INNOVATIVE INFORMATION SYSTEMS LTD v. SUN MICROSYSTEMS OF CALIFORNIA LTD

HCA1977/2005

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

ACTION NO. 1977 OF 2005

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JUDGMENT

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1. At all material times up until 13 July 2005 the plaintiff “IIS” was a wholly owned subsidiary of a Japanese publicly listed company called Itochu Corporation (“Itochu”).  IIS was a Hong Kong company which carried on business in the field of computer and software services including the provision of technical consulting services. It did Itochu’s business in Hong Kong. 

2. As part of its Hong Kong business IIS had a long standing business relationship (often referred to in these proceedings as a business “partnership” although, as acknowledged by both parties, not a partnership in the legal sense) with the defendant “Sun”. 

3. The relationship went back to 1995.  However the embodiment of the relationship which is the subject matter of this case, concerns three contracts between the parties which were signed in 2002.  

4. This action stems from the fact that on 3 August 2005 Sun, in writing, summarily terminated those three contracts. 

5. In short, their reason for doing so was that on 13 July 2005 there had been a management buyout (“MBO”) by three employees of IIS which severed the relationship between Itochu and IIS.  Sun took the view that without the backing of Itochu it was not prepared to continue its contractual relationships with IIS. 

6. IIS claim that by not giving certain periods of notice under each contract Sun were in breach and IIS claim damages for loss of profits and costs incurred during the notice periods.  Sun maintains that, in the circumstances that prevailed at the time, they were entitled to give written notice of termination without notice.  They also make a counterclaim. 

7. The court’s task is to examine the contractual provisions and decide if, on the facts, Sun were required to give written notice of termination.  If so, their failure to do so would constitute a breach and they would be liable for the losses incurred as a result during the periods of notice. 

The contractual provisions

8. (A) The General Terms Agreement, which was referred to in the proceedings as the “Reseller” Agreement, included, inter alia, the “iForce Business Terms Exhibit”. 

9. This latter document has the following termination clause :

“9.1   Termination of Exhibit.  For the avoidance of doubt, the termination provisions set out in the General Terms shall apply to this Exhibit

9.2 Additional provisions relating to termination under this Exhibit.

(a)   Either party may terminate an Accepted Order immediately by written notice : (i) if the other party commits a non-remediable material breach of such Accepted Order; or (ii) if the other party fails to cure any remediable material breach with thirty (30) days of being notified in writing of such breach. 

(b)   This Agreement will terminate automatically if Company ceases to do business in the normal course, becomes or is declared insolvent or bankrupt, is the subject of any proceeding relating to the liquidation or insolvency of Company which is not dismissed within ninety (90) days or makes an assignment for the benefit of its creditors. 

(c)   Sun may terminate this Agreement immediately by written notice if Company undergoes any change in ownership or control (whether by way of voting or contract rights or otherwise) or in its business, which change Sun considers material, in the light of the fact that Company has been appointed by Sun because of its present financial, technical and managerial conditions.”[Emphasis added]

10. Sun relies on clause 9.2(c). 

11. The termination provisions referred to in 9.1 are as follows :

“8.1   Termination for cause.  Either party may terminate the General Terms or any Exhibit immediately by written notice :

(a)   if the other party commits a non-remediable material breach of the General Terms or Exhibit (as the case may be); or

(b)   if the other party fails to cure any remediable material breach within thirty (30) days of being notified in writing of such breach.  

8.2 Termination without cause.

(a)   Either party may terminate the General Terms immediately by written notice if no Exhibit is in effect. 

(b)   Either party may terminate any Exhibit at any time upon expiration of ninety (90) days’ written notice.”

12. IIS claim they were entitled to the benefit of this contract for a further 90 days.  

13. (B) The Local Strategic Provider Agreement (“LSPA”).  This contract was the key profit making agreement between the parties.  It enabled IIS to provide hardware installation, maintenance and support services to Sun’s customers.  Its termination provision were :

“14.2    Termination.  Either Party may terminate this Agreement : (i) with or without cause, and for any reason, with one hundred eighty (180) days Notice to the other Party (unless stated otherwise in a Section of this Agreement); (ii) immediately, by Notice upon material breach by the other Party, if both Parties agree that such breach cannot be remedied; (iii) by Notice, if the other Party fails to cure any remedial material breach of this Agreement within thirty (30) days of receipt of Notice of such breach; and (iv) immediately … (not relevant to this action). 

16.8 Change of Control.  In the event of the direct or indirect taking over or assumption of control of LSP or of substantially all of its assets by any government, governmental agency or other third party, Sun may terminate this Agreement upon written notice to LSP.”

14. Sun relies on clause 16.8.  IIS claim they were entitled to 180 days’ notice.  

(C) The Subcontractor Master Consulting Agreement (for technical consulting services).  On clause 2.3(a) :

“Sun may terminate this agreement

(a) without cause and for any reason on thirty (30) days written notice to Subcontractor, at any time;”

Sun relies on clause 2.3(e) :

“Sun may terminate this agreement …

(e) if the Subcontractor is merged, consolidated, sells all or substantially all of its assets, or implements or suffers any substantial change in management or control, a receiver, manager or liquidator is appointed over the whole or any part of the business assets of Subcontractor, Subcontractor makes an assignment for the benefit of its creditors, any proceedings are commenced by, for or against Subcontractor under any bankruptcy, insolvency or debtor’s relief law, Subcontractor becomes unable to pay its debts as they fall due, or an order is made or a resolution passed for the dissolution or winding up of Subcontractor.”

15. It is accepted that there are no discrete sub-issues relevant to one contract but not another.  The key issue is : was notice required?  IIS’s quantification of their claim is based on the 180 days’ notice required under the LSPA because they say that is where most of the profit came from.  As a matter of construction however the key focus is on the Reseller Agreement.  The Reseller Agreement included the General Terms, the iForce Partner Guide, the iForce Business Terms and a Letter of Authorization.  It was the underlying contract which formed the basis of the parties’ business relationship. 

16. The issue is : whether the MBO entitled Sun to invoke clause 9.2(c) and terminate without notice.  Much of the evidence concerned the MBO. 

The MBO

17. Prior to the MBO in July 2005 all IIS’s directors were Japanese directors of the parent company Itochu.  There was just one Japanese director resident in Hong Kong, namely Mr Murase.  The shares in IIS were held by Itochu through four different companies. 

18. In 2005 Itochu decided that it wished to dispose of IIS.  The reason being that IIS had recorded financial losses from 2002 to March 2005.  Mr Murase explained to the management in Hong Kong, in February 2005, that the parent company wanted, either to close down IIS completely or find an independent buyer.  Negotiations took place with a possible buyer in early 2005 but nothing materialized.  

19. The final option to save IIS was a buyout by the Hong Kong management.  This is what occurred.  Mr Ben Lau, Mr Simon Fu and Miss Anita Yau purchased the company in the name of Huge Creation Holdings Limited with their respective shareholdings being 82%, 9% and 9%.  Further details of the MBO are not important.  IIS was no longer connected to Itochu with effect from 13 July 2005.  

20. All three of the new owners gave evidence in support of IIS’s claim.  Broadly speaking I found them to be a sincere and hardworking group of individuals whose evidence, in many respects, I accepted.  I am sure they were taken by surprise when 21 days after the MBO Sun withdrew its support and terminated their relationship.  I shall refer briefly to some examples of the evidence from IIS witnesses which I accept.  However, as will be seen, the weight to be attached to it when evaluating Sun’s decision to terminate is a separate matter. 

21. I accept, for example, that Sun would have been aware of the proposed MBO from, at least, the meeting which took place on 9 June 2005.  Iris Leung, a sales director of Sun, was present at that meeting.  She was informed of the proposal.  I think that IIS’s witnesses’ evidence that she responded “positively” to the idea was somewhat overstated.  I accept that she said nothing negative about it but I also accept her evidence that she was fairly neutral saying no more than that she would report the matter higher up the chain of authority.  Ben Lau and his colleagues were no doubt excited and positive themselves about the proposed buyout and, in such circumstances, can be forgiven for putting a positive spin on developments.  I also accept, from Sun’s witnesses, that the names of the buyers were not finally communicated to Sun until a fax on 12 July.  It would have been obvious that the key players were going to be Ben Lau and his immediate colleagues.  However there was talk of an independent investor joining also.  This did not materialize and the final list of three names was only communicated at the eleventh hour. 

22. Another example, was their perception of their level of “partnership” with Sun.  For each area of business Sun “scored” their partners and awarded them a particular level.  It is true that in two areas IIS was already at the top level.  In a third area (referred to as the JCOE, the Java Centre of Excellence), they were one below the top level.  In the Statement of Claim it was pleaded that they were promoted to the top level at a meeting on 16 June.  In evidence Ben Lau accepted that they were not actually promoted at that meeting but that it was to be a formality thereafter.  In truth, however, it seems that, although the promotion would probably have been certified in due course, it was by no means imminent.  It is perhaps a small point but is another example of IIS being somewhat more upbeat about developments than they were entitled to be. 

23. Much evidence was given about IIS’s credit lines.  Sun afforded IIS generous credit arrangements.  This, I accept, was largely due to the fact that Itochu was IIS’s parent company.  Without Itochu, IIS needed bank support.  In short, I accept that they arranged credit of US$300,000 with a reputable bank on a continuing basis in good time before the MBO.  US$300,000 was not as generous as the previous arrangements (US$500,000) but it was still a working credit line.  I accept also that when Sun issued the formal written termination notices on 3 August 2005 the council within Sun’s organization which made the decision were not aware that this credit arrangement had been set up and provided by IIS. 

24. Leading up to the MBO it is understandable that the new proposed owners of IIS were optimistic and confident.  What now has to be considered is whether their confidence and belief that the contracts with Sun would continue was based on a reasonable and legitimate expectation or was based on a misguided assumption and/or a failure fully to appreciate the terms of the contracts they had with Sun.  I am sure Mr Ben Lau did believe and was confident that the relationship with Sun would continue.  When asked in evidence whether he would have gone ahead with the MBO had he known even that Sun would terminate on full notice being given, he very honestly answered in the negative. 

Legal principles

25. The applicable legal principles when construing the words of a contract are largely agreed by Mr Russell Coleman SC who appeared for IIS and Mr Rimsky Yuen SC, leading Mr Victor Dawes for Sun.  

26. Mr Coleman helpfully set out the key principles as summarized in Absolom v. TCRV Ltd [2006] 2 Lloyd’s Rep. 129 :

“(1)    The aim of the exercise is to ascertain the meaning of the relevant contractual language in the context of the document and against the background to the document.  The object of the enquiry is not necessarily to probe the ‘real’ intention of the parties, but to ascertain what the language they used in the document would signify to a properly informed observer. 

(2) The interpretive exercise must not be done in a vacuum, but in the milieu of the admissible background material.  That comprises anything that a reasonable man would have regarded as relevant in order to comprehend how the document should be understand, provided that the material was reasonable available to both parties at the time (i.e. up to the time of the creation of the document).  

(3) However, evidence of negotiations and subjective intent are not admissible for the purposes of this exercise. 

(4) A commercial document must be interpreted so as to make business commonsense in its context.  But if a ‘detailed semantic and syntactical analysis of a word in a commercial contract is going to lead to a conclusion that flouts business commonsense, it must be made to yield to business commonsense’.”

27. It is an objective exercise seeking a purposive construction of the words used in the context of the whole agreement and bearing in mind it is a commercial contract. 

28. In short, Mr Coleman invites the court to consider the situation, in fact, at the material time and conclude that the circumstances which permitted Sun to terminate without notice had, simply, not arisen. 

29. Inter alia, he relies on matters such as :

(a)  the healthy relationship between IIS and Sun;

(b) the lack of “reasonable efforts” on the part of Sun to meet and discuss the future after the MBO;

(c) mere change of ownership, without more, does not entitle Sun to terminate without notice;

(d) Sun’s failure to properly consider whether the MBO would in fact result in a material change;

(e)  the words of the contracts permit an interpretation that IIS had a reasonable expectation that Sun would decide to maintain the relationship after the MBO; and

(f)  if any doubt exists about the true meaning of any particular clause, the contra proferentum rule will be applied in IIS’s favour. 

Application of the principles to the facts relating to Sun’s decision to terminate without notice

30. The decision to terminate was made by Sun’s “GCBG Council” (Greater China Business Governance).  That was a council of three people of which one, Mr Peter McGinley, gave evidence.  At the material time he was Sun’s finance director. 

31. The council met to discuss IIS on more than one occasion.  Mr McGinley’s witness statement referred to “meetings” being held and executives from the three key departments of business, legal and financial being present.  He put the matter succinctly as follows : “It was concluded that we would terminate our relationship with IIS on the basis that IIS no longer had the financial support of the Itochu Corporation and the IIS restructuring effectively altered the financial, technical and management structure of IIS”.  Mr Coleman submits that this decision, properly analysed in context was at least unreasonable and arguably more, namely capricious or arbitrary.  No dishonesty or bad faith is pleaded or alleged. 

32. After careful consideration of the facts, the legal principles and the words of the contracts I have come to the conclusion that Sun did not act unreasonably.  

33. The “Reseller Agreement” contained the general terms of business, I will therefore deal with it first in a little more detail than the LSPA and SMCA. 

(1) The Reseller agreement

34. It is clear from clause 9.2(c) (paragraph 9 above) that summary termination is permitted (in writing) if two conditions are satisfied.  No other construction is possible.  The first condition is that IIS has undergone a “change in ownership or control” and the second condition is that such change is “material” (as defined). 

(a) Change of control?

35. That there had been a change of ownership and control by virtue of the MBO is unarguably so.  The directors of “Huge Creation” were all former employees of IIS.  None had been directors or shareholders of IIS beforehand.  The Itochu presence and influence had gone completely.  Before the MBO the true ownership and control had been wholly in the hands of the Japanese directors, afterwards it was wholly out of their hands.  The definition of “control” in these circumstances (taken from Sanofi-Sythelabo SpA v. 3M Health Care Ltd [2002] CLC 1208) does not help IIS :

“… A company can be considered to be in the control of that person or those persons who can make or unmake its officers and dictate their conduct mediately or immediately.  This does not mean that the controller will be involved in the day to day running of the company.  He may never need to exert his control.  His power may remain sheathed because the company is always run to his satisfaction.  But he has control if, when necessary, he can directly or indirectly make the company do his bidding. …”

(b)Material change?

36. According to clause 9.2(c) “materiality” must be considered in the context of IIS’s “present financial, technical and managerial skills”.  Those very words appeared in Mr McGinley’s witness statement.  He readily conceded in cross-examination that that phrase had been drafted by the lawyers.  That may be so but the statement is still signed by the witness as true and confirmed as such in evidence.  Mr Coleman seemed to suggest that less weight should be attached to this evidence because it was “drafted by lawyers”.  In this case I do not agree.  Mr McGinley was an impressive witness and I am satisfied that Sun’s council, with him as one of the three members, considered that the change was indeed “material”.  It was their honest and considered judgment.  It is abundantly reasonable, in my judgment, to attach substantial significance to the fact that IIS was no more than Itochu’s arm in Hong Kong.  It was also reasonable to conclude that the strength of the relationship between Sun and IIS in Hong Kong was because Itochu was its parent company.  The truth of this is demonstrated by the fact that IIS was under a contractual obligation to inform Sun whenever there was a change of as little as 5% of the shareholdings in IIS.  If they required immediate notice of a 5% change it is hardly surprising that they genuinely considered a 100% change to be material.  The significance of the fact that IIS obtained a bank guarantee of US$300,000 and the fact that Mr McGinley was unaware of it is, in my judgment, plainly outweighed by the significance of the sudden absence of Itochu in IIS’s business. 

37. In short, the new IIS had decided to “go it alone” under new management.  Sun cannot be criticized for not sharing their optimism. 

(2) LSPA

38. Clause 16.8 of the LSPA refers to “the … taking over … by … a third party”.  This is plainly what happened.  “Huge Creation” was a “third party” which took over. 

(3) SMCA

39. The relevant clause is clause 2.3(e).  It applies if there is “any substantial change in management or control …”. 

40. The same arguments apply without further elaboration.  The result is the same. 

41. For all the above reasons I find that IIS’s claim must fail. 

Damages

42. In spite of my decision on liability I consider some observations on issues of quantum may be apposite. 

43. At trial IIS’s claim was for loss of profits in the sum of US$807,000.  This figure was calculated from the gross profits from August 2004 to July 2005.  It was intended to represent an estimate of the profit that would have been made during the 180 days notice period.  

44. The calculation was flawed in at least two respects.  Firstly, it was based on gross profits, not net profits.  Secondly, it used the recent months when a profit had been made, ignoring the three previous years when losses had been recorded.  

45. Acknowledging the error of using gross rather than net figures Mr Coleman recalculated the quantum of the plaintiff’s claim in the form of an appendix to his written final submission.  For this calculation he used the net profits for April and May 2005.  This produced a figure for loss of net profits actually higher than the pleaded figure for loss of gross profits. 

46. This merely serves to demonstrate the difficulties in calculating loss of future profits in a case of this nature.  Had I been required to do so I would have taken into account a longer period of business and compared the relationship between gross and net profits over that period. 

47. In the event it would, I think, have been difficult to persuade me that a fair figure for loss of net profit would have been much higher than (on average) 30% of gross profit.  30% of the pleaded loss would have produced a figure remarkably similar to Sun’s counterclaim to which I turn shortly.  

48. Mr Yuen submitted that IIS’s case on damages was flawed through lack of reliable evidence.  There was some force in his contention that, at best, only nominal damages could be awarded due to the speculative nature of the amount claimed and the lack of any reliable evidential basis for their calculations. 

49. IIS also claimed smaller sums for (a) severance payments to staff who were laid off as a result of Sun’s termination and (b) surplus rental payments made for the office premises which became too large for the new business.  

50. Both these heads of damages faced difficulties.  It was difficult for Ben Lau to disagree that if Sun had given full notice the lay-offs would have occurred anyway.