HORACE YAO YEE CHEONG AND OTHERS v. PEARL ORIENTAL INNOVATION LTD

CACV 146/2009

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF APPEAL

CIVIL APPEAL NO. 146 OF 2009

(ON APPEAL FROM HCA NO. 916 OF 2006)

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J U D G M E N T

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Hon Rogers VP:

1.  This was an appeal from a judgment of Suffiad J given on 22 May 2009 whereby the judge gave judgment in favour of the three plaintiffs against the defendant in the following amounts: $1,509,128.18 and $54,264.58 in favour of the first plaintiff, $1,685,600.00 in favour of the second plaintiff and $3,697,274.26 in favour of the third plaintiff.  All such sums were ordered to be paid together with interest thereon at the judgment rate from 14 June 2005 until payment.  The judge also ordered the defendant to pay the plaintiffs the amount of the costs awarded to the plaintiffs by orders of the court in HCA 1245 of 2004.

2.  In paragraph 124 of the judgment the judge gave the underlying basis for the judgment in the following terms:

“In the final analysis, I am persuaded by the submission of Mr Wong who appeared for the plaintiffs that this is a proper case in which to lift and pierce the corporate veil and thereby to treat the defendant as being the same entity as DHL for all the reasons given above.”

3.  At the conclusion of the hearing of this appeal judgment was reserved which we now give.

Background

4.  Before considering the issues arising on this appeal it is appropriate to set out the background to the case.  Dransfield Holdings Ltd (“DHL”) was incorporated in the Cayman Islands in October 1992.  In May 1993 the plaintiff was appointed the Managing Director or Chief Executive Officer.  DHL was listed on the Hong Kong Stock Exchange.  Its business included warehousing, edible oils, brewery, trading and vending machines.  Unfortunately it would appear that, at least after a time, DHL’s business did not prosper.  Except for the year ended the 31 March 2000, DHL, including the companies within its Group, incurred significant losses for the 5 years up to the year ended 31 March 2001.  Indeed for that last year the Group recorded a loss of approximately $131.5 million.  According to the letter from the Independent Financial Adviser dated 28 June 2002, which was part of a circular to shareholders of DHL prepared in connection with a Scheme of Arrangement to which reference will be made below, as at 30 September 2001, the Group had net current liabilities of approximately $146.6 million.  The total current liabilities were given as $179.7 million comprising, mainly, interest-bearing bank loans of approximately $131.8 million.  The Independent Financial Adviser stated that the Group had audited net assets of approximately $176.3 million as 31 March 2001 but as at 30 September 2001 the net assets were $114.9 million.

5.  The circular itself referred to the losses sustained by the Group and the financial position of the Group being described in Appendices I and III to the circular, but those Appendices were not, apparently, made available to the court.  The directors stated, in terms which were repeated in the letter from the Independent Financial Adviser,:

“The abovementioned financial statements have been prepared on a going concern basis, the validity of which depends upon the successful outcome of the re-scheduling of the Group’s banking facilities and other liabilities; the ongoing support of the Group’s major bankers; the procurement of new equity and other financing and the orderly disposal of certain assets of the Group.  The auditors stated that the inherent uncertainties surrounding the circumstances under which the Group might successfully continue to adopt the going concern basis are so extreme that they disclaimed their opinion.”

6.  That view of the auditors had been expressed in early September 2001.  The plaintiff stated in evidence that because his fellow shareholders and directors requested him to resign, he did so, effective on 3 October 2001.  However, the plaintiff remained a director of DHL until June 2002 although he was re-designated as a non-executive director on 31 January 2002.

7.  In December 2001 the Group’s bank had filed a petition with the relevant law court in Shenzhen to obtain judgment in respect of a loan owed by Victorison Logistics Service (Shenzhen) Ltd (“Victorison (Shenzhen)”) the outstanding amount of which was the equivalent of $37.6 million.  Victorison (Shenzhen) was a subsidiary of DHL which had guaranteed the loan up to the equivalent of $46.18 million.  Agreement was reached with the bank in December 2001 that there would be a repayment of $700,000 per month subject to a lump sum repayment of $10 million prior to 30 April 2002.

8.  The bank disposed of a property in the middle of February 2002 and there was a shortfall of indebtedness of $15 million owed by another subsidiary of DHL to the bank.  The letter from the Board referred to DHL then entering into a debt restructuring agreement with the bank in March 2002.  The narrative continues that in May 2002 the bank served statutory demands on DHL and some of its subsidiaries; that appears to have been resolved with a supplemental agreement.  Eventually, it appears that the bank agreed that there would be an amount of $25.9 million to be paid on 31 August 2002.  That would then leave a liability to the bank of $28.9 million.  It was considered that should the amount of $25.9 million not be paid the bank was liable to take further action.

9.  It was in those circumstances that DHL entered into a subscription agreement with DiChain Systems Limited which has been termed the flagship company of China Merchants Group.  That agreement provided for the setting up of a new company into which the subscribers would invest more than $53 million, referred to below as the subscription monies, and there would be a Scheme of Arrangement whereby the existing DHL shares would be cancelled and new shares issued.  The existing shareholders of DHL would receive new shares in the new company.

10.  DHL was redomiciled from the Cayman Islands to Bermuda.  Under the heading “Purpose of the Redomicile and the Scheme” in the letter from the Board in the circular, the first paragraph states that the directors had decided to effect a redomicile in order to expedite the implementation of the Scheme.  The second paragraph under that heading refers to the purpose of the Scheme being to provide protection to the subscribers insulating them against the risk associated with any possible contingent liabilities of which the management and directors were not aware.  It would seem that those two statements are interlinked.  The letter from the Independent Financial Adviser takes the matter further because it states that “The Scheme has the benefit of segregating Newco from the existing liabilities (both actual and contingent) of the Group.”  It would appear that, in contrast to what might be considered the usual practice in Hong Kong, no provision was made for creditors when the Scheme was sanctioned by the court in Bermuda.

11.  The redomicile of DHL took place in June 2002.  The circular to which reference has been made was issued at the end of June 2002 and the Scheme of Arrangement became effective in August 2002.  Following that, DHL’s listing status was withdrawn and in its place the defendant’s shares were listed on the Hong Kong Stock Exchange.

12.  In February 2003 China Merchants Dichain (Asia) Investment Holdings Limited which became DiChain (Asia) Investment Holdings Limited and is now called Pearl Oriental Logistics Holdings Ltd (“Pearl Logistics”) was incorporated as the flagship company for the logistics business in the new group.

13.  The circular revealed that in October 2001 DHL had contracted to dispose of its 29.67% interest in DF China Technology Inc (“DFCT”).  That was a company listed on the NASDAQ Exchange for RMB10 million.  That sale was only partially completed and DHL was left with 19.76% interest.  In the defendant’s 2003 annual report it is recorded that as at 31 March 2003 the defendant owned 19.76% of DFCT.  It is then said that the Group’s shareholding was increased to 30% by converting debt owed by DFCT and then there was a sale of the shares.  The process resulted in a gain of some $16 million.

14.  In August 2003, Victorison (1988) Ltd (“Victorison (1988)”), a wholly owned subsidiary of DHL, transferred 7 shares in Good Value Holdings Ltd to Pearl Logistics.  The importance of that as regards this case is that Good Value Holdings Limited, held through another subsidiary, Victorison (Shenzhen), which later changed its name to Dichain Logistics Services (Shenzhen) Co. Ltd, a major asset, namely, bonded warehouses in Futian.  This transfer was the basis of the major complaint which gave rise to the judgment in this case.

15.  Although the plaintiff said in his evidence that he had “officially” pointed out to his fellow directors in early 2002 that DHL owed him money and, presumably, to the second and third plaintiffs as well and had asked them to come up with a plan, it was not until May 2004 that the plaintiffs issued the writ in High Court Action 1245 of 2004.  The plaintiffs obtained judgment in their action in June the following year.  The defendant sold its shareholding in DHL on 23 July 2005 for $2 and issued a public announcement to that effect on 29 July.  Three days earlier the directors of DHL had declared the company was insolvent.  There was a meeting of creditors held on 4 August 2005.  Eventually on 21 September 2005 DHL was wound up on the petition presented by the plaintiffs.  The writ in this action was issued in April 2006.

The judgment below

16.  It would appear that the judge below came to the conclusion that it was appropriate to lift and pierce the corporate veil and treat the defendant as being the same entity as DHL because he held that there had been some impropriety, wrongdoing, concealment, sham or fraud.  Exactly which of those was the factor which the judge found which guided him is not entirely clear.  In coming to the conclusion the judge said that paragraph 65:

“It seems clear enough from the evidence of Zhou that from the outset the defendant had embarked upon the acquisition of DHL under the Scheme of Arrangement with a view to acquiring all the benefits it can from DHL, including its listing status, but at the same time segregating from itself the liabilities incurred by DHL.  It seems that the only exception were the bank loans to DHL which the defendant had guaranteed to repay.  As for the other liabilities of DHL, such as the debts owed by DHL to the plaintiffs and which were unsecured, the view taken by the defendant was that such liabilities would be “segregated” from the defendant, probably on the basis that those were the debts previously incurred by DHL, a different and separate legal entity from the defendant, and therefore not the responsibility of the defendant.”

17.  As already pointed out, the circular issued by DHL in 2002, which explained the Scheme of Arrangement, was predicated on the separation that the judge considered objectionable.  There was no safeguard for creditors under the Scheme of Arrangement.  As already mentioned it may well be that it was considered that a court in Bermuda would be likely to sanction a Scheme of Arrangement which did not provide for the creditors, which may explain why it was considered more expeditious to change the domicile of DHL.

18.  The judge then went on to refer to the plaintiffs’ case that in taking that course the defendant had stripped DHL of its assets in a “wrongful” manner.  The judge referred to the plaintiffs having narrowed their case to 2 instances of asset stripping.  The first was what the judge said was the realisation of DHL’s part interest in DFCT for $16 million and secondly the transfer of the 7 Good Value Holdings Ltd shares.

19.  The judge explained what he considered was the improper or wrongful conduct in paragraph 95 of the judgment where he said that there had not been proper or sufficient value given for the assets which had been stripped away whilst leaving existing liabilities.

20.  Finally, the judge held that there had been concealment from the public of what had taken place and he referred to the annual reports of 2004 and 2005 as having made no mention of Pearl Logistics becoming the ultimate holder of the company that owned the bonded warehouses in Futian.

This Appeal

21.  On this appeal, Mr Lam SC, who appeared on behalf of the defendant, first of all challenged the judge’s findings in respect of the 2 transactions as well as seeking to demonstrate that the defendant had not acted in anyway that could be described as constituting culpable non-disclosure.  As to the law, he argued that even if there had been asset stripping of the nature alleged by the plaintiffs, that still did not give rise to a situation where the court could give judgment against the defendant for liabilities incurred by DHL on the basis of lifting or piercing the corporate veil.

The $16 million profit

22.  It has to be said that the judge appears not to have been wholly convinced that the plaintiffs’ point in relation to the $16 million profit was sound.  In paragraph 90 of the judgment the judge accepted that there was some evidence that DHL’s liabilities exceeded $16 million which would support the contention made by Mr Zhou, who was appointed managing director of the defendant in 2004, that the profit had been used to defray liabilities, although he did not demonstrate exactly how.

23.  Mr Lam demonstrated that there had been absolutely no attempt either by the defendant or DHL to disguise the fact that it intended to sell the interest in DFCT if at all possible.  The intention to sell and indeed the previous attempt to sell the interest, which was aborted and resulted in a partial sale, was recorded, as has been noted, in the 2002 annual report of DHL.  Thereafter it was clear both from the circular and the 2003 annual report of the defendant that attempts to dispose of the interest in DFCT would continue.  The ultimate sale was fully disclosed in the 2004 annual report of the defendant.

24.  The parlous state of DHL’s finances has already been referred to.  One factor alone can be mentioned, namely, that on 15 May 2002 part of the subscription proceeds, i.e. more than $25 million, were assigned to the bank for the repayment of loans by DHL.  The defendant’s interim report in 2005 discloses that when the DHL shares were disposed of there were net liabilities of the companies of $19.7 million.  The defendant’s accounts were naturally subsequently audited and there is no indication that the audit revealed any inaccuracy in respect of the DFCT shareholding.  It is also to be observed that the liquidators have not sought to raise any query over the sale of the interest in DFCT and the treatment of the proceeds of sale.

Good Value Holdings Limited

25.  There is no dispute that a major asset of DHL, if not the major asset, had been the warehouses in Futian which was held through Good Value Holdings Limited.  The warehouses had a value of some $121 million.  DHL held the 7 issued shares in October 1992 and in May 1994 the 7 shares were transferred to Victorison (1988).  When DHL was in severe financial difficulties, those shares were transferred to the bank on 6 March 2002 and were released and transferred back to Victorison (1988) in March 2003.  In August 2003 the 7 shares were transferred to Pearl Logistics.

26.  The defendant’s case is that the value of the warehouses was not the same as the value of the shares.  The audited accounts show substantial loan facilities backed by a pledge of assets.  The 2002 annual report of DHL, under note 34 to the accounts, shows that the bonded warehouses and the 7 shares in Good Value Holdings Limited were pledged to the bank.  The same is shown under notes to the accounts of the defendant in the 2003 and 2004 annual reports.  In the 2004 report, reference is made in note 36 of the accounts to the defendant having given guarantees of $98 million in respect of banking facilities granted to a subsidiary.  The amount of the facilities utilised appears to have been reduced slightly in 2005.  Mr Zhou gave evidence that the warehouse company had taken a loan of $90 million and that the defendant had guaranteed that liability.

27.  In summary, it would appear that it cannot be said that the shares in Good Value Holdings Limited had the value attributed to them by the plaintiffs.  The defendant had clearly guaranteed the loans that had been obtained on the strength of the Futian bonded warehouses.

Failure to make disclosure

28.  The judge also said at paragraph 104 of the judgment that there was “concealment from the public eye” of what he regarded as asset stripping.  First of all, it would appear that all necessary disclosures in the accounts and report were made. There is no requirement that intermediate holding companies of operating subsidiaries be disclosed.  Victorison (Shenzhen) an operating subsidiary, which later changed it name to DiChain Logistics Services (Shenzhen) Co. Ltd, was referred to in the 2003, 2004 and 2005 annual reports and that was the company that held the Futian bonded warehouses.  In the second place, it is difficult to understand how any supposed concealment would have affected the plaintiffs.  Even if the transfer by Victorison (1988) to Pearl Logistics should have been disclosed, the earliest that that could have occurred would have been the publication of the 2004 annual report in July 2004.  By that date, the plaintiffs had already issued their writs.

The insolvency of DHL

29.  The plaintiffs also sought to raise a point that it had not been explained as to why DHL become insolvent.  The judge relied on that submission in coming to his conclusion.  The March 2002 accounts showed that there were only $17.8 million in net assets as of March 2002.  By that stage a very substantial amount of the value of the interest in subsidiaries (something over $200 million) had been written off   Had any further provision been made the company would have been asset insolvent on the balance sheet alone.  As it was, the auditors’ approach to the solvency of DHL, as referred to above, shows the dangerous position of the DHL as of 2002.  The auditors were clearly not satisfied that DHL could be valued on a going concern basis.  The fact that the auditors “disclaimed their opinion” is indication enough of the precarious situation of the company.

30.  Mr Lam was at pains to emphasise that despite the fact that the plaintiff had made a complaint to the Commercial Crimes Bureau, there was nothing to show that any impropriety had been found.  The plaintiffs themselves had sought the winding of DHL, but nothing has emerged from the winding up to show any impropriety on the part of the defendant and certainly the liquidators have taken no action that would indicate it was their view that any matter required investigation.

31.  I would summarise my conclusions on this aspect of the case that the factual basis on which the judge proceeded to consider the submissions in respect of lifting or piercing the corporate veil were simply not made out.

Is it open to the plaintiffs to obtain judgment against the defendant?

32.  As has already been noted, the judge approached the case, as he was invited to do by the plaintiffs, on the basis that the defendant had stripped the assets of DHL improperly and wrongfully.  It would appear that what was considered improper and wrongful was the fact that the transfer of the assets was “without proper or sufficient value” coupled with the fact that the existing liabilities of DHL were not met and the creditors of DHL were left “high and dry”.

33.  For the reasons already indicated, I consider that the plaintiffs’ case has not been made out on the facts.  But even if it could be shown that the defendant had stripped the assets of DHL to detriment of DHL’s creditors that would not, in my view, give rise to the plaintiffs being able to gain judgment against the defendant.

34.  The fact that the defendant had “stripped” DHL of its assets and had acted improperly does not, of itself, give rise to a cause of action that may be brought by the plaintiffs.  The wrongs, if they be wrongs, were done to DHL.  As Mr Lam pointed out there may be causes of action which DHL could rely upon, for example: if it could be established that there was no genuine transfer then DHL might have a claim for a declaration that it was the beneficial owner of the 7 shares in Good Value Holdings Limited.  But that would be a claim by DHL or the liquidator.  In any event, Mr Neoh SC, who appeared on behalf of the plaintiffs, disavowed reliance on such a proposition and averred that it was the plaintiffs’ case that the 7 shares had been effectively transferred.  There could also be proceedings under section 60 of the Conveyancing and Property Ordinance Cap. 219 to avoid the disposition as having been made to defraud creditors.  But that is a remedy which is brought for the benefit of the company and the creditors as a whole.  It does not give rise to any right of action on the part of an individual creditor.  The same principle applies as in a case where a shareholder mounts a derivative action, the relief granted is on behalf of the company.  The relief in such an action would be granted to the company because the wrong was done to the company.

35.  The principle is sometimes referred to as preventing recovery of reflective loss.  In a case where a company is insolvent it is doubly important because were the plaintiffs to recover from the defendant on the basis that the defendant had assets of DHL other creditors of DHL would not recover what was due to them.  The essence of distribution in a winding up is that creditors of equal rank should share whatever assets remain equally.  If the plaintiffs were to succeed in recovering from the defendant on the basis that they were recovering assets that should have belonged to DHL, the other creditors of DHL would not recover their just share.  As already noted, it would appear that when DHL went into liquidation there were debts to the tune of $19.7 million.  The first plaintiff himself gave evidence that there had been a meeting of creditors.

36.  In paragraph 107 of the judgment, the judge referred to paragraph 9C of chapter 7 of Gore-Browne on Companies which sets out the circumstances in which the veil of incorporation will be pierced or circumvented so as to treat the rights and liabilities of a company and its parent as one for any purpose.  The plaintiffs’ case is that only one of those circumstances applies in the present case namely where the company is a mere façade used for some fraud or improper purpose.

37.  When taxed as to what was the façade or sham in this case Mr Neoh was hard pushed to settle on anything that could said to have been a sham.  In the end, one can only consider what the judge said, namely, that the defendant had to be treated as the same entity as DHL.  If that be the case then DHL itself would have been the sham or façade.  That, on the plaintiffs’ case, it clearly was not.  On the plaintiffs’ case it was the party wronged.

38.  It has to be observed that lifting or piercing the corporate veil does not give rise to a cause of action in itself.  It is a relief or remedy which can be granted when there is an underlying cause of action.  It is, therefore, important to determine what the underlying cause of action is.

39.  In the second place the device of lifting the corporate veil has been said to be a blunt instrument.  Whatever a blunt instrument might mean in the context, I consider it more appropriate to regard the device of lifting the corporate veil as arbitrary.  It is something that must be carefully applied and, in the context of circumstances said to warrant it in this case, it must be clearly established that the whatever liabilities were incurred the party said to be liable to discharge those liabilities on the basis of lifting the veil had used the party nominally incurring the liability as a façade.  That was not the case here.

40.  The judge clearly considered that the defendant’s course in, in effect, taking the asset of the bonded warehouses in Futian and leaving behind the debts as morally reprehensible.  Leaving aside the fact that the plaintiffs’ case appears to overlook the fact that the warehouses and the shares of the company holding them were seemingly mortgaged to the bank and had to be redeemed by the defendant, even if that were inaccurate, it would seem that the course of taken was envisaged when the Scheme of Arrangement was formulated and that Scheme was approved by the court in Bermuda.  The first plaintiff was one of DHL’s directors at the time when the directors put forward the Scheme.  Whereas every sympathy can be given to the judge for considering it reprehensible that where a business appears to be in severe financial difficulties, a party coming in should seek to set up a new company which would take the best assets, including the listing status and real estates, and leave behind the debts, that does not, of itself, give rise to a cause of action on the part of a creditor of the existing company against the new company.  Whilst a court will always strive to grant a remedy where a wrong is perceived, there is a limit to which the court can adopt an approach, which would resemble using the proverbial free-wheeling palm tree.

41.  In conclusion I would allow this appeal, set aside the judgment in the court below and make an order nisi of costs in favour of the defendant.

Hon Le Pichon JA:

42.  I agree.

Hon Harris J:

43.  I agree.