CHUNG MEI INDUSTRIES LTD v. SO KWOK KEUNG

HCA 2604/2005

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

ACTION NO. 2604 OF 2005

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BETWEEN

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J U D G M E N T

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Introduction

1.  The outcome to this action turns on whether the Defendant Mr Raymond So’s remuneration was to be calculated based on the audited net profit of the companies comprising the Chung Mei Industries group (and at this stage I use this description loosely) which take in manufacturing of small electrical products, rental and sales of real estate and income earned from managing stocks and shares or, whether it is to be restricted to the audited net profit of a single company, the Plaintiff Chung Mei Industries Limited, which is a manufacturer of small electrical household products.

2.  The Plaintiff’s claim, which is dependent on a finding that the Defendant was to be remunerated on the latter basis, is for the return to it of $2,925,000 paid to the Defendant as advance commission based on hoped for profitability which, in the event, did not eventuate and which in such circumstances is now said to be repayable by him to the Plaintiff.

The Parties

3.  The principal protagonists are Mr Sebastian Man and the Defendant Mr So.  Both are highly sophisticated and accomplished businessman.  Mr Man comes from a well-to-do business and social background. He is the main shareholder of the Plaintiff which he purchased in the late 1980’s from his father and a group of other shareholders.  The Defendant, who is a qualified accountant, has been a highly successful Managing Director of Durable Electric, a leading manufacturer and seller of a wide range of small household appliances, mostly to large retailers in the USA.  Prior to his employment by the Plaintiff he had established a very successful track record with Durable Electric leading it to a period of sustained high profitability and growth. For this he was being paid $300,000 a month.

4.  For his part, Mr Man had been heading the Chung Mei group, which included the Plaintiff, as well as a property development company and the management of the group’s stock and securities fund, through a period of growth and profit but perhaps without the hoped for significant success which any entrepreneur wishes to achieve.  So far as the Plaintiff company is concerned, as a separate and distinct business, Mr Man managed it so that its annual sales turnover grew from $20 million in 1989, when he purchased it, to $200 million in 1997.  By late 2003, it employed 1,000 people.

5.  After 1997, Mr Man has said that he was not able to significantly increase turnover from its peak of $200 million. Disappointingly, profits also began to sag after 1997.  In 2001, a profit of $8.2 million was achieved from a turnover of $186 million [a margin of 4.4%], in 2002 profit was $6 million from a turnover of $227 million [a margin of 2.6%] and it then dipped to just $220,949 on a reduced turnover of $175 million [a margin of 0.125%]. 

6.  He determined that the time had come for him to put in a more experienced professional manager who would have the expertise to grow the Plaintiff to become a strong and profitable manufacturer.  Another reason for wishing to take a more back-seat position was that he wished to devote more time to charitable community-based work and to re-establish himself on the political stage, he having been a member of the Provisional Legislative Council before the handover in 1997.

7.  The choice of the Defendant as the ideal person to increase turnover and profit based on his known success at Durable Electric was facilitated through a Mr Wilson Chan, who has given evidence for the Plaintiff in this trial.  In 2003, the Plaintiff had taken on a number of Durable Electric’s employees who had been introduced by Mr Chan and who himself had previously been employed by Durable Electric.  It was he who introduced Mr Man to the Defendant.

8.  Suffice it to say, for present purposes, that the Defendant was not interested in joining the Plaintiff unless he was offered similar remuneration to the $300,000 a month that he was earning at Durable which had annual profits of $200 million on a turnover that was probably ten times that of the Plaintiff.

9.  It will be necessary in due course to relate the rationale which underpinned the Agreement under which the Defendant was employed by the Plaintiff.  At this stage, it is sufficient to set out the main terms of the Agreement upon which the Plaintiff’s claim is brought.

The Agreement

10.  As one might expect, the final Agreement that the parties arrived at was the result of keen negotiation over a number of meetings, between Mr Man and the Defendant.  The Plaintiff’s solicitors had previously prepared two draft Agreements which were the basis for further discussion, negotiation and amendment.  The Agreement which was finally signed by the parties was the third attempt to arrive at a consensus.  The focus of contention was the amount and the method by which the Defendant was to be remunerated.  The Defendant was insistent that he was not willing to join the Plaintiff unless he received no less than $300,000 a month.  Mr Man’s position was that there was no way that a company like the Plaintiff, that was barely breaking even in 2003, was able to pay the Defendant the $3.6 million a year that he was demanding.

11.  A compromised position was agreed on.  The Defendant would be paid a basic salary of $75,000 a month plus a further $225,000 as “advance commission” [Para. 2(a) and (b)] which he would need to earn by increasing the Plaintiff’s profits at rates which I will come to shortly.  If profits were less than a target amount, he would need to return a proportion of the $225,000 and if the profits were below a specified amount or, worse still losses were incurred during the financial year, he would need to repay all of the $225,000 which, unfortunately is what happened.

12.  The Agreement is in the Core Bundle pages 150-164.  The Defendant’s remuneration was based on his basic salary and commission as well as his potential participation in an Incentive Scheme.

13.  As to his commission-based remuneration, the description that I am about to provide is no substitute for a complete reading of the relevant terms of the Agreement, but I intend to provide sufficient detail and references for an essential understanding of what was involved.

14.  As to the $75,000 monthly basic salary provided for in Para. 2(a), this was the Defendant’s to keep — payable in any event.

15.  In addition, the Defendant was given the opportunity to earn well in excess of the basic amount.  It is described as a commission and was based on the Defendant’s performance as reflected by the Plaintiff’s profit and its sales turnover.

16.  Commission is dealt with in para. 2(b), (c), (d), (e) and (f).

17.  Para. 2(b) provides for the monthly payment to the Defendant of $225,000 as an advance commission supra, and also provides that the Defendant “acknowledge(s) that the advance commission payable under this contract may be subject to a downward adjustment at the end of each calendar year in accordance with Paragraphs 2(c) and 2(d)”.

18.  The Defendant started his employment on 1 December 2003.  The Plaintiff’s financial year ended on 31 December.  The Plaintiff made the advance commission payments to the Defendant from 1 December 2003 until 31 December 2004 amounting to $2,925,000 which it now seeks to recoup.

19.  I now come to the contractual basis which the Plaintiff relies on for the return of this sum.  Under Para. 2(c) the expression “Net Profit” means Chung Mei’s audited profit.  Chung Mei is the shorthand expression for Chung Mei Industries Limited, the Plaintiff (opening paragraph of the letter of appointment CB/150).  The calculation of audited profit for these purposes is subject to a number of excluded and included deductions [Para. 2(a)(i)(ii)] which I do not need to recite here.

20.  Para. 2(d) and (e) are of vital importance in the determination of whether the Defendant is to keep the advance commission payments, repay part or, all of it.

21.  Para. 2(d) relates to the situation where the Plaintiff’s net profit is above $10 million in any one financial year.  If it is, the Defendant would be entitled to keep all of the payments and, as will be seen in a moment, under a separate Incentive Scheme he may be able to get further payment.  It can therefore be fairly said that a profit of $10 million is the performance target by which the Defendant preserves all of the advance commission payments made to him.

22.  If the Plaintiff’s audited profit comes in below $10 million, the Defendant then begins to lose his commission.  If the profit is below $10 million but above $5 million, the Defendant is required to repay $150,000 out of each payment of $225,000.  In other words his actual commission is reduced to $75,000.  Over the 13 months that these advance payments were made he would need to repay $1,950,000. 

23.  Para. 2(e) applies where the audited profit is less than $5 million.  In such circumstances, the Defendant has to pay back all of the advance commission payment, that is to say $150,000 under Para. 2(d) and the balance over of $75,000 under Para. 2(e).  He of course retains his basic salary of $75,000 a month under Para. 2(a).

24.  The Plaintiff’s case is that its audited profit for the year-end 31 December 2004 was in fact a loss of over $19 million [see Deloitte’s audit report in CB 23/217], which meant that the Defendant was liable to pay back all of the advance commission payments under the various sub-clauses of Para. 2 to which I have referred.

25.  Mr Jeremy Chan, who appears for the Plaintiff, submits that whatever the Defendant seeks to do or say about the Plaintiff’s audited accounts, there is simply no way in which the Defendant is able to haul himself up to a profit of at least $5 million which would preserve for him $75,000 of the monthly advance commission payment nor a fortiori, to $10 million which would allow him to keep all of it.

26.  Given the nature of the argument put forward on the Defendant’s behalf by Mr Bernard Yuen, it will be helpful to explain the remainder of the remuneration provisions contained in the Agreement.

27.  Para. 2(f) deals with sales turnover rather than the audited profit, whereas (d) and (e) are triggered by actual profit, (f) is concerned only with sales.  If the Plaintiff achieves sales of $350 million in the first calendar year of the Agreement [2004] and $400 million in the second calendar year then, regardless of net profit in those two calendar years and regardless of “sales performance … in the calendar year immediately following the second calendar year and thereafter …,” the Defendant will cease to be subject to the repayment arrangements of the advance commission contained in Para. 2(d) and (e).  And so, this was to be an important “safe haven” provision, as Mr Chan has described it, under which the defendant would be rewarded for growing the business irrespective of whether profit failed to match $10 million or even $5 million.  In such circumstances, he could still retain all of his advance commission payments. This might be thought to be a just reward considering that in 2001 turnover was $186 million and in 2002 it was $227 million and, by Para. 2(h) “for information purposes only” the anticipated turnover in 2004 was $200 million. Rises to $350 million and $400 million would therefore be seen as meriting the retention of all of the advance commission payments.

28.  Finally, under the heading of remuneration there was also an Incentive Scheme covered in Para. 3 which the Defendant was to administer.  This scheme is only available to those involved in the small household appliance department.  The Defendant is an “Eligible Participant”. What the scheme does is to further reward the Defendant and the other eligible participants in circumstances where the audited profit of the Plaintiff exceeds $10 million during the financial year.  Para. 3(k) [CB 157/158] provides an illustration table as to how the scheme is to operate and the amounts of money that would be available for distribution amongst the eligible participants.  Subject to improving profits, beyond $10 million, to which the Incentive Scheme is linked (as opposed to sales turnover), the Defendant would be able to earn more than the combined total of $75,000 as basic salary and $225,000 commission which he would be entitled to keep once a profit of $10 million is achieved.

29.  It is also significant that for 2003, 2004 and 2005, the Defendant was also to be in receipt of $300,000 a month from Durable Electric under his severance package with it, he having ceased his employment there in November 2002.  This is a feature of the evidence which I will need to comment on further when I come to consider the rival contentions as to whether this Agreement for the Defendant’s remuneration was restricted to profits from the Plaintiff alone or from the Cheung Mei group of companies.

30.  I think it is sufficient to say that provided the Plaintiff is able to prove, to the court’s satisfaction, that the audited profit of the Plaintiff for 2004 was below $5 million and that it is only the Plaintiff’s profit and not the group’s combined profit that needs to be added to the computation, then the Plaintiff must be held to have succeeded in the action.  Subject to the arguments that I am about to consider, there can be no other outcome based on a correct interpretation of the relevant terms of the Agreement to which I have already referred.

Whose Audited Profit

31.  The starting point to the argument must be the Agreement itself which plainly identifies the Plaintiff, and no other company or entity, and the Defendant as the only contracting parties.  The next point is that under the Agreement, the Defendant was engaged to manage the Plaintiff and no other company or entity related to it.

32.  The Defendant, who was and no doubt still is, a highly respected figure in the small household good industry must have been a considerable catch, if I can so express it, for Mr Man to engage to lead the Plaintiff’s operations.  The Defendant had been managing a leading manufacturer in the same industry as the Plaintiff and operating at a completely different level.  Durable was a billion dollar turnover company whilst the Plaintiff was then expected to turnover $200 million and just about break even.  Durable’s profit had been increased to $200 million with the Defendant at the helm.

33.  It is not surprising therefore that Durable was able to remunerate him at the rate of $300,000 a month.  This was simply not possible for the Plaintiff to match on its recent performance.  This said, I accept that the Defendant was not prepared to make the move unless in some way or another he could achieve similar levels of pay from the Plaintiff.

34.  In the course of their discussions, I have no doubt that Mr Man would have wished to “puff up” the Plaintiff and in doing so he revealed to the Defendant that his (Man’s) business activities encompassed not only the Plaintiff, as a still reasonably modest household goods manufacturer, real property holdings principally comprising the Chung Mei Centre, owned by another company (not by the Plaintiff), the “La Mer” luxury development at Bisney Road, Pokfulam, also owned by yet another company, and fund management.  In mentioning all of these other commercial ventures and activities, I have no doubt that part of Mr Man’s motive was to show that, as the principal person behind all of these ventures, he was in individual of substance and a serious and successful businessman, as were the companies associated with him.  In doing so, he wished to impress the Defendant, who had been employed by such a large player in the Plaintiff’s industry, that a move to the Plaintiff would take him to a serious, well-established and commercially ambitious organisation.

35.  The Defendant has advanced a different case to this.  He says that Mr Man had represented to him that his commission would be based on the combined profits of all the companies within the Chung Mei group and would not be limited, as the Agreement says it is, to the Plaintiff’s alone. The Defendant says, really in order to satisfy himself of the good standing and financial prospects of the group, that independently he did his own “due diligence” on the Chung Mei companies to ensure that their combined profits were likely to be large enough to enable him to keep the advance commission payment of $225,000, otherwise he would not be willing to join the Plaintiff.

36.  Mr Chan, with his customary industry, has prepared a detailed closing note which he has addressed me on, as to why it is inherently improbable that Mr Man would have countenanced a structure by which the Defendant’s commission would be based on the group’s profits and not just on the Plaintiff’s profits.  I have found his submissions completely persuasive although for my part one does not need to analyse the dispute in the same sort of depth. 

37.  In saying this, I do not want to overlook one aspect of the Defendant’s presentation of his case which is that in the original defence there was no mention of the consolidation of the profits of the Chung Me group so as to form the basis of the computation of profit.  The original defence basically put the Plaintiff to proof of his case.  A year after the original defence, there was a substantial amendment dated January 2007 which, for the first time, raised the allegation that consolidated group profit would form the basis of the Defendant’s remuneration.  It strikes me that this change of tack amounts to an afterthought by the Defendant which must seriously affect the credibility of this part of his case.  It is inconceivable, had it really been the truth, that this would not have figured prominently in the original pleading in February 2006. 

38.  I am bound to say that it is very strange indeed that a man of the Defendant’s business experience, who is now suggesting that all of the group’s profits were to be taken into account, would sign an Agreement that plainly contradicts such an arrangement.  On its face, the Agreement could not be clearer.  It is also significant that the final version is the third draft, the Defendant having amended to his satisfaction, the first two drafts.  I think one is entitled to make this rhetorical observation; why would someone sign such a detailed agreement which unmistakably ordains remuneration based on the Plaintiff’s audited profit when he says the representation made to him was that profit was to include all of the group’s profit.  I simply do not accept the Defendant’s evidence on this.  I find as a fact that no such representation was made to him by Mr Man.

39.  The fact of the matter was that the Defendant must have satisfied himself, based on his success at Durable, that he would be able to get profit up to $10 million and certainly achieve at least $5 million.  He was prepared to back himself on this and that is why he agreed to the remuneration structure based on the Plaintiff’s profit only which he was to manage and for which he was being brought in to grow given his previous notably successful track record.

40.  No doubt, sensibly, he did his own due diligence into associated companies such as that which owned the Chung Mei Centre and La Mer, to familiarise himself with the group, of which the Plaintiff was an important part, in order to understand with whom and what he was to become part of.  This in my judgment was the reason why he made the enquiries that he did and not to ensure that the group profit as a whole would take him past the target $10 million which would preserve his advance commission payment.

41.  It is also significant that over most of the term of the Agreement with the Plaintiff, the Defendant would also be in receipt of his $300,000 a month severance package from Durable and so, even if he only achieved $5 million as profit he could still keep $75,000 a month as commission plus his $75,000 a month fixed salary.  He would therefore, even on more modest profits, expect to receive a total of $450,000 a month on a combined basis from his previous employer and from the Plaintiff.

42.  Unfortunately, in circumstances where the Defendant was prepared to back himself, the performance target of $10 million or even at least $5 million, did not come to pass.  In the event it all went very badly with substantial losses being incurred.

43.  In circumstances where I am completely satisfied that Mr Man made no representation to the Defendant that the group’s profit would be taken into account but only, as the Agreement says, the Plaintiff’s profits for whom the Defendant was to be responsible, I find as a fact that the Plaintiff has clearly succeeded on this issue.

44.  Given my finding that none of the representations laid at Mr Man’s door by the Defendant were made, there is no question of having to pierce the corporate veil of the Plaintiff for which, in any event no provision, has been made in the Defendant’s pleadings, nor can any estoppel be said to arise on these facts.  The parties had contracted, and only contracted, on the basis of their written agreement.

Computation of the Amount Owing

45.  As I have already indicated, as a matter of computation, based on the terms of the Agreement, the amount claimed by the Plaintiff is correct which, subject to the point on the Plaintiff’s audited accounts, Mr Yuen accepts to be the case.

The Audit

46.  Mr Yuen has sought to make much of the fact that the auditors have refused to provide an unqualified opinion for the Plaintiff’s accounts.  As Mr Yuen has correctly submitted the Plaintiff needs to show through its audited accounts that its profit was below $5 million.

47.  It is helpful to set out in full the auditors qualified opinion which is at CB/216:

“As explained in notes 11 and 12 to the financial statements, the Company has not prepared consolidated financial statements nor has it accounted for its share of the results of its associate in accordance with Statement of Standard Accounting Practice 32 ‘Consolidated financial statements and accounting for investments in subsidiaries’ and 10 ‘Accounting for associates’ issued by the Hong Kong Institute of Certified Public Accountants. In our opinion, there is insufficient information concerning the subsidiaries and associate in these financial statements to give a true and fair view of the state of affairs of the Group at 31 December 2004 or of the Group’s results and cash flows for the year then ended. It is not practicable to quantify the effects of the departure from these requirements.

Except for any adjustments that might have been found to be necessary had we been able to obtain sufficient information concerning the recoverability of the amount due from a subsidiary as aforementioned and the failure to prepare consolidated financial statements and account for its share of results of its associate, in our opinion the financial statements give a true and fair view of the state of the Company’s affairs at 31 December 2004 and of its loss and cash flows for the year then ended and have been properly prepared in accordance with the Companies Ordinance.

In respect alone of the limitation on our work relating to the amount due from a subsidiary, we have not obtained all the information and explanations that we considered necessary for the purpose of our audit.”

Before I discuss the effect of this, it is convenient to also set out here the income statement which shows the net loss of $19,302,489 [CB/217]:

“	NOTES	2004 HK$	2003 HK$
Turnover	5	183,094,074	519,985
Turnover	5	183,094,074	175,519,985
Changes in inventories of finished goods and work-in progress		4,264,962	(394,990)
Raw materials and consumable stores		(143,299,810)	(119,722,064)
Other operating income		4,153,335	3,316,930
Staff costs		(24,351,459)	(21,849,478)
Selling and distribution costs		(5,831,089)	(9,547,623)
Depreciation		(4,353,258)	(3,812,565)
Other operating expenses		(32,605,257)	(22,616,775)
(Loss) profit from operations	7	(18,928,502)	893,420
Finance costs	8	(915,879)	(672,471)
(Loss) profit before taxation		(19,844,381)	220,949
Taxation	9	541,892	(89,994)
Net (loss) profit for the year		(19,302,489)	130,955”

48.  Mr Yuen’s point is that when faced with a qualified opinion of this nature, it is quite impossible to reliably extrapolate a true profit or loss figure.  In such circumstances, the Plaintiff has simply failed to prove its case on profit (and/or loss) upon which it seeks to compute its claim, with the consequence that the action must fail.

49.  But in this regard, I have the evidence of Mr Fordham, who was called by the Plaintiff to give his expert opinion on the effect of the qualified opinion on the issue of the profit of the Plaintiff as stated in the audited accounts.

50.  Mr Yuen has questioned Mr Fordham on the figure of $50,529,156 set out at CB/226, which is the amount due from subsidiaries which was up by $1.3 million from the previous year.  It is the lack of information about the subsidiary companies that has resulted in the qualified opinion.  This could have been resolved had consolidated accounts being prepared for the whole group.

51.  Mr Chan points to the fact that historically the figure due from subsidiaries has risen by about $1 million each year and this is borne out by the accounts put into evidence [see CB/180 for 2001, CB/202 for 2002 and CB/226 for 2003 to 2004].

52.  Mr Fordham, in two very detailed reports which he adopted, has very firmly come to the conclusion that notwithstanding this feature and an amount due from a subsidiary in the sum of $7,417,460 can in no way affect the loss of profit before taxation which came to $19,844,381.  The auditors had been unable to obtain sufficient information as to the recoverability of this amount.  He has come to the view [CB/142, paras.63-67] that notwithstanding this issue, on a proper analysis, there is no question that for the year ended 31 December 2004, the Plaintiff’s net profit was below $5 million.

53.  In the absence of any proper challenge to Mr Fordham’s evidence, which it seems to me has been impeccably reasoned, I can see no basis for saying that the Plaintiff has failed to prove its case as it needs to prove it on its “audited profit”.  What needs to be proved is that the profit was less than $5 million — in such circumstances the amount claimed in the action will need to be repaid by the Defendant.  That is the extent of the Plaintiff’s contractual obligation and in my judgment it has complied with it. Whilst Mr Yuen has done his best to suggest otherwise, he has had to try and make bricks without straw.  I am completely satisfied by Mr Fordham’s analysis of the situation that whatever the qualified opinion may say the undoubted fact is that the profit of the Plaintiff was below $5 million.

The Result

54.  Accordingly, there must be judgment to the Plaintiff on the claim for $2,925,000, together with interest from the date when this needed to be repaid until judgment, at 1% above prime rate and thereafter at the judgment rate until payment.  Costs will follow the event on a party and party basis.  The order on interest and costs will be orders nisi.