RE PCCW LTD

HCMP 1699/2004

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

MISCELLANEOUS PROCEEDINGS NO. 1699 OF 2004

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REASONS FOR JUDGMENT

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1. This is a petition presented by PCCW Limited ("the Company") for confirmation of reduction of capital by cancellation of the share premium account, under sections 48B(1) and 58(1) of the Companies Ordinance, Cap. 32. I have made an order in terms at the conclusion of the hearing and these are the reasons for judgment.

The background

2. The Company was incorporated on 24 April 1979 and its issued share capital is listed on The Stock Exchange of Hong Kong Limited and on the New York Stock Exchange, Inc., in the United States. It acts as a holding company and its subsidiaries are engaged in the provision of local and international telecommunication services, internet and interactive multi-media services, the provision of computer, engineering and other technical services mainly in Hong Kong, investment in and development of systems integration and technology-related businesses, and investment in and development of infrastructure and properties in Hong Kong and mainland China.

3. The present capital of the Company is HK$1.6 billion divided into 6.4 billion shares of HK$0.25 each. As at the date of the presentation of the petition on 7 July 2004, 5,368,754,074 of the shares have been issued and are fully paid or credited as fully paid, and there is a credit of HK$173,459,910,505.00 in the share premium account. As at 2 August 2004, the figure standing to the credit of the share premium account is HK$173,464,615,915.00. Article 62(b) of the Articles of Association provides that the Company may by special resolution reduce its share capital, any capital redemption reserve fund or any share premium account in any manner authorised and subject to any conditions prescribed by law.

4. By a notice dated 23 April 2004 incorporated in a circular issued to shareholders, the Company convened an extraordinary general meeting on 19 May 2004 and a special resolution was duly passed to cancel the share premium account by shareholders holding approximately 99.69% of the shares.

5. The primary purpose for cancelling the share premium account is to eliminate the accumulated losses of the Company of HK$152,932,345,321.00 as at 30 June 2004 so as to accelerate the time for payment of dividends and to bring its capital account in line with its available assets. As to the balance of HK$20,532,270,594.00 arising from the cancellation, it is proposed to credit the amount to a special capital reserve account for the purpose of eliminating any future loss of the Company. The proposed cancellation of the share premium account does not involve either the diminution of any liability in respect of unpaid capital or the payment to any shareholder of any paid-up capital or of any sum standing to the credit of the share premium account.

The accumulated losses

6. From mid 1999, the Company and its subsidiaries ("the Group") made substantial investments in technology and internet-related businesses on a global scale. In 2000, the Company acquired Cable & Wireless HKT Limited, which was the leading telecommunications company in Hong Kong. In 2001, the Company entered into joint ventures with Telstra Corporation Limited, which is Australia's leading telecommunications company. These investments and other substantial investments were made at a time when the "technology bubble" had become inflated, with unprecedented and rapid escalation in value in technology and internet-related businesses, and widespread expectation in the industry that there would be substantial increase and sustained growth in business.

7. The Company first sustained a loss in 1999, which, with the exception of the profitable year in 2001, led to accumulated losses of HK$152,932,345,321.00 as at 30 June 2004. A predominant portion of the accumulated losses was the result of provisions made by the Company for impairment losses, due to the bursting of the technology bubble, in respect of its investments in subsidiaries and other ventures. Detailed explanation was given in the affidavit of Mr. Alexander Arena, an executive director of the Company and the chief financial officer of the Group, for each financial year from 1999 to 2003 and for the six-month period ended 30 June 2004.

8. Of the accumulated losses, it is recognised that only the provisions made by the Company in respect of its investments in Cyber Net Technologies Limited, which held a minority interest in SoftNet Systems, Inc., are permanent losses, in the sense as understood in the present context (In re Jupiter House Investments (Cambridge) Ltd. [1985] 1 WLR 975 at 978H to 979B; Boyle & Marshall on Practice and Procedure of the Companies Court, 1997 ed., para. 4.9.4). Non-permanent or unrealised losses amounted to a total of HK$151,046,807,723.00.

Undertakings for protection of creditors

9. In respect of non-permanent losses, a suitable undertaking is required from the company seeking confirmation of reduction of capital to ensure that in the event the lost capital is recovered, it would not be distributed as dividends, so that the interest of the existing creditors may be safeguarded (In re Jupiter House Investments, supra.; In re Grosvenor Press Plc. [1985] 1 WLR 980; Re Capital Asia Ltd. [1999] 2 HKC 854; Boyle & Marshall, op. cit. at para. 4.9.5 ). The question of suitable undertakings was gone into at the hearing of the summons for directions when an order was made to dispense with the settlement of a list of creditors. A modified form of undertaking was offered by Mr. Robin Potts, QC, then appearing on behalf of the Company. The actual terms of the undertaking, which was accepted by the court, as set out in the re-amended order, are contained in the schedule annexed hereto.

10. In accordance with standard practice, it is proposed that any recovery or profit derived from the investments against which provisions have been made by the Company, up to the amount of the reduction, being HK$152,932,345,321.00, be kept in a non-distributable account designated as a "special capital reserve account", unless the creditors of the Company existing at the date when the reduction becomes effective shall have been paid off or consented to the distribution from the account, but that the amount in the special capital reserve account may be reduced to the extent that the paid-up capital or the share premium account is subsequently increased by an issue of shares for cash or other new consideration or capitalisation of distributable profits. This usual form of undertaking is modified in two respects.

11. Firstly, it is proposed that the balance of HK$20,532,270,594.00 (being the difference between the amount cancelled and the accumulated losses as at 30 June 2004) arising from the cancellation of the share premium account is also to be credited to the special capital reserve account, for the elimination of any future loss of the Company. There is no objection in principle for a company to use the special reserve to write off future deficits on its profit and loss account, provided that the usual undertaking is also to apply in this situation as in the writing off of past losses (Quayle Munro Ltd., Petitioners [1994] 1 BCLC 410 at 412e to h).

12. The second modification is to allow the Company to treat, as realised profits potentially capable of being distributed to shareholders, amounts in the special capital reserve account up to an amount equal to the difference between the amount of a bank guarantee or guarantees (to be procured by the Company from time to time for the protection of creditors existing at the effective date of the cancellation of the share premium account) and the aggregate of the fees and expenses incurred in issuing such guarantees.

13. Section 59(3) of Cap. 32 provides that even if the proposed reduction does involve either the diminution of any liability in respect of unpaid share capital or the payment to any shareholder of any paid-up share capital, the court may, if having regard to "any special circumstances of the case it thinks proper so to do", direct that the settlement of a list of creditors in section 59(2) be dispensed with. There is no limit imposed on the circumstances which the court may consider to be special in this context, and a guarantee of all non-consenting creditors is a recognised method of safeguarding the interests of creditors (Boyle & Marshall, op. cit. at paras. 4.9.8, 4.9.12 and 4.9.13; In re Lucania Temperance Billiard Halls (London) Ltd. [1966] 1 Ch. 98 at 102D to 103A). A company is not restricted from adopting a mixture of the creditor protection methods (Gore-Browne on Companies, 44th ed., vol. 2, para. [44.5.10]).

14. On 18 June 2004, the Standard Chartered Bank ("the bank") issued a commitment letter stating that on demand of PCCW-HKT Telephone Limited ("HKTC"), a subsidiary wholly owned by the Company indirectly, it would enter into an agreement in the form of a facility letter to grant a guarantee facility to HKTC with the Company as beneficiary. On 13 July 2004, the facility letter was executed between the bank and HKTC with the form of the guarantee attached as a schedule thereto. Upon HKTC creating a charge in favour of the bank over its cash deposit and the cancellation of the share premium account becoming effective, HKTC will, within one year from the date of the facility letter, have the right to demand the bank to issue one or more guarantees up to a maximum amount of HK$780 million. With the exception of the fees and expenses incurred in issuing the guarantees, it is provided in the facility letter that all other debts and claims of the bank against HKTC under the facility will be subordinated and postponed to the relevant liabilities on the same terms as the bank's debts and claims against HKTC under the guarantees are to be subordinated. The deed of charge in respect of the cash deposit of HKTC likewise contains a provision that all claims of the bank against HKTC under the deed are, with the exception of the fees and expenses for issuing the guarantees, subordinated and postponed to the remaining relevant liabilities on the same basis as in the form of the guarantee.

15. It is provided in the undertaking that no distribution will be made out of the special capital reserve account unless a guarantee in the form set out in the schedule to the facility letter and in an amount equal to the aggregate of the amount proposed to be distributed and the amount of all fees payable to the bank in connection with the issue of that guarantee has been put in place. Once a guarantee has been issued under the facility, it may only be terminated or amended with the approval of the court, in accordance with clause 5(a) of the form of guarantee.

16. All guarantees to be issued by the bank under the facility letter are to expire no later than the fourth anniversary of the date of the facility letter. Notwithstanding the expiry of a guarantee, clause 1.3 of the form of guarantee imposes on the bank a continuing liability if a relevant creditor has made a written demand for payment on the bank before its expiry or, if the Company disputes the claim, the bank's obligation will only continue if that creditor has served a written demand on the bank before the expiry date and has commenced court proceedings within one month of the written demand on the bank.

17. I have been taken to the actual and contingent liabilities of the Company, as the guarantees are to expire on the fourth anniversary of the facility letter issued on 13 July 2004. The actual current and non-current liabilities are well within the guaranteed period. As for contingent liabilities, they are either within the guaranteed period or may be safely disregarded for present purpose. The Company has provided performance guarantees to third parties other than financial institutions on behalf of certain subsidiaries, and incurred miscellaneous contingent liabilities under various representations, warranties, guarantees and indemnities given by the Company in relation to various "one-off" transactions, as well as transactions incidental to the day-to-day running of the ordinary course of business, such as recurrent obligations to pay trade creditors, professional advisers, rentals or rates. For such contingent liabilities, the contractual commitment periods for these payments are typically short, the Company and the relevant subsidiaries are not aware of any grounds upon which claims are likely to be made in future, and the Company has expressed confidence it will be able to service recurrent payment obligations in the ordinary course of its business.

18. Lastly, insofar as intra-group indebtedness is concerned (the total amount as at 5 July 2004 is HK$67,508,047,655.00), all of the relevant members of the Group have signified their consent to the cancellation of the share premium account and the subordination of their claims against the Company by a deed dated 7 July 2004.

19. I am satisfied that by the undertakings offered by the Company, the interests of the relevant creditors would be suitably protected.

The conditions for reduction of capital

20. The conditions in section 58(1) for an application for confirmation of reduction of capital have all been complied with. There is provision in the Articles of Association empowering the Company to reduce the share premium account and a special resolution for the cancellation of the share premium account has been passed.

21. The principles upon which the court would act to confirm a reduction of capital or a share premium account are well established (Re Thorn EMI Plc (1988) 4 BCC 698 at 701; Re South China Strategic Ltd. [1997] HKLRD 131 at 133E to G; Re Lippo China Resources Ltd. [1998] 1 HKLRD 20 at 23I to 24A; Re China Light & Power Co. Ltd. [1998] 1 HKLRD 158 at 170G to H) and are as follows:

(1) the shareholders are treated equitably;

(2) the reduction proposals are properly explained in the circular to the shareholders;

(3) the interests of relevant creditors are safeguarded; and

(4) the reduction is for a discernible purpose.

22. There is no question of inequitable treatment of any of the shareholders. The cancellation only applies in respect of the share premium account in the Company's reserves, not to any paid-up share capital or any shareholding of its members.

23. As for the purpose and effect of the cancellation of the share premium account, they have been fully explained in the circular dated 23 April 2004 despatched to the shareholders.

24. For the reasons stated earlier, I am satisfied there should be adequate protection to the relevant creditors by the undertakings offered by the Company.

25. The elimination of losses by cancelling the share premium account is a legitimate and discernible purpose for the reduction of capital.

26. Hence, each of the four criteria for reduction of capital is satisfied.

27. Before exercising the discretion to confirm the proposed reduction, the court was informed of the up-to-date amount of the share premium account to be cancelled, by a further affidavit of Mr. Arena filed on 2 August 2004, since the special resolution passed on 19 May 2004 did not, and could not at that time, set out the amount to be cancelled due to the outstanding share options and convertible bonds and note (Re TIP-Europe Ltd. (1987) 3 BCC 647 at 651 to 653; Re Lippo China Resources, supra. at 27I; Boyle & Marshall, op. cit. at para. 4.11.4). As mentioned earlier, the latest figure standing to the credit of the share premium account is HK$173,464,615,915.00. The increase since 7 July 2004 is due to the allotment and issue of a further 1,147,661 ordinary shares of HK$0.25 each, upon the exercise of 1,147,661 of the outstanding share options at the price of HK$4.35 per share.

28. For the reasons given above, I have made an order confirming the cancellation of the share premium account in the terms of the draft order submitted.

Schedule

The Undertakings of the Company

"AND the Company by its Leading Counsel undertaking that:-

(1) forthwith upon the proposed cancellation of the Share Premium Account taking effect,

(a) the sum of HK$20,532,270,594, being the sum by which the amount standing to the credit of the Share Premium Account proposed to be cancelled exceeds the accumulated losses of the Company as at 30 June 2004; and

(b) all retained profits, if any, accruing to the Company between 1 July 2004 and the date when the proposed cancellation of the Share Premium Account shall become effective; and

(2) if, subsequent to the date when the proposed cancellation shall take effect, any of the investments of the Company set out in the Second Schedule hereto against which provision for impairment loss or diminution in value had been made for the period ended 30 June 2004 shall be revalued in excess of the written down value of the relevant investment recorded in the accounting records of the Company as at 30th June 2004 or any sum received by the Company in respect of such investment whether by way of distribution or repayment of loans or interest or such investment shall be realised for a sum in excess of such written down value, then a sum equal to the amount of the revaluation or the sum received by the Company in respect of such investment as aforesaid or the sum realised in excess of such written down value up to an aggregate amount of HK$152,932,345,321

shall be credited to a Special Capital Reserve and that so long as there shall remain outstanding any debt or liability of or claim against the Company at the date when the proposed cancellation shall take effect which, if such date were the date of the commencement of the winding up of the Company, would have been admissible in proof against the Company and the person entitled to the benefit thereof shall not have agreed otherwise, such reserve

(a) shall not be treated as realised profit; and

(b) shall for so long as the Company shall remain a listed company be treated as an undistributable reserve of the Company for the purposes of Section 79C of the Companies Ordinance or any statutory re-enactment or modification thereof

PROVIDED ALWAYS that

(i) the amount standing to the credit of the Special Capital Reserve may be applied for the same purposes as a share premium account may be applied or may be reduced or extinguished by the aggregate of any increase in the issued share capital or in the Share Premium Account of the Company resulting from an issue of shares for cash or other new consideration or upon a capitalisation of distributable reserves after the date when the proposed cancellation shall become effective;

(ii) a sum or sums up to an aggregate amount of HK$20,532,270,594 standing to the credit of the Special Capital Reserve may be applied by the Company for the purpose of eliminating any loss sustained after 30 June 2004 but PROVIDED FURTHER THAT if subsequent to the elimination, any of the investments of the Company against which provision for impairment loss or diminution in value has been made for the period respecting the loss shall be revalued in excess of the written down value of the relevant investment recorded in the accounting records of the Company as at the end of that period or any sum received by the Company in respect of such investment whether by way of distribution or repayment of loans or interest or such investment shall be realised for a sum in excess of such written down value, then a sum equal to the amount of the revaluation or the sum received by the Company in respect of such investment as aforesaid or the sum realised in excess of the written down value up to an aggregate amount of HK$20,532,270,594 or the total amount of the non-permanent losses sought to be eliminated, whichever is less, shall be re-credited to the Special Capital Reserve; and

(iii) upon the coming into force of a guarantee or guarantees issued by Standard Chartered Bank (HK) Limited in the form set out in the Third Schedule hereto, the Company shall be released from this undertaking but only to the extent of an amount equal to the amount of such guarantee or guarantees as may be issued from time to time less all the fees and expenses as may be incurred by the Company for the purpose of and incidental to the issue of such guarantee or guarantees

AND the Company by its Leading Counsel further undertaking for so long as the aforesaid undertaking shall remain effective to publish or cause to be published or to procure its auditors to record by way of note or otherwise in its audited or interim financial statements or in the accounts of the Company published or distributed in any other form or in any prospectus issued by or on behalf of the Company

(1) a summary of the aforesaid undertaking; and

(2) all the material terms of the guarantees as may from time to time be issued by Standard Chartered Bank (HK) Limited as referred to in proviso (iii) of the aforesaid undertaking"