RE NTK TECHNOLOGY (HK) LTD

HCCW 528/2008

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

COMPANIES (WINDING-UP) NO. 528 OF 2008

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J U D G M E N T

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Introduction

1.  On 4 November 2008 the petitioner, Au Kwok Hung, issued a petition seeking a winding up of the 1^st Respondent, NTK Technologies (HK) Ltd (“Company”), alternatively, such order as the court considers just including a order that one or other of the respondents buy his shares in the Company at net asset value or a fair price.  The Company was incorporated on 11 May 1993 and at that time was called Ocean Forest Industries Limited.  It had initially one principal shareholder, NTK (HK) Ltd (“NTKHK”), which owned 1,999,000 of the 2,000,000 issued shares of the Company.  The remaining share was held by Mok Yu.  All shares were fully paid up.  On 7 June 2006 the shares were transferred: 18,000,000 to the 3^rd Respondent, Ip Pok Sum, and 200,000 to Au Kwok Hung.  The reasons for the transfer are explained below.  On 11 May 2007 Mr Ip transferred his shares to the 2^nd Respondent, NTK Holdings Ltd.

2.  Mr Au’s relationship with Mr Ip began in 2002 when he joined NTKHK as a factory manager.  He was promoted to deputy general manager in August 2002.  Mr Au was responsible for the production and operational side of the business and Mr Ip dealt with financial matters and sales.  It is common ground that Mr Au contributed successfully to the business.  Precisely how much and in what way is a matter of dispute, but in my view nothing turns on this.  Mr Au says he played a significant role in the development of NTKHK’s production of thermal products used for the dissipation of heat generated during the operation of computers.  Mr Ip plays down the extent of his contribution, but acknowledges that Mr Au was doing a sufficiently good job that he offered him a stake in a new company, which was intended to exploit the potential for thermal products and to take over most of NTKHK’s business with the exception of some property that it owned.  The new company was the 1^st Respondent, which was renamed on 15 July 2005. There is a difference between the parties concerning precisely what was agreed during these discussions, although as the trial progressed the extent of the difference became increasingly small.  Mr Au says that there were discussions in the first 8 months of 2004 culminating in an agreement that he would become Mr Ip’s partner.  This was to be achieved by NTKHK’s business being transferred to the Company in which Mr Ip and Mr Au were to have 80% and 10% stakes respectively.  The value of the shares was to be calculated on the basis of a multiple of 6 times NTKHK’s average net profit for the years 2003 and 2004, which was approximately $20,000,000.  The consideration for Mr Au’s shares was to be paid by deducting $15,000 per month from his salary from August 2004 and end of year bonus and subsequently from his entitlement to dividends.  Although deductions were made in his salary from August 2004 it was not until 15 June 2006 that instruments of transfer and bought and sold notes were executed transferring 200,000 shares to Mr Ip and acknowledging receipt of consideration. They were duly stamped.  On the same day a shareholders agreement was signed in the form of a deed.  The first recital expressly acknowledges that Mr Au is the legal and beneficial owner of 200,000 shares.  The agreement is short, but comprehensive and appears to have been either drafted by a lawyer or based on a precedent.  Consistent with what Mr Au says was the agreement about the payment of the consideration for his shares (effectively repayment of a loan by Mr Ip) it provides in clause 6.2 that all Mr Au’s dividends shall first be used to repay all monies owed by Mr Au to Mr Ip.

3.  Mr Au complains that subsequently to him becoming a shareholder Mr Ip conducted the affairs of the Company in a way which unfairly prejudiced to him.  The specific matters on which he relies are as follows:

(1)   Failure to explain to Mr Au why, what Mr Au understood were significant profits, were not being distributed as dividends or how they were being used.

(2)   Refusing to provide detailed financial information.

(3)   Agreeing in principal in the middle of 2007 to purchase Mr Au’s shares and encouraging him to resign as a director and then failing to progress the negotiations and instead causing the Company’s business to be transferred to one owned by Mr Ip.

Shareholder Issue

4.  Mr Ip’s case as contained in his affirmations and as explained by Ms Poon, who appeared for him at the trial, was that despite the fact that Mr Au was registered as a shareholder of the Company after the execution of the instruments of transfer and what the terms of the shareholders agreement says, it was agreed that Mr Au would not be treated as a shareholder until he had paid in full for the shares transferred to him and that as a legal consequence, rather than by express agreement, until then he held them on trust.  Mr Au denies this.  I explained at the outset of the trial that I thought this was a problematic argument given the contents of the contemporaneous documents.  As it transpired Mr Ip’s evidence in examination in chief did not support this case.  Ms Poon, for reasons I return to later, found it necessary to ask Mr Ip rather more in examination in chief than should have been the case.  She twice asked him what the terms of his oral agreement with Mr Au were which led to the shareholders agreement.  Twice he said that he could not remember precisely, but they were reflected in the shareholders agreement.  Not once in his evidence in chief or in cross-examination did he say anything that suggested that he did not think that Mr Au was to be treated as a shareholder until he paid in full for the shares; on the contrary the tenor of his evidence was to the opposite as he made it clear that he placed much value on Mr Au’s role in running the Company’s operations.  For example, he accepted that he had offered Mr Au 20% of the Company, but Mr Au thought this was too big an investment for him and said he only wanted 10% to which Mr Ip agreed.  However, notwithstanding this Mr Ip offered to give Mr Au 20% of the profits as he was keen to encourage his involvement in the business.  I, therefore, conclude that no such agreement was reached and that the suggestion it was agreed that Mr Au was not to be treated as a shareholder was something dreamed up during the course of preparation of Mr Ip’s first affirmation. Perhaps unsurprisingly Ms Poon did not pursue this argument in her closing and in these circumstances it seems to me that the argument that Mr Au cannot properly claim unfair prejudice falls away and the case falls to be assessed on the basis that at all material times Mr Au was a shareholder.

3^rd Respondent’s application to file new evidence

5.  Approximately two thirds of the way through her cross-examination of Mr Au, Ms Poon asked for an adjournment in order to compile a new affirmation from Mr Ip intended to plug gaping holes in his evidence, which had presumably become apparent to her during Mr Ko’s , who appeared for Mr Au, opening submissions and Mr Au’s evidence.  She told me that she wished the new affirmation to deal with the following matters:

(1)   The terms of the oral agreement;

(2)   The circumstances in which the shareholders agreement came to be drafted and signed;

(3)   What business was transferred to the Company and why the transfer took place;

(4)   The allegations of secret profits being made.

6.  As this description suggests Ms Poon was asking for the 3^rd Respondent to be given the opportunity to start afresh and put in an affirmation which dealt properly with the principal issues in the proceedings and in certain respects alter his evidence; I have in mind the evidence relating to the transfer of NTKHK’s business.  It transpired during the application that Ms Poon wished to adduce new documentary evidence by putting documents which had not been disclosed and which she accepted Mr Au had probably not seen before to Mr Ip in chief.  It did not seem to occur to her that these documents should be put to Mr Au, although it should perhaps be said in her defence, that this was because she had not seen the documents at the time of her application.  She managed to produce from her solicitors some of the documents for me to look at which related to Mr Au’s evidence that prior to him joining NTKHK it did not produce thermal products and some ledgers showing it selling what appeared to be DVD loaders during 2004 and 2005.  On inspection of the documents it became apparent that they did not demonstrate, as those who had passed them to Ms Poon presumably had assumed, that Mr Au’s evidence in relation to these matters was wrong.

7.  It is not satisfactory for a respondent to try and reconstruct his evidential case after the petitioner is well into his evidence and it has began to become apparent to counsel that his client’s evidence is inadequate.  This is inconsistent with the new litigation culture introduced by the Civil Justice Reforms (and was in any event never acceptable) and unfair to the opposite party.  In this case Mr Au had come to court expecting to face a particular case supported by particular evidence.  He was well into his evidence.  What Ms Poon requested would have required Mr Au’s evidence to be interrupted while he gave instructions to his legal team on whatever new evidence the Respondent produced.  It seems to me that this is unfair to him.  He was not in any way to contribute for the predicament that the 3^rd Respondent found himself in and Mr Au and his legal team would have found themselves having to address possibly substantial new evidence under time constraints and the other pressures attendant with a trial.  Although I recognise that commonly there are unexpected turns of events during trials in my view what was sought in this case goes beyond what is acceptable.  I, therefore, refused the application for an adjournment and told Ms Poon that I would not admit any new evidence other than legitimate reply evidence.  As it transpired Ms Poon was given considerable latitude in examination in chief in fleshing out Mr Ip’s case.

Breakdown of Trust and Confidence

8.  There is no dispute between the parties that the trust and confidence between the parties has broken down and Mr Ip, I was informed by Ms Poon at the commencement of the trial, agreed to have the Company wound up.  Mr Au position is that this would not properly address his grievances.  I was told by Ms Poon that the Company has assets worth about $300,000, because Mr Ip accepts that he has transferred the Company’s business to NTKHK, a subject I return to later.  As a result Mr Au would get little from a winding up of the Company unless claims were pursued by a liquidator against Mr Ip arising from his transfer of the business to a company owned by him for no value.

Petitioner’s Case

9.  Mr Au’s case is this.  In his discussions commencing in 2004 with Mr Ip leading to the shareholders agreement it was agreed that the Company’s profits would be distributed as dividends in due course.  By 2007 Mr Au understood from the financial information that he had that the Company had become highly profitable and began to ask Mr Ip about the distribution of dividends.  Mr Au never got a satisfactory answer to this question or his subsequent questions about what the surplus funds were being used for.  He started to seek detailed accounting information from accounts staff.  He did not receive it, because so he was lead to believe, Mr Ip was blocking its release.  He also became aware that Mr Ip was establishing his own business to produce thermal products in competition with the Company.  These matters led him to lose confidence in Mr Ip and in mid-2007 he told him that he wanted to sell him his shares.  Discussions followed, which were conducted through an intermediary, Tony Lee, during which Mr Ip agreed to buy back the shares although no price was agreed.  Mr Au assumed that there would be little difficulty in agreeing a price and on 27 or 28 December 2007 resigned as a director at Mr Lee’s suggestion and ceased his involvement in the management of the Company.

10.  Mr Ip did not progress the negotiation of the share sale and did not provide Mr Au with the necessary documents for him to assess what the Company was worth.  Mr Au commenced legal proceedings to obtain financial documents.  He obtained court orders requiring Mr Ip to allow inspection of documents, which Mr Ip was either very slow to comply with or did not comply with properly.

11.  In July 2008 Mr Au became aware of a notice published by the Company announcing to its suppliers and customers that with effect from 1 July 2008 all its business would be handled by NTKHK.  It appears from the documents that the Company ceased to carry on any business from about October 2008.  It is not in dispute that Mr Ip transferred the Company’s business to NTKHK during 2008 and that the Company is, but for any claims it might have against Mr Ip, for practical purposes valueless.  It follows that any valuation of Mr Au’s shares based on the current value of the Company will be minimal and that on a winding up he will receive a very small amount.

12.  Mr Au’s review of such financial documents as he had been provided with by Mr Ip pursuant to the court orders confirmed, in his view, the concerns he had about the way in which Mr Ip had dealt with the financial affairs of the Company.  His complaints are as follows:

(1)   Mr Au has 2 management accounts for the periods April 2007 to October 2007 and April to November 2007 respectively. The former is signed by both Mr Au and Mr Ip and shows the Company making profits for the financial year to 31 October 2007, a period of 7 months, of $6,248,831.35. The second for the period ending 30 November 2007 shows the profits increasing to $9,222,105.27.  The audited financial statement for the year ending 31 March 2008 shows a profit before tax of $1,197,834.14.  He raised this matter in paragraph 5 of his 3^rd affirmation and suggested that the thermal business was progressing successfully at the time he resigned and the profit should have been in line with the management accounts and must have been more than $1,197,834.14.

(2)   Support for his complaint, Mr Au says, is to be found in some the documents that have been disclosed.  For example purchase orders were disclosed for the period March 2007 to September 2008.  They show total sales of $30,000,000.  The financial statements for the 12 month period ending 31 March 2008 show sales of $66,000,000.  Mr Au says that this indicates that Mr Ip has probably not disclosed all the records that he has.  I note at this point that in paragraph 5 of his 2^nd affirmation Mr Ip says, when attempting to explain the inconsistency between the management accounts and the financial statement, that “after the Petitioner left in December 2007, the business of 1^st Respondent came to a low season.  Moreover, the sale was reduced and there were many slow moving stocks over HK$10,000,000.  Hence, the profits of the company dropped”.  This suggests, if true, that the reason for the apparent inconsistency cannot be a sudden increase in sales.

(3)   Pursuant to Barma J’s orders Mr Ip also disclosed bank statements, which show considerably greater deposits into the accounts, $135,000,000 for the period 30 April 2007 to 31 March 2008 and $157,000,000 for the period 30 April 2008 to 31 December 2008 respectively, than can be explained by the turnover shown in the audited accounts, which for the year ending 31 March 2008 show a turnover of $66,000,000 and for the financial year ending 31 March 2009 a turnover of $41,000,000.  This is consistent, so Mr Au argues, with his belief that the accounts given to the auditors were tampered with.

13.  Mr Au also queries how the relationship between the Company and the actual manufacturer of products was structured.  Mr Au says that the shareholders agreement clearly provides that the Company would manufacture products and that it was intended this would be done using a factory in Xintang with which NTKHK had an established relationship.  My understanding of this complaint is that rather than the Company simply pay the cost of manufacture the accounts show that NTKHK (in practice Mr Ip) was selling them the products at what he believes to be a mark up.  As a consequence, says Mr Au, Mr Ip had failed to transfer NTKHK’s business as required by the shareholders agreement.  Mr Au says that it is clear that this is what the parties intended from contemporaneous financial documents: the “financial plan weekly”, which shows that the Xin Tang factory costs were budgeted for by the Company, the profit and loss account, which is titled “NTK Technologies (HK) Limited – Xin Tang Comparative Manufacturing Account” and the fact that the Company placed purchase orders with suppliers for materials to be delivered to the Xin Tang factory.

3^rd Respondent’s Case

14.  Mr Ip’s evidence in his affirmations addressing these complaints was vague.  In essence he argues as follows.  Mr Au’s announcement of his wish to sell his shares and exit the Company came as a shock.  The reasons which he gives for having reached this decision are unjustified.  He said that it was never intended to transfer all of NTKHK’s business to the Company.  It was intended to transfer the connector and thermal business.  He accepts that he decided to transfer the Company’s business to NTKHK after Mr Au left.  He did so for various reasons.  First, because with Mr Au gone there was no reason to use the Company.  Secondly, because of queries about the Xintang’s factories activities by the Mainland customs and excise. Thirdly, because the Hong Kong Inland Revenue was investigating the Company. He did not do so to strip the Company of its assets in order to minimise what he might have to pay Mr Au.  So far as the inconsistencies in the accounting documents identified by Mr Au are concerned he said he did not know enough about the accounts to be able to comment.

15.  Mr Ip’s evidence was unsatisfactory.  He has produced no documents with the Mainland customs and excise to support his story and during cross-examination seemed unsure whether or not this was a reason for transferring the business perhaps because it has been pointed out to him that as the Xin Tang factory manufactured products for NTKHK it was unclear how moving the Company’s business to NTKHK might help reduce the adverse impact of any action taken by customs and excise.  It transpired that the Inland Revenue’s investigations were at least initially of NTKHK and, therefore, it would have made no sense for Mr Ip to transfer the Company’s business to NTKHK because of tax concerns.

16.  Mr Ip has known about the forensic accounting points for sometime as they are referred to in Mr Ip’s affirmations and one might reasonably expect him to have taken the trouble to look into these matters and explain why Mr Ip has jumped to the wrong conclusions.  He has not done so.

17.  Mr Ip’s evidence has changed in material respects during the course of the trial and on occasions lacked coherence.  I have already mentioned his substantial change of position in respect of the nature of Mr Au’s interest in the Company.  So far as the transfer of NTKHK’s business to the Company is concerned his initial position was that it had not been intended to transfer NTKHK’s business to the Company, but when he came to give evidence he stated that the parties’ agreement was as recorded in the shareholders agreement.  Clause 2.1 of that agreement states that the Company will manufacture and trade in “precision connectors, cable assembles, thermal solution and products and digital products”.  This was NTKHK’s business.

Conclusion

18.  My conclusion is that Mr Ip has been at best indifferent to Mr Au’s interest in the Company and once Mr Au ceased to have a role in its activities he has had no regard for them at all.  He has not accepted offers to mediate their dispute and has made no effort to agree a price for Mr Au’s shares.  The transfer of the Company’s business to NTKHK has unfairly prejudiced Mr Au’s interests as a shareholder in the Company.  A winding up order is not an appropriate remedy as a consequence of the transfer of business.  I will make an order that Mr Au purchases Mr Ip’s shares.  Mr Ko invited me to value the shares in the following manner.  Clause 5.1 of the shareholders agreement provides that if Mr Au wished to sell his shares Mr Ip should buy them at 6 times the average net profit for the previous 2 years multiplied by his proportion of the issued shares.  There are no accounts for any relevant 2 year period.  Mr Ko invites me to use the figures in the NTK Technologies (HK) Limited – Xin Tang comparative trading and profit & loss account for the period April 2007 to November 2007 and to extrapolate from this information what the likely yearly profit would have been at the time Mr Au left the business and Mr Ip agreed to buy his shares.  The figure is $13,833,157.90 x 6 x 10% = $8,299,894.74.  Mr Ko says that Mr Ip has not demonstrated, or sought to demonstrate it might reasonably be said, that the profit and loss account is inaccurate.

19.  Mr Ko argues that given Mr Ip’s recalcitrance in complying with Barma J’s orders it is reasonable to assume that he will be obstructive in providing information, which will allow an independent valuer to calculate a figure.  He also makes the point that Mr Ip should have disclosed all relevant documents and if all he has is genuinely what is before the court at this stage (which is what Mr Ip says) a valuer is only ever going to be able to take a rough and ready approach to valuation. This seems to me to be a fair point.  Mr Ko also says that the rough and ready approach he advocates is consistent with the terms of the shareholders agreement and is fair and realistic given the way in which Mr Ip has arranged the affairs of the Company.

20.  Ms Poon accepted that if I were to conclude that Mr Ip should buy Mr Au’s shares clause 5.2 should be followed.  However, she said any calculation should be adjusted to reflect the fact that Mr Au has not repaid the loan to buy the shares and that such an adjustment was expressly provided for in clause 5.2.  If such an adjustment were to be made the calculation would be as follows:  (average net profit x (10% x 920,000/2,000,000)) x 6.  This results in a calculation of $13,833,790.90 x 4.6% x 6 = $3,818,126.29.

21.  Mr Ko’s response to this point was that it was intended that the loan should be repaid out of the dividends declared by the Company and that Mr Ip had not made any distributions despite the fact that the Company was in substantial profit.  The difficulty with Mr Ko’s argument is that clause 6.1 in my view clearly provides that no dividends were to be declared before 31 March 2011 unless there was an earlier sale to third parties in which case there would be a dividend in order, presumably, to distribute retained earnings.  In other words if Mr Au chose to sell his shares before March 2011 he would only be paid for the shares he had actually paid for.  It seems to me clear that Mr Au had not appreciated this at the time he approached Mr Ip and told him he wished to sell his shares.

22.  As I understood Mr Ko’s position it was that if the court was not with him on the application of clause 5.2 the court should order the shares to be purchased at fair price calculated at that date that the petition was presented.  There was no debate before me as to the extent to which the shareholders agreement limited my discretion to order a valuation on such basis as I conclude is fair.  The fact is that given the way in which Mr Ip has managed the Company’s affairs it is difficult to identify a date for a valuation or a basis for valuation, which is not hypothetical because it is unclear whether or not he did cause NTKHK’s business to be transferred in its entirety to the Company and on what subsequent date he transferred the Company’s business to NTKHK.  Any valuer would have be directed to value the Company at a particular date on the assumption that all the business had been transferred.  It seems to me that a fair date would be 31 December 2007 at which point the parties had agreed in principle that Mr Ip would buy Mr Au’s shares.  The valuation would be on an earnings basis with no discount for minority interests.  What I have concluded I cannot do is to take the formula agreed in the shareholders agreement and vary it to reflect disapproval of Mr Ip’s conduct.  The agreed formula expressly provides for a reduction in the price if the acquisition price has not been paid in full.  The commercial thinking behind this is obvious and fair.

23.  In my view given the problems that any valuer will have in valuing the Company the fairest course is to adopt clause 5.2, which has the benefit for Mr Au of employing a 6 times earning multiple, which in my experience is generous.  As Miss Poon did not object to Mr Ko’s calculation except in respect of the reduction to reflect the loan I shall use that calculation.  The amount to be paid by Mr Ip to Mr Au is therefore, $3,818,126.29.  Interest should be paid on this amount from a date approximating when this sum should have been paid if the parties had progressed expeditiously to agree a price.  In my view this is 1 April 2008.  I will hear the parties on what the rate of interest should be used as I have no information concerning what rate Mr Au would pay on borrowings.

Costs

24.  Mr Ko submitted that if I found in Mr Au’s favour I should award him indemnity costs on 2 grounds.  The first concerned the unsatisfactory case that was presented by way of defence.  Mr Ko did not go so far as to say that Mr Ip was acting mala fide.  He seemed to suggest that if a party presents a case, which on any rational view is destined to fail his opponent should not have to shoulder the normal discount that results from taxation on a party and party basis.  I disagree, although I can see the attraction in the argument.  It does not seem to me that the fact that a defendant and his legal team have mounted a particularly poor defence to a claim thus making the plaintiff’s case that much easier to establish is a ground for ordering indemnity costs. The second ground is that despite an early offer to mediate and encouragement by the court to mediate at the pretrial review the defendant declined these offers; or at least did not respond to them.  Mr Ko points out that Practice Direction 3.3 provides that the court may take this into account when determining costs.  In the context of section 168A petitions any mediation is currently voluntary and although I find the defendant’s conduct unsatisfactory I do not think that it is a ground for making an indemnity costs order.  I, therefore, order that the 3^rd Respondent pay the Petitioner’s costs of the action on a party and party basis.