An encrypted Court of Appeal judgment reveals a classic basket case of corporate governance problems at Applied Development (0519) - a case study of what can go wrong with small, family-run HK-listed companies.

Trouble and strife at Applied Development
18 January 2011

Browsing the court judgments this weekend, our eyes alighted upon MKGWH v RKSH (the Judgment, 12-Jan-2010) in the Court of Appeal. The initials were used because this case has its roots in a divorce case, but to any student of HK-listed small-caps it is quite obviously the case of Mimi Wong Kar Gee v Raymond Hung Kin Sang, and given the content of the Judgment, investors in the HK-listed company, Applied Development Holdings Ltd (ADH, 0519), have a right to know what is going on, hence this article, because the disclosures of ADH certainly haven't told you the full picture. What follows is exemplary of many of the corporate governance problems that plague small family-run listed companies in HK.

Mimi Wong Kar Gee (Ms Wong) and Raymond Hung Kin Sang (Mr Hung) were married in 1973. Mr Hung founded the predecessor of ADH in 1976, and Ms Wong joined the group in 1977, according to the annual report. ADH has been listed since 1986. In an almost sarcastic nod to the Code on Corporate Governance, on 31-May-2005 Mr Hung stepped down from Chairman and remained Managing Director, while Ms Wong became Chairman. That is probably not what the authorities had in mind when they drafted Code Provision A.2.1 which says that the two roles should be separate. In reality, it makes no difference when the Chairman and MD are also the controlling shareholder(s).

Mr Hung and Ms Wong have three children, one of whom, Marcus Hung Kai Mau, has been an Executive Director since 16-Aug-2005 when he was 22. Ms Wong petitioned for divorce in 1999. In Jun-1999, a decree nisi was granted, but the decree absolute was not granted until Mar-2010 on Mr Hung's application.

The Judgment bring to light the following points:

  1. Under the Company's bye-laws, the Chairman is not required to retire by rotation. This breaches Code Provision A.4.2 of the Code on Corporate Governance in Appendix 14 of the Listing Rules, which requires retirement by rotation for all directors at least every 3 years. Despite that, the 2010 annual report (p20) says "The Company has complied with the provisions in the Code on Corporate Governance". This is obviously false. The annual report on page 23 states: "All Directors...are subject to retirement by rotation at least once every three years". That too is false. In the 2009 annual report, it did state on page 24 that "the Chairman will not be subject to retirement by rotation". In the corresponding paragraph in 2010, that was omitted, but there has been no change to the bye-laws since 2009.
  2. As part of her remuneration as a director, Ms Wong lives in 2 (or 3 - see below) apartments in a building on the Peak, of which ADH owns 4 out of 6 apartments. She has lived in the apartments for the past 6-7 years. A look at the annual reports confirms this - in the year to 30-Jun-2010, she had rent-free accommodation with a rateable value of $2.241m (2009: $2.379m). That's on top of salaries and other benefits of $3.315m, a discretionary bonus of $134k, share options worth $1.6m and MPF contributions of $12k, taking her total pay to $7.302m.
  3. In Dec-2010, in the course of communications with the Stock Exchange of Hong Kong Ltd (SEHK) regarding a Very Substantial Disposal (VSD) (announced on 14-Dec-2010), SEHK took the view that since Ms Wong was no longer an ED and thus accommodation was not provided under her remuneration package, the licence for her occupation after Jun-2010 constituted a continuing connected transaction.
  4. At a board meeting on 17-Dec-2010, ADH decided to terminate the license by one month's notice, given on 18-Dec-2010 and expiring on 18-Jan-2011, today.
  5. On 21-Dec-2010, Mr Hung requested ADH to "consider all possible options for [Ms Wong] to continue living at [the Peak property]". Apparently he had given an undertaking to the court on 17-Dec-2010 (the same day as the board meeting) to take steps to procure that Ms Wong could remain at the property including persuading the board to grant a licence, and his payment of the licence fee.
  6. On 24-Dec-2010, the INEDs wrote to Mr Hung, indicating that after Ms Wong's re-designation to non-executive director, she was a bare licensee. The INEDs also said "that she had not been participating in the Company's operations since 2000". If that is the case, then why was she paid so much? The same INEDs were a majority of the members of the remuneration committee, so they should know. They also said that the license fee being paid for the property was below market.
  7. On the same day, ADH received advice from its solicitors Baker & McKenzie setting out the non-compliance with the Listing Rules regarding the licence and advising rectifying actions, including seeking independent shareholders' approval. ADH considered this to be "too costly and less preferable to a termination of the licence".

Severn Villa

According to the annual report, ADH owns flats 1A, 1B, 2B and 3B of Severn Villa, 3 Severn Road, The Peak. The 4-storey (including carport) property was built in 1982. The properties were acquired through a listed then-subsidiary now known as JLF Investment Co Ltd (JLF, 0472) in Sep-2001 for about HK$61m. ADH sold its stake in JLF in a deal struck on 1-Dec-2003, and at the same time, ADH acquired from JLF a company called iQuorum Cybernet Ltd, subsidiaries of which owned properties (including the Severn Villa Properties), antiques, and shares of ADL.

The JLF circular dated 12-Jan-2004 includes a valuation report as at 31-Oct-2003. The total gross floor area of the 4 units in Severn Villa is 6,200 sq ft, plus a 1,550 sq ft roof on block B. The valuation was put at only HK$38m. At the time, the property was vacant and under renovation, with completion expected in early 2004, and it was intended that the Chairman of ADH (then Mr Hung) would live in 2 of the units. The circular also includes an antique valuation report of 142 antiques.

The VSD announcement of 14-Dec-2010 contains a vague paragraph about Ms Wong's occupation of the apartments. It says that she occupied 3 of the 4 units owned by ADH (not 2 of 4 as mentioned in the Judgment) and that pursuant to a license fee agreement (the date of which is not mentioned) the Severn Villa Properties (not a defined term) "began to generate its rental income of approximately HK$122,000, not formed as a director remuneration" for the period from 10-Jun-2010 to the 30-Jun-2010 year-end. It states "The terms of the license fee agreement have been agreed at arm length's basis since January 2004 when Ms Wong was an executive director of the Company and entitled to be provided a free accommodation by the Company." In more garbled English, it said:

"No matter that the Company will further follow up any actions in respect of this continuing connected transaction as required by and complied with Chapter 14A of the Listing Rules immediately."

What the heck does that mean? We cannot decipher it, but can tell you that there has been no announcement or circular seeking independent shareholders' ratification of the connected transactions.

A free home for life?

It is notable that according to the Judgment (para 11), the Deed of Divorce dated 20-Nov-2001 included an agreement that the apartments will be registered in the name of the Company but would be "for [Ms Wong] to reside in for her lifetime". Investors might wonder whether that would be a fair use of company assets after she was no longer working for the company - after all, it was presumably not a term of the divorce that she must always work for ADH. It appears that the assets of ADH itself were being treated since 2001 as marital assets, rather than just the couple's shareholding in ADH. We fail to see how this was in the interests of those shareholders who were never married to Mr Hung.

Furthermore, it is unclear how ADH could ever have sold the properties if Mr Hung was obliged to procure ADH to make them available to Ms Wong for her lifetime. That brings us to interesting claims in the accounting policies...

Accounting policies

For the year to 30-Jun-2008 onwards, new accounting standards required ADH to state the critical judgments made in applying accounting policies. They then included the following wording each year:

"The Group's investment properties in Hong Kong with a carrying value of [X] are currently used as directors' quarter[s]. However, it is the Group's intention to hold the properties for capital appreciation but not for own use. The Group has appointed a property agent to seek for potential buyers in the market. Accordingly, the properties have been accounted for as investment properties instead of property, plant and equipment....
The Group's plan is to sell the properties to the market. Until the date the disposal is taken place, the properties would be occupied by the directors on a temporary basis. Therefore, no rental income is expected to be generated from the properties up to their disposal."

This policy had no doubt been silently followed in earlier years before they had to explain it, because they had always been accounted for as investment properties, and the directors had lived in them since at least 2004, after the renovation. The policy allowed ADH to book the investment revaluation through the income statement, rather than holding the properties as premises used for staff quarters, at depreciated cost. This made ADH's profitability appear a whole lot better than it would have been otherwise. Yet if these properties were only occupied on a "temporary basis" and the directors intended that ADH would sell them, then how is that consistent with the 2001 divorce agreement that Ms Wong would continue to live in them during her lifetime?

But that's not all.

The curious case of the blue-glazed vase

On 25-Sep-2008, Mr Hung sent an e-mail to Ms Wong and others about the need for ADH to improve its financial position. He suggested selling antiques. In 2009, ADH produced an internal control manual which provided certain procedures to be followed before its assets can be deal with. According to the Judgment, Ms Wong did not follow these procedures when an antique vase was sold through an auction house for $2.6m on 8-Apr-2010. It is probably this one, which went for $3.14m including Sotheby's exorbitant commissions, or what they euphemistically call "buyer's premium", about 20%. The net price for the vase was $2.496m - indicating that a further 4% was paid by the seller. Notably Sotheby's expected price on that vase, if we have found the right one, was only $0.8-1.0m.

The Judgment says that on 14-Apr-2010, according to an "internal report of Misappropriation" (the Internal Report), a member of staff of ADH "discovered" the sale via the auctioneer's website. This strikes us as somewhat odd - you might wonder why a member of staff spends time browsing the hundreds or thousands of items on the site - unless they suspected or knew that the vase was up for sale in the first place.

On 15-Apr-2010, Mr Hung sent a "handwritten note by email" (presumably, an image of handwriting) to Ms Wong, copied to their son and the Company Secretary, saying that ADH still lacked cash, and asking for the proceeds of the Sotheby's vase sale as well as arranging the sale of some paintings and another vase. Ms Wong apparently gave (or said she would give) instructions to Sotheby's for the money to be paid into ADH's bank account, but then she countermanded that and told them to put the payment "on hold".

On 26-May-2010, Mr Hung's solicitors wrote to his wife's claiming that she had arranged for the sale of the vase "without the Company's consent or prior knowledge" and demanding that she authorize payment by Sotheby's of proceeds to ADH. Why didn't ADH just authorize Sotheby's directly? Perhaps Sotheby's thought they were acting for her personally and would not take instructions from ADH. Also, why were Mr Hung's solicitors, and not ADH's solicitors, writing to her about the company's assets?

On 2-Jun-2010 (according to the Internal Report), Sotheby's informed ADH that the proceeds had been put into Ms Wong's personal account.

On 4-Jun-2010, Ms Wong's solicitors replied denying sale without consent, denying having taken the proceeds, but acknowledging that she had not instructed Sotheby's to release the proceeds to ADH, because ADH owed her $3.1m, including $2.65m in salary from Oct-2008 to May-2010. She wanted to deduct this from the auction proceeds. She also claimed that certain ADH funds were not being properly accounted for. She said accountants would be instructed to investigate.

Removal of Ms Wong as Chairman

On 8-Jun-2010, ADH circulated a board resolution (attaching the Internal Report) for removing Ms Wong as Chairman and director. That was invalid. The Judgment doesn't say why, but we guess that ADH's bye-laws require unanimous consent for written resolutions. So a board meeting was convened for 10-Jun-2010. Ms Wong appeared with her solicitors and as Chairman declared it "cancelled", as there were initially too few directors present ("inquorate"). After she left, the meeting apparently took place by telephone conference. According to the minutes, the board considered the Internal Report and resolved to remove Ms Wong as Chairman and re-designate her as non-executive director.

The company announcement of this move is remarkably bland. It simply states that the 28-year old son has been appointed Chairman and that Ms Wong has been redesignated as non-executive director. It says "The considered by the Board to be in the best interests of the Company and its shareholders as a whole". The announcement contained no hint of the strife behind the scenes, and says:

"there are no other matters relating to the appointment of Mr. Marcus Hung as chairman of the Board or the appointment of Ms Wong as a non-executive director of the Company that needs to be brought to the attention of the shareholders"

Given the allegations on both sides, we regard that as false and misleading, and call on the SFC to investigate.

The secret Investigation Committee

The next day, 11-Jun-2010, Ms Wong complained to SEHK challenging the power of the board to remove her and listing her allegations against Mr Hung regarding company funds unaccounted for.

On 15-Jun-2010, a board meeting decided to set up an Investigation Committee (IC) comprising the 3 INEDs, to investigate, with the assistance of forensic accountants, (1) the allegation of Ms Wong's unauthorised sale of the vase and (2) Ms Wong's complaint to SEHK about PRC rentals, which she said were not properly accounted for.

Investors were never told about these allegations or the existence of the Investigation Committee. We don't know who the "forensic accountants" were. According to the Judgment, On 9-Jul-2010, there was an "acrimonious" board meeting, including Ms Wong, in which the IC report was considered. The IC found that (1) the sale of the vase was not in compliance with ADH's internal control procedures and was unauthorised, and (2) there was no misappropriation of PRC rentals.

Eventually on 28-Jul-2010 Ms Wong instructed Sotheby's to pay the proceeds into ADH's account. The ADH accounts for the year ended 30-Jun-2010 record in the cash flow statement "proceeds from the sale of an antique" at $2.496m and "gain on disposal of an antique" of $2.196m, implying a book cost of $300k.

Incidentally, the 2010 annual report contains the usual "Corporate Governance Report" and states that during the year, a review of internal controls "showed that the internal controls system operated, on the whole, satisfactorily." Again, no disclosure of the alleged unauthorised sale of the vase, and no mention of the IC or the forensic accountants.

Removal from the board

As a consequence of her removal as Chairman, Ms Wong, now just an ordinary director, was subject to re-election at the Annual General Meeting. The AGM circular regarding the re-elections was dated 8-Sep-2010. Finally, some light was shining on dark places. Page 7 states:

"(i) On 3 August 2010, [ADH] commenced a legal action against Ms. Wong seeking a return of a number of antiques and artwork which are the Company's assets and which in the past have been placed in the custody of Ms. Wong and which she has not returned to the Company; and
(ii) On 24 August 2010, Ms. Wong commenced a legal action against [Mr Hung] and [ADH] seeking, among other things, to inspect certain books of accounts, statutory records and documents of the Company."

The net book value of the antiques and artwork was put at HK$1.14m. The "other assets" in the ADH group balance sheet at 30-Jun-2010 were $1.546m, representing "antiques held for long-term investment purposes" (see note 16), so she held most of them. The fair value of these assets is probably much more than the book value, if the vase is any guide.

The AGM was scheduled for 22-Oct-2010. Fearing that she would be voted out, in Aug-2010 she applied for an injunction. The hearing took place in mid-September 2010 (again, no announcement from ADH) and on 7-Oct-2010, the judge ordered Mr Hung to take all necessary steps, including voting at the AGM, "to restore Ms Wong to an executive directorship of [ADH] and thereafter continuing as an executive director".

On 15-Oct-2010, Mr Hung was granted leave by the same Court to appeal. So when the meeting began, he proposed an adjournment to mid-January 2011, which was passed without objection. The Court of Appeal heard the case on 4-Jan-2011, and in the Judgment on 12-Jan-2011 it set aside the lower ruling, stating that this was a public company, not a family company, and accepting an undertaking from Mr Hung not to vote the Family Shares at the AGM.

Questionable options and voting

On 21-Oct-2009, the board of ADH decided to conditionally grant options (the 2009 Options)to subscribe a total of 44.43m shares (5.09% of ADH) at $0.29 per share to Mr Hung (22.7m), Ms Wong (13.33m) and their son (8.4m). That was the day of the annual results, but there was no mention of it, and it was not until a circular dated 29-Oct-2009 that shareholders were told. The failure to announce the conditional grant on 21-Oct-2009 was a breach of Listing Rule 17.06A (introduced on 1-Jan-2009), and we urge the Stock Exchange to investigate. This is particularly serious given the size of the grant.

The somewhat flimsy excuse for the grant was "After considering the past contribution to the Group from the above Directors, the Remuneration Committee...proposed the their reward". Strange, given that the family already had a controlling interest in the firm, and given that options are supposed to be an incentive to future performance rather than a reward for the past.

Past performance had been pretty crappy anyway: Mr Hung already held options to subscribe 45,611,141 shares with an exercise price of $0.54 for 5 years granted on 25-Apr-2006 (the 2006 Options). This was a massive grant itself, for shares equivalent to 5% of existing issued shares, so, being more than both 0.1% and $5m, it was subject, under the Listing Rules, to independent shareholders' approval with a circular dated 19-May-2006. It was approved on 7-Jun-2006 with a turnout equivalent to 78.24% of the shares eligible to vote. The 2006 Options were cancelled without explanation or announcement at some time during the 6 months to 30-Jun-2009, when the share price was far lower than the exercise price.

For the vote on the 2009 Options, the family (including a trust) held a total of 421,205,640 shares, and ADH itself owned 34,329,000 shares through a wholly-owned subsidiary, making a total of 455,534,640 shares (52.17%). These should all have been excluded from voting, and ADH claimed that they were. This would leave 417,683,186 shares eligible to vote.

However, the poll results on 24-Nov-2009 show that 319,765,160 shares voted in favour of the 3 options grants and 239,400 against, a total turnout of 320,004,560 shares, or 76.61% of the shares eligible to vote. Both the turnouts for the 2006 Options vote and the 2009 Options vote are exceptionally high, particularly for a small-cap without much institutional ownership. For all the other resolutions at the 2009 AGM, on which the family was allowed to vote, the turnout was 330,222,616 - that's only an additional turn-out of 10,218,056 shares, or 1.17% of ADH. If the family trust didn't vote in favour of the option grants, then it apparently didn't vote in favour of anything else either. But there were no other shareholders over the 5% disclosure threshold in ADH.

Compare that with the poll results at the adjourned 2010 AGM on Friday (14-Jan-2011). There, Mr Hung had undertaken to the Court of Appeal not to vote the Family Shares at the AGM, so you would expect that the public turn-out would be similar to 2009. But the highest turnout from other shareholders was only 53,488,137 shares, on resolutions 1 and 2b. That's only about one sixth of the purported number of "independent" shares which were voted in favour of the options in 2009 and 2006.

It is difficult to avoid the inference that at least some of the family's shares were voted in favour of the 2006 Options and the 2009 Options. We call on the SFC to investigate whether ADH's and the directors' claims that the shares were not voted were false and misleading.

An INED with a bogus degree

And in the words of Steve Jobs, "there's one more thing". In the circular of 24-Oct-2009, it was stated that Mr Lo Yun Tai, an INED since 5-Mar-1998, would not offer himself for re-election at the AGM. That would reduce the number of INEDs below the 3 required by the Listing Rules. Despite knowing that, it was not until 4 months later, on 24-Feb-2010, that ADH got around to appointing a replacement, Su Ru Jia (Mr Su).

And what a high-calibre individual he is. He "holds a MBA degree from International East-West University of America" they said. That would be this one (EWU), an unaccredited diploma mill which was purportedly operated out of Hawaii until the Department of Commerce & Consumer Affairs sued it in 2002. For more on that, see our other story today - Guangdong Investment's unaccredited MBAs.

©, 2011

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