Press plc (1985) 1 BCC 99, 412 at 99, 414, a leading English authority. That form of undertaking has long been accepted as an adequate protection for all those who would be creditors of the company (including contingent and perspective creditors), when the reduction takes effect.

11. In Re Grosvenor Press plc (supra) Nourse J. considered the question whether it was necessary in the normal case to safeguard the interests of future creditors and shareholders. He analysed the earlier decisions, namely Re Jupiter House Investments (Cambridge) Limited (1985) 1 BCC 99, 457 and Ex parte Westburn Sugar Refineries Limited [1951] AC 625. These emphasize that there should be no risk that the company's accounts would deceive future creditors and shareholders. Nourse J. was unable to see any ground, either in principle or on authority, for thinking that the Court ought usually to require that a reserve be set aside indefinitely to safeguard the interests of future creditors and shareholders. At 99, 416, he expressed the view that anyone who gives credit to or acquire shares in the company after the reduction takes effect is prima facie adequately protected by existing statutory safeguards. He concluded (at 99, 417) that :

" It would [not] be right for the Court, except in special circumstances, to require a reserve to be set aside indefinitely. The statutory procedures which allow for its reduction demonstrate that there is no status of inviolability attaching to a company's capital. There is no purpose in being allowed to discard with one hand a loser which you must take back with the other." (emphasis added)

12. I see no reason to disagree with either the analysis of or the conclusion reached by the learned judge and they appear to be equally applicable to reductions of capital that occur in Hong Kong. Accordingly, the undertaking in the present case is in the "usual" form, there being no special circumstances to require the setting aside of any reserve indefinitely to safeguard the interests of future creditors and shareholders.

13. So far as the two provisos are concerned, it is not apparent from the report whether they formed part of the undertaking given in Re Grosvenor Press plc. In my judgment, they do not detract from the principles laid down in that case. The first proviso does no more than to preserve the Company's statutory rights under s.48B of Cap.32 which expressly authorises the application of a share premium account for the purposes specified in that section and as such is unobjectionable. Under section 48B(3), the share premium account may be applied, inter alia, in paying up unissued shares of the Company to be issued to members of the Company as fully paid bonus shares, i.e. for capitalisation issues. The second proviso ensures that the special capital reserve cannot be reduced or extinguished except by new consideration or the capitalisation of distributable profits. The apparent rationale is to protect existing creditors since only "new" consideration or capitalised distributable profits may be so applied.

14. So long as the undertaking remains effective, there is a further undertaking by the Company (1) to cause or procure its auditors to report by way of note or otherwise a summary of that undertaking in its audited financial statements or in the accounts of the Company published in any other form; and (2) to publish or cause to be published in any prospectus issued by or on behalf of the Company a summary of that undertaking. This gives additional protection by ensuring that relevant information concerning the reduction in capital is readily available to any future creditor or shareholder dealing with the Company. In this regard, the undertakings in the present case go further than Re Grosvenor Press plc.

15. Discernible purpose

16. In Re Thorn EMI plc (supra) at p.701, Harman J. held that "discernible" means "something which is demonstrated by evidence to the court and is something sufficiently solid and near in expectation to be a real prospect."

17. In that case, one of the discernible purposes was to make available a reserve for the writing off or setting off of goodwill arising on consolidation. "Goodwill" in this context is the excess of the consideration paid for an acquisition over the fair net asset value of what was acquired. See Re Ratners Group plc (supra) at 294 where goodwill was defined as :

"excess of the value of the shares issued [in the rights issue] over the fair value of the tangible assets acquired."

As noted by Harman J. in that case, the Institute of Chartered Accountants introduced a Statement of Standard Accounting Practice No.22 ("SSAP 22"). The learned Judge explained (at p.294) that its effect was that :

"... companies should write off in their accounts the item which accountants wrongly call goodwill. That can be achieved either by writing it off over a period by debiting amounts each year to the profit and loss account, which has the result, adverse to a company, of reducing its apparent earnings per share. Alternatively the so-called goodwill can be written off against reserves in the balance sheet. For that purpose there has grown up a regular practice of reducing the share premium account so as to create a capital reserve which upon consolidation, though not in the parent company's own balance sheet, can be used to eliminate the so-called goodwill."

18. A most helpful discussion of the concept of how goodwill arises on consolidation and the process of its being "written off" or "set off" against reserves is to be found in Re Thorn EMI plc. The evidence filed in support (quoted at p.700) states that goodwill

"remains as a balancing item in the consolidation process gone through when consolidated accounts are made, even when the item becomes invisible because of set off against other reserves."

Thus as Harman J. explained at pp.700-701 :

"... the process of consolidation takes place each year and in each year the reserve representing retained profits falls to be included in consolidated reserves ... consolidation is a process which occurs every year in order to reflect the underlying accounts for that year of the companies making up the group whose accounts are consolidated.

It is only when one appreciates that the item described in SSAP 22 as 'goodwill' is not an item which is in any true sense written off or disposed of on consolidation that full understanding can occur. The full truth appears when one understands that in a consolidated account the accountants have to take the accounts of the underlying companies, combine them together with the accounts of the holding company so as to produce as nearly as possible an account that would represent the state of affairs if there were but one company, but that those consolidated accounts are merely a reflection of and based on the underlying accounts of the individual companies and do not represent any actual production of distributable profits, or actual provisions for loss, save in so far as they are representative of the underlying accounts of the companies themselves."

Harman J. accepted the submission that upon the preparation of consolidated accounts, in each year the question of setting off goodwill on consolidation must be faced afresh, and the set-off in that year depends on the reserves then available for the purpose. But as the learned Judge noted at p.702 :

"... The inwardness of it lies in particular in the concept, which I believe is easily forgotten, that consolidated accounts are prepared each year, not from the foot of the previous accounts but from the actual underlying accounts for that year of the companies in the group whose accounts are being consolidated. The essence of the matter is that this is an exercise in combining figures in the course of which items arise which may be set off one against the other. In particular ... upon consolidation inter-company indebtedness arises, each debt or each credit of which will have properly appeared in the balance sheet of the underlying companies as an asset or a liability. But upon consolidation they are to be set off one against the other. They should ... net off to nil. I confess to thinking that the word 'should' is a mild word: if they do not net off to nil there is something very seriously adrift with the underlying accounts. ...

That illuminates the fact that consolidation does not throw into one account all the figures below. The figures below will include assets which are not recorded in the consolidated balance sheet because they are assets of one company in the group derived against liabilities of another company in the group and thus set off in the accounts of the group as a whole. Nonetheless they are real assets and real liabilities in the underlying accounts. That process will have to be done each year afresh. It will be done regardless of the figures in the previous year, which will have nothing to do with the actual netting off of liabilities and assets in the consolidated account for a particular year. In the same way the reserves available, which are used to balance or set off the excess of price paid over net separable assets bought, is an exercise which will have to be accomplished each year anew. Thus there is no question of going back and rewriting the 1986 accounts where the goodwill, so called, was set off against perhaps profit and loss account balances, or other reserves, or the 1987 accounts where such things were also done. When the 1989 accounts come to be written up in a year's time the exercise will be to find out what amounts there are representing ... consolidation differences and what reserves there are then extant which can properly be balanced against it."

19. Whilst Hong Kong has not adopted SSAP 22 as a mandatory requirement, it is a guideline as appears from Statement 2.204 of the Exposure Draft issued by the Hong Kong Society of Accountants. There is evidence before me that elimination, as opposed amortisation, forms part of the accounting policy of the Group for the treatment of goodwill arising in its consolidated accounts. That being so, I am satisfied on the evidence that a discernible purpose exists in the present case.

20. It is further proposed that the balance after setting off the goodwill arising on consolidation will be applied for future capitalisation issues as well as setting off goodwill arising on future acquisitions. The former falls within the first proviso of the undertaking set out above and section 48B(3)(a) of Cap.32. As regards the latter, there is ample evidence of the Group's previous history of acquisitions to warrant it as one of the discernible purposes.

The Special Resolution

21. Whilst the exact amount was not stated in the special resolution, that is not an impediment as the court may confirm the reduction so long as the exact amount is known at the time of the reduction: see Re Tip-Europe Ltd (1987) 3 BCC 647.

Conclusion

22. For the reasons set out above, this is a proper case for the court to confirm the reduction of the Company's share premium account. No minute of this reduction is necessary: See Re Paringa Mining and Exploration Co. Ltd [1957] 1 WLR 1143 and The Supreme Court Practice 1997 para 102/4/9.

23. I am indebted to leading counsel for the Company for his considerable assistance in this matter.