A recent judgment of the Grand Court of the Cayman Islands (the “Court“) in China Shanshui1 has considered validation orders to allow for the trading of shares on the Hong Kong Stock Exchange whilst a winding up petition is pending. It also considered the basis upon which a validation order previously agreed by consent of the parties could be varied.
China Shanshui Cement Group Limited ("the Company") was incorporated in the Cayman Islands in 2006. It is the parent company of a group of companies engaged in the production of cement in mainland China and its shares are listed on the Hong Kong Stock Exchange ("the SEHK"). Towards the end of last year, Tianrui (International) Holding Company Limited ("Tianrui") presented a petition to the Court to wind up the Company on the just and equitable ground. Tianrui is a substantial shareholder in the Company and also a competitor in the cement industry. The petition has not yet been heard.
Section 99 of the Cayman Islands Companies Law (2018 Revision) – The Fundamentals
- Section 99 provides that "when a winding up order has been made, any disposition of the company's property and any transfer of shares or alteration in the status of the company's members made after the commencement of the winding up is, unless the Court otherwise orders, void."
- The winding up of a company is deemed to commence at the time of presentation of the winding up petition.
- The common issue is the validity of transactions between the date of presentation and the date any winding up order is ultimately made. This period of time can be substantial.
- In order to make sure that transactions are not avoided, validation orders are often sought from the Grand Court and frequently granted, provided the shares in question are fully paid.
Validation Order – The Hong Kong Stock Exchange
Shareholders of SEHK-listed companies can deposit their shares into CCASS (an electronic system which facilitates the clearing and settling of trades on the SEHK) by transferring the legal title to their shares to HKSCC (which acts as the common nominee for shares held in CCASS) and delivering their physical share certificates to CCASS. Thereafter, CCASS will permit the beneficial interest in such shares to be bought and sold through its computerized order matching system, which matches the prices of buying and selling orders, with CCASS acting as the central clearing counterparty.
In order to surmount the difficulties that section 99 of the Companies Law posed to this process after the presentation of Tianrui's petition, the Company sought a validation order for the transfer of legal title in the Company's shares to HKSCC.
There are four elements which must be established before an applicant is entitled to a validation order in the case of a solvent company:
- The proposed disposition must appear to be within the powers of the directors.
- The evidence must show that the directors believe the disposition is necessary or expedient in the interests of the company.
- It must appear that in reaching the decision to make the disposition the directors have acted in good faith (the burden of establishing bad faith being on the party opposing the application).
- The reasons for the disposition must be shown to be ones which an intelligent and honest director could reasonably hold.
In order to satisfy these four elements, "there must be a body of evidence which, viewed objectively, establishes that the decision is one which a reasonable director, having only the best interests of the company in mind, might endorse" [Henderson J in Fortuna2]. The Grand Court should also consider whether irregularities in the conduct of the affairs of the company can be shown, even if the company is clearly solvent.
The reasons put forward by the Company for seeking the Validation Order included that:
- The SEHK had prompted the Company to make the application.
- Eighteen shareholders had requested the deposit of their physical shares in CCASS to avoid being forced to do so outside the SEHK-sanctioned system.
- The illiquidity of the Company's shares had had a significant adverse effect on the Company – and would make it difficult for the Company to raise significant capital from the equity markets in the future.
In its decision, the Court confirmed that it is only the right to transfer legal title that is affected by section 99 of the Companies Law. The shareholders remain free to deal with the beneficial interest in their shares. It was accepted that the shareholders in this case could have sold their beneficial interest in their shares off market.
The central issue was whether the use of the CCASS system would cause serious and irreversible consequences given (according to expert evidence adduced by Tianrui) it would be impossible to unwind the transactions. In light of this, was the decision to allow share transfers to facilitate the use of the system one which a reasonable honest and intelligent director would make?
The Court determined that there was an abundance of evidence and reasons which indicated that the Directors considered that it is necessary and expedient to seek the validation order.
"... the reasons are reasons which an intelligent and honest director could reasonably hold in good faith and obviously have a clear commercial basis. It is rational as well as reasonable that the Company would wish to bring down the illiquidity of its shares, and the Company being a holding Company, would have good reasons in wanting to reduce difficulties, such as illiquidity, lying in the way of its raising required capital in the equity markets in the future."
The Court did not consider it necessary to delve deeper into the causes of the illiquidity as it was satisfied that the type of transaction the directors approached the Court to validate "clears the bar and ought to be validated" and Tianrui did not provide any compelling evidence that the transfers to allow for trading on CCASS would be detrimental to the Company as a whole.
Variation to Previous Validation Order
The Court had made a previous validation order (on 11 October 2018) that was largely made by consent of the parties (the “Validation Order“). The Validation Order included a US$2 million spending cap on payments and dispositions made in each calendar month (the “Spending Cap“) and an obligation to report to Tianrui on any payments made in excess of HK$500,000 in the ordinary course of business (the “Reporting Obligation“). It also contained a liberty to apply provision. The Company sought to vary the Validation Order to remove the Spending Cap and the Reporting Obligation, which it says were negotiated in the context of Tianrui seeking the appointment of Joint Provisional Liquidators and at a time when the Company was under tremendous commercial pressure. Tianrui objected to these variations primarily on the basis that the Company previously agreed to the order by consent, liberty to apply is not a license to re-write the Order and the Company failed to provide evidence showing good grounds for the variation.
The question in relation to the variation turned on the point that the inclusion of the Reporting Obligation and Spending Cap (whilst not being usual practice in the Cayman Islands in relation to solvent listed companies) was agreed by consent. Mangatal J., applying Chanel3, said "where one is dealing with a consent order containing the term "liberty to apply", good grounds must be shown... even in interlocutory matters a party cannot fight over again a battle which has already been fought unless there has been some significant change of circumstances or the party has become aware of facts which he could not reasonably have known, or found out, in time for the first encounter. The fact that he capitulated at the first encounter cannot improve a party's position."
The Company relied on one key change of circumstance in respect of the request to vary the Reporting Obligation and Spending Cap. That being that the Hong Kong Petition against the Company, which was presented at the same time as the Cayman Petition to commence an ancillary liquidation in Hong Kong, was no longer in place.
The Court was not persuaded that the discontinuance of the Hong Kong Petition constituted a sufficient circumstance or good ground to support the removal of terms agreed between the parties. Further, Mangatal J. commented 'the fact that the Company miscalculated the practical effects of the Validation Order are not a sound basis for discharging the aspects of the Validation Order which they seek to have discharged'.
In any event, the court examined the Reporting Obligation and the Spending Cap, and the rationale behind each of them, to see whether they had utility in the particular circumstances of this case and determined they should be maintained.
This decision confirms that the Court will continue to validate transactions for the transfer of shares (even on a computerised public stock exchange, such as the SEHK, where it might not be possible to identify the new shareholders) in cases where the directors believe the transfer is necessary or expedient in the interests of the company, and that decision is made reasonably having only the best interests of the company in mind. The court will not allow a shareholder, by filing a winding up petition, to attack such decisions without compelling evidence proving that the transfer is likely to injure the company.
The case is also a reminder that significant attention should be paid to the terms of a consent order given the difficulties which may be encountered in varying them subsequently.
 In the matter of China Shanshui Cement Group Limited (unreported, Mangatal J, 12 September 2010)
 In the matter of Fortuna Development Corporation [2004-05] CILR 533
 Chanel Ltd v FW Woolworth & Co. Ltd  1 W.L.R. 485
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