IN RE CAPITAL ASIA LTD.

HCMP 5475/98

------------------------

H E A D N O T E

------------------------

Companies Ordinance - reduction of capital and of share premium account - accrued non-permanent losses attributable to a large number of investments

Protection of creditors - undertaking to pay future recoveries into a special reserve account - scope of undertaking

HCMP 5475/98

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

MISCELLANCEOUS PROCEEDINGS NO.5475 OF 1998

------------------------------

J U D G M E N T

------------------------------

1. This is a petition by Captial Asia Limited ("the Company") for confirmation by the court of a reduction of the capital as well as a reduction of the share premium account of the Company. At the date of the petition, the Company had an authorised share capital of $500 million divided into 2,000,000,000 ordinary shares of $0.25 each of which 1,400,592,674 ordinary shares of $0.25 each are in issue.

Capital reorganisation

2. The 1998 audited accounts of the Company show that as at 1 April 1997, the Company had retained profits of $103,635,000, but that it recorded a loss of $597,407,000 for the year ended 31 March 1998. After netting off the loss against the returned earnings, there is an accumulated loss of $493,772,000 as at 31 March 1998. Taking into account the figures in the unaudited management accounts of the Company for the three month period ended 30 June 1998, the aggregate accumulated losses of the Company as at 30 June 1998 stood at $497,509,863.52.

3. The reduction of capital the court is asked to confirm provides for $0.24975 to be cancelled on each of the issued ordinary shares of the Company and part of its share premium account to enable the Company to eliminate the accumulated losses. At the same time, the nominal value of each ordinary share is reduced, ultimately to $0.01 (by means of reducing the nominal value of each ordinary share from $0.25 to $0.00025 and, upon the capital reduction taking effect, consolidating every 40 ordinary shares of $0.00025 each into one ordinary share of $0.01). The purpose is to ensure that the nominal value of each ordinary share will fall below the recent market value of each ordinary share as traded on the Stock Exchange of Hong Kong Limited. Between 1 April and 16 October 1998, the shares traded at prices between $0.152 and $0.011.

4. The effect of the capital reorganisation proposals is illustrated by the summary below :

The losses

5. The unaudited management accounts for the 15 month period ended 30 June 1998 show aggregate losses of just over $601 million. They comprise an operating loss during that period of over $32 million, loss on an investment fund of just over $6 million and exceptional losses (set out below) aggregating almost $563 million.

6. The Company has filed voluminous evidence including a supporting affirmation of Wong Chi Fai, one of its directors, running to over 170 pages with 2,000 pages of exhibits. Mr Wong and all current directors of the Company were only appointed at the end of March or early April 1998 when the Company's present ultimate principal shareholder, Emperor International Holdings Limited ("Emperor"), indirectly acquired 25.27% of the Company. Emperor acquired the shareholding from the previous owner Mr Alex Wong

Ching Ping but on condition that Mr Alex Wong acquire CA Pacific Group Ltd. (including the then recently insolvent CA Pacific Securities and CA Pacific Finance) which formed part of the Company for $1.00. The remaining 74.73% remain in public hands with no such shareholder having an interest greater than in 10% of the shares.

7. The exceptional items aggregating $562,927,995.74 are made up as follows :

The bulk of the supporting evidence was directed at explaining the provision for diminution in value of interest in over forty of its subsidiaries. That meant that the accounts of those subsidiaries had to be gone into to establish the diminution in value.

8. There is no doubt that the evidence filed in this case is thorough. Each item of loss has been fully explained. I am satisfied that such losses have in fact been incurred. As to the question whether each item of loss identified is permanent or non-permanent, at the summons for directions stage, I was in agreement with the classification made by the Company with one exception. In that one instance, the loss was classified as permanent. The Company now accepts that that item ought to be regarded as a non-permanent loss. In the result, what the evidence establishes is that the non-permanent losses incurred by the Company amount to $521,065,043.36 and the aggregate amount of permanent losses is $80,080,031.

The issues

9. In the course of the hearing, two matters concerning the protection of creditors arose which required consideration. One related to the undertaking from the Company and the other to the Company's financial condition.

10. The undertaking

11. At the conclusion of the hearing on the summons for directions which was heard on 12 November and 1 December 1998, the Company gave the following undertaking :

"AND the Company by its Leading Counsel undertaking that any amount taken into account in the accounts of the Company for the 15 month period ended 30 June 1998 by way of provision in respect of the investments or loans or transactions, as the case may be, set out in the first column of the Schedule hereto and as more particularly described in the paragraphs of the aforesaid Affirmation of Wong Chi Fai (as supplemented by the aforesaid Supplemental Affirmation of Wong Chi Fai) identified in the second column of the Schedule respectively set opposite such investments or loans or transactions which shall be recovered by the Company up to an aggregate amount of HK$497,509,863.52 will be credited to a special capital reserve in the accounting records of the Company and that so long as there shall remain any debt of or claim against the Company outstanding at the date when the proposed reduction of capital and of the share premium account 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 persons entitled to the benefit thereof shall not have agreed otherwise, such reserve

(i) shall not be treated as realised profits and

(ii) 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 above-mentioned Ordinance or any statutory re-enactment or modification thereof"

The undertaking contained the usual provisos. See Re Lippo Resources Limited [1998] 1 HKC 161, 165C-F; 9 Atkin's Court Forms (1995 Issue) 97, footnote 4. In addition, it also contained the further undertaking to publish a note of the undertaking in its audited financial statements or accounts or any prospectus issued on behalf of the Company. See Re Lippo Resources Limited at 166G-I. This requirement of noting the accounts followed Re Hodder & Tolley Ltd. (1975) 2 NZLR 395 at 398 l.45 and 400 ll.30-35.

12. Under the terms of the undertaking, amounts recovered by the Company up to the amount of loss incurred in respect of each of the investments in the subsidiaries, loans or transactions set out in the Schedule to the Order on the summons for directions ("the specified investments") are to be paid into a special reserve for the benefit of creditors existing at the date of the order confirming the reduction, subject to an overall cap of the amount of capital to be written off, viz. $497,509,863.52. The question which arises is whether the court should accept this as adequate protection for existing creditors. More specifically, the question is whether as between the specified investments, the amount to be paid into the special reserve should be restricted to the amount of the loss established in respect of each individual item or whether it should extend to the first $497.5 million to be recovered by the Company from such specified investments irrespective of their position inter se.

13. The effect of sections 79B and C of Cap.32 is that a company cannot pay dividends on its shares so long as it has a deficit on its profit and loss account. If the court were to confirm a reduction of capital to enable the Company to write off its losses, the Company would be put in a position of being able to distribute profits which would otherwise have to be applied to reduce the deficit shown in its profit and loss account. As noted in Boyle and Marshall on Practice and Procedure of the Companies Court at 4.9.4, this could involve prejudice to the interests of creditors who would be entitled under section 59 to object to the reduction. It does not follow from the fact that the reduction does not involve either diminution of liability or payment to a shareholder of paid-up capital that creditors could not be injured. It is thus stated in Buckley on the Companies Acts (1981 Edn.) at 189 as follows :

"...but sub-s.(2), by the words 'and in any other case if the court so directs', protects the possible case of their being injured, e.g. by a writing off of paid-up capital not lost or unrepresented and thereby possibly setting free a corresponding amount of capital assets for distribution amongst the members."

The relevant section in Cap.32 is s.59(2). I agree with that statement. In such a situation, the court should not confirm the reduction without giving creditors the right to object under section 59(2).

14. Whilst it is recognised, as stated in Boyle and Marshall (supra) at 4.9.5 that :

"the court will generally regard as appropriate an undertaking given to the court by the Company that any such profit, as and when realised, will be credited to a non-distributable reserve,"

or, as stated in Ho on Public Companies and Their Equity Securities at 15.3.3 that :

"reduction will not be permitted unless the company undertakes to place all subsequent recoveries in a permanent capital reserve account"

it is not entirely clear from such general statements how the undertaking is to operate or exactly what sums are subject to it where the loss stems from more than one single investment or transaction. Take by way of illustration a company that has three separate businesses or investments, whether or not such businesses are conducted via separate subsidiaries. Assume that business A is profitable and that the accumulated non-permanent losses arose from businesses B and C as to $5 million each. The writing off of the accumulated losses of $10 million in the example given would enable the company to distribute by way of dividend any future profits when realised to the extent that they are not subject to the terms of the undertaking. Does the undertaking (i) extend to profits generated from business A? or, (ii) profits generated from business B in excess of $5 million?

15. The two leading cases on the subject are Re Jupiter House Investments (Cambridge) Limited [1985] 1 WLR 975 and Re Grosvenor Press Plc [1985] 1 WLR 980. In Jupiter House, the accumulated loss on the profit and loss account of ￡384,058 sought to be written off was attributable to the fact that a substantial property owned by the company suffered from unexpected defects. However, there was evidence before the court that it was possible that the company would be able to recover most or even all of the loss in proposed litigation claiming ￡500,000. The loss proved was thus expected to be transitory. In those circumstances, the undertaking offered by the company and accepted by the court was to ensure that :

"...if the company is successful in recovering money by its claim, the amount of the recovery, up to the amount of ￡384,058, by which the capital is now sought to be reduced, would be taken direct to capital reserve and would not be available to distribute by way of dividend. Thus there would be no chance of moneys which in truth represented capital of the company being used to pay dividends."

16. In re Grosvenor Press, the company acquired a business of publishing and distributing two publications from an associated company for ￡725,000. This was resold the same day and at the same price to its wholly owned subsidiary Grosvenor Press International Limited ("GPI"). The price was left outstanding as a loan by the company. Shortly thereafter, it was agreed that the capital of GPI should be increased and reorganised and the company disposed of 49% of the shares to a third party. One of the terms of the agreement was that GPI would issue 700,000 "B" secured redeemable loan stock to the company in consideration for the cancellation of the loan of ￡725,000. The sum of ￡725,000 was written off after consultation with the auditors as an exceptional item. Because of this, as at 30 April 1984, the company's accounts revealed a deficit of ￡722,348 which the company decided to eliminate. The evidence before the court was that although it was not possible to attribute any value to the investment in the development and promotion of the publications represented by the holding of the "B" secured redeemable stock of GPI, it was anticipated that profits would be made by GPI. Because it was clear that the capital was not permanently lost, the company offered an undertaking for the protection of the creditors. That undertaking was to credit to a special reserve :

"any sum received by the company in respect of its investment in the share capital and the secured redeemable loan stock of GPI (whether by reason of a realisation or repayment of the whole or any part of such investment or the payment of dividends or interest or otherwise howsoever) up to a maximum amount of ￡725,000."

17. It seems tolerably clear from those two cases that profits derived from businesses or investments not themselves the subject of any reduction of capital are prima facie not affected by the undertaking although the underlying rationale is less readily apparent. Presumably there would be little point in embarking on that exercise if future profits cannot be released for distribution. It is to be noted that the specified investments, by and large, appear not to be in subsidiaries considered by the Company to be its principal subsidiaries in its 1998 Accounts. Again, presumably, there are profitable subsidiaries.

18. Mr Poon, S.C., for the Company submitted that having regard to the terms of the undertaking in each of those two cases, the undertaking is confined to the amount 'written off' in respect of each of the specified investments. Whilst the form of the undertaking in those two cases would appear to support Mr Poon's position, it is to be noted that in each case, the court was concerned with a single investment or transaction which gave rise to the loss. The cap is readily explicable, being equal to the amount of capital to be reduced as is the present case. But the question now before the court, viz. whether it is appropriate to further cap the undertaking as between the various investments which gave rise to the losses, did not arise in those cases and therefore did not fall for consideration.

19. A feature of the present case is that non-permanent losses amount to approximately $520 million whereas the amount of capital to be reduced is only $497 million odd, after netting. The losses stemming from the specified investments have been 'pooled' for that purpose and netting highlights that fact. What is being written off is part of the capital of the Company, attributable to the value of losses from that particular basket of investments comprising forty-seven different items. In any event, an arithmetical approach to the operation of the undertaking is artificial because of the netting off exercise.

20. Whilst the Company's approach is a possible approach, it is not the only approach. In substance, the court is being asked to write off a composite fund. Looked at globally, I see no reason why the undertaking should not attach to all future recoveries from those investments collectively up to an amount equal to the amount of capital to be reduced. Were it not so, I would anticipate even greater difficulty in 'policing' or 'monitoring' the undertaking which is intended to protect existing creditors.

21. In exercising my discretion to confirm the reduction, it is the approach that gives the maximum protection to existing creditors that should prevail. It may well be, as submitted by Mr Poon S.C. that the liquidator owes a duty to the creditors to pursue the directors for any breach of the undertaking. But in that scenario, the horse would have bolted.

22. The Company's financial condition

23. In Re South China Strategic Ltd. [1997] HKLRD 131, Rogers J (at 134G-H) observed :

" Generally speaking, in a reduction of capital the court looks to see whether there are sufficient assets of an immediate nature which would cover both the capital to be reduced and the liabilities of the company with an ample margin of security. If there are not, the court must be cautious."

24. The question is whether those observations apply to the present case. If they do, the Company may be in difficulty because according to its unaudited management accounts for the 15 month period up to 30 June 1998, during that 15 month period, the operating expenses exceeded the Company's income by over $2 million a month on average. Its net current assets as at that date stood at $2.8 million. It seemed tolerably clear that without an injection of funds, the Company cannot survive for very long. At the hearing of the petition, the court was provided with the Company's unaudited management accounts for the month of September 1998. Its financial condition had improved somewhat inasmuch as the monthly operating shortfall was in the region of $1 million rather than $2 million and its cash situation had also improved in that it had net current assets of almost $11 million.

25. Leading counsel for the Company who was also the amicus in Re South China Strategic submitted that the observations made in that case are confined to schemes which involve repayment of capital or any outflow of funds from the Company. At first glance, the scheme in Re South China Strategic did not appear to involve any repayment of capital. It was represented to be a simple re-domicile when, as it emerged, the company had been making substantial losses and the scheme in fact involved the elimination of its existing capital of over $189 million and reinstatement of paid-up capital of only $1,000. There was no proper explanation before the court as to the nature of the losses, their extent and how they came about, although it seemed that the accumulated loss was $88 million. (See page 134D of the report).

26. The scheme document in Re South China Strategic was produced to the court. It included a provision, (para.1E) to the effect that the balance of the credit arising in the books of account of the company as a result of the reduction of its share capital together with the credit arising in its books as a result of the cancellation of its share premium account would be credited to a reserve account which would be "distributable subject to any restrictions or conditions imposed by the court to protect the interest of the creditors of the company". Mr Poon, S.C., submitted that because there was inadequate evidence as to the extent of the losses, it was impossible to say what part, if any, of the existing capital and share premium account to be cancelled would go towards the elimination of those losses. In view of the provision in the scheme for distribution i.e. para.1E, it is fair to describe the scheme as involving the repayment of capital and that the observations of Rogers J should be read in, and confined to, that context.

27. Mr Poon, S.C., proceeded to develop the dichotomy between reductions which do not involve any outflow of funds from the Company and those that involve either a return of capital in excess of wants of the Company or the diminution of any liability in respect of unpaid share capital (which rarely occurs these days) or the payment to any shareholder of any paid-up share capital. A settlement of a list of creditors will not be dispensed with unless the Company has sufficient cash and gilt-edged securities of a sufficient value to cover all its provable liabilities (other than those guaranteed by a bank or when the creditor has consented to the reduction) as well as any amount proposed to be returned to the shareholders with a reasonable margin of safety to cover possible oversights. See Buckley on the Companies Act at 191; Boyle and Marshall on Practice and Procedure of the Companies Court at 4.9.9; the annotation at 102/4/34 of the Supreme Court Practice 1999 and In re Lucania Temperance Billiard Halls [1966] Ch.98, 102.

28. Upon further consideration of the facts and the scheme document in Re South China Strategic, I am inclined to agree that that case did involve at least the possibility of a return of capital inasmuch as it was not explicit what losses were to be eliminated by the credit thrown up through the reduction of capital, given para.1E of the scheme which envisaged the distribution of the cancelled capital to the members of the company. I am therefore prepared to accept that the observations made in Re South China Strategic do not apply to the present case which is purely one of loss reduction.

Conclusion

29. For the reasons set out above, I do not regard the undertaking given by the Company as adequate protection for the creditors. I am prepared to confirm the reduction of capital sought and cancellation of the share premium account only upon a fresh undertaking of the Company that all future recoveries from the specified investments up to an amount not exceeding $497,509,863.52 be credited to a special reserve upon the usual provisos. If the Company is willing to give such an undertaking, a minute of order should be submitted for approval. If not, the Petition will be dismissed. Once the Company has had an opportunity of considering this judgment, the court should be notified of its decision.