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General Restructuring and Insolvency Regime in Hong Kong

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With the epidemic levelling off locally, some restrictive measures have been relaxed but businesses continue to feel the pressure posed by Covid-19. Many companies will need to manage solvency risks in the coming months, and some may need to consider taking the inevitable route of closure. This article explains the different ways of closing down a company in Hong Kong.

In Hong Kong, company closures are usually effected by either “deregistration” or “winding-up”. Despite leading to the same result, the procedures involved are different. Closure of a defunct solvent private company by way of deregistration is relatively straightforward, cost-effective and fast. In contrast, winding-up involves the process of settling the accounts and liquidating the assets of a company for the purpose of repaying debts and making residual distribution to members. As could be imagined, winding up requires relatively higher costs and time.

Deregistration

Only a private company formed and registered under the Companies Ordinance (Cap. 622 of the Laws of Hong Kong)(“CO”) may apply for deregistration. The company must be a defunct solvent company. In addition, it must meet the following conditions before making an application for deregistration:

a.    all the members of the company agree to the deregistration;
b.    the company has not commenced operation or business, or has not been in operation or carried on business during the 3 months immediately before the application;
c.    the company has no outstanding liabilities;
d.    the company is not a party to any legal proceedings;
e.    the company’s assets do not consist of any immovable property situate in Hong Kong; and
f.    the company has obtained a “Notice of No Objection to a Company being Deregistered” (“Notice of No Objection”) from the Commissioner of Inland Revenue.

What steps are involved in deregistration?

An application for deregistration should be delivered to the Registrar of Companies (the “Registrar”), within 3 months from the date of issue of the Notice of No Objection.

If all documents are in order, a letter acknowledging receipt of the application will be issued in 5 working days. The Registrar will publish a notice of the proposed deregistration in the Gazette. If no objection to the deregistration is received within 3 months after the date of publication of the notice, the Registrar will deregister the company by publishing another notice in the Gazette declaring it to be deregistered on the date of publication of that other notice. The company is then dissolved on deregistration. The whole process takes approximately 5 months.

Voluntary Winding Up

If a company does not satisfy the pre-requisites for deregistration (e.g. if the company has operating business in recent months), it can instead be dissolved by members’ voluntary liquidation (“MVL”) or creditors’ winding up. In rare cases, a Compulsory Winding up Petition by the High Court of Hong Kong may also lead to a winding up. MVL and creditors’ winding up will be discussed below.

How does voluntary winding up work?

MVL requires the company to be solvent i.e. having the ability to settle all of its debts in full. Before a company commences MVL, it should settle all outstanding liabilities and dispose of assets held in order to expedite the process. To kick off the process, the company would have to resolve issue a certificate of solvency and the shareholders would have to resolve the winding up decision.   

In the certificate of solvency, directors have to certify that a full inquiry into the company’s affairs was made, and having so done, they have formed the opinion that the company will be able to pay its debts in full within 12 months from the winding-up. If the Certificate is not filed, or if the company subsequently becomes insolvent after commencement of MVL, the winding up will be conducted as a creditors’ winding up[1].

The company has to convene an EGM to pass a special resolution for the dissolution of the company, and an ordinary resolution for the appointment of a liquidator. A notice of the resolution has to be advertised in the Government Gazette and liquidator must deliver a notice of his appointment to the Hong Kong Registrar of Companies within 14 days of the appointment.

The liquidator, who is usually a solicitor or a professional accountant, will deal with the affairs of the company, liquidating its assets and paying creditors of the company. Once tax clearance has been obtained from the Inland Revenue Department, the liquidator will proceed to distribute any surplus and return the capital back to shareholders. If the company has the simplest structure of huge assets or liabilities, the process may take around 8-9 months, depending significantly on the tax clearance process mentioned (which may take up to 3-6 months).

What should a company be aware of after MVL has commenced?

After the commencement of winding up, it should be noted that:-

1. From the day of commencement of winding-up (i.e. the day when the company is dissolved by special resolution), the company must cease business operation, except for those required for winding-up[2].

2. The powers of the board of directors will cease unless the liquidator has decided that the board shall continue to have such powers.

3. Unless with the sanction of the liquidator, any transfer of shares or alteration of members’ status shall be void.

What if overseas winding-up proceedings are commenced against Hong Kong assets/business?

It is common for MNCs to have presence one way or the other in HK (such as by way of holding assets or having business in HK). If a foreign parent undergoes foreign insolvency proceedings and there are liquidators appointed by foreign Court, foreign liquidators might encounter difficulties during its enforcement action in HK. To address this, foreign liquidators might resort to the Hong Kong Companies Court to obtain a recognition order of the foreign insolvency proceeding in order to lay their hands on the company’s Hong Kong properties.

The HK Court has been open to providing such assistance to liquidators, provided that certain conditions are satisfied. Indeed, liquidators from a common law jurisdiction will likely be granted recognition and assistance, and recent cases show that the Court will even recognize insolvency proceedings in the PRC, a civil law jurisdiction (for details, please see our article on “Legal Update – HK Court Recognizes Application by PRC Liquidators”).

Good news to foreign liquidators but bad news to businesses which might want to protect the Hong Kong assets in case of liquidation — there are claw back mechanisms under CWUMPO whereby certain transactions preceding winding up could be void by liquidators. In particular, transactions or dispositions which are undervalue or unfairly preferential to one creditor over the others are subject to claw back if they happen within specified timeframes before liquidation.

What can a Hong Kong subsidiary do if its foreign parent is being wound up overseas?

A subsidiary is a legal entity with its own stock, and is separate and distinct from its parent company. When a parent company goes bankrupt, legally it should have no impact in the subsidiary.

Practically however, the foreign parent’s ownership interest in the Hong Kong subsidiary is an asset. The liquidators of the parent company have a duty to manage and liquidate assets of the parent company in order to pay debts. What the liquidators will do is to arrange for the liquidation of the Hong Kong subsidiary in order to distribute assets to creditors of the foreign parent company. Essentially, with an insolvent parent, the Hong Kong subsidiary will be at risk of a complete upheaval.

 To expedite the liquidation process, it is advisable for the Hong Kong subsidiary to engage legal advisors so as to better understand each step of the proceedings. Our firm is experienced in handling cross border insolvency, and has frequently collaborated with foreign counterparts in similar matters. If such needs arise, our firm will be happy to provide assistance.  

Scheme of arrangement

Hong Kong lacks procedure akin to Chapter 11 procedures in the United States which aims at rescuing companies on the verge of insolvency. The closest alternative in Hong Kong is the scheme of arrangement, which is frequently used by companies to give effect to a debt restructuring. Importantly, a scheme is neither an insolvency nor a bankruptcy process, and are relatively low profile in terms of publicity as no Gazetting is required.

A company in fiscal difficulty would usually compile a proposal for its creditors, proposing terms for a compromise of the company’s debts so that creditors may accept a lesser amount in full settlement of the debt. It should be noted that even where a company is undergoing a winding-up procedure, the liquidator has power to initiate a scheme of arrangement.

What are the procedures effecting a scheme of arrangement?

Once the proposal has been finalized, the application is made to the Court for its approval to convene meeting of each class of affected creditors. In each of the meetings, the scheme must be approved by both a majority of at least 50% in number, and a majority in number presenting at least 75% in value of the voting creditors. Upon the Court’s approval, an order sanctioning the scheme will be made.  Such order will bind all creditors of the company, even if they did not vote.

What kind of company can invoke a scheme?

Apart from companies incorporated under the CO in Hong Kong, the Courts of Hong Kong may also approve schemes of arrangement having a “sufficient connection” with Hong Kong, as evidenced by factors such as listing on the Hong Kong Stock Exchange, creditors and/or management located in Hong Kong etc. In other words, foreign-incorporated companies, such as those from offshore jurisdictions, can also apply for approval of the scheme (as long as they can establish a sufficient connection with Hong Kong). It is therefore common for a foreign company with debts and liabilities in Hong Kong to seek the Court’s sanction for a scheme of arrangement in Hong Kong.

Our firm has extensive experience in assisting businesses in their closing down exercise in HK including the devising of a restructuring strategy, advice on each step of the restructure, negotiations with creditors if necessary, as well as preparation of proposed terms of the scheme. We will also be able to offer bespoke advice on the suitability of implementing a scheme and whether other alternatives are available to the company, so as to tailor to the specific needs of each company. 

If you have any question regarding the topic discussed above, please contact our partner Anna Chan at anna.chan@oln-law.com for further assistance.

Disclaimer: This article is for reference only. Nothing herein shall be construed as Hong Kong legal advice or any legal advice for that matter to any person. Oldham, Li & Nie shall not be held liable for any loss and/or damage incurred by any person acting as a result of the materials contained in this article.

[1] Sections 237A & 237B, Companies (Winding up and Miscellaneous Provisions) Ordinance (Cap. 32 of the Laws of Hong Kong)(“CWUMPO”).

[2] Section 231, CWUMPO.

Globalaw Doing Business in Asia Pacific Guide 2020

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As a proud exclusive member firm for Hong Kong of Globalaw, a worldwide network of more than 100 independent law firms with over 4500 lawyers in 165 cities. 

We are pleased to publish the Globalaw Doing Business in Asia Pacific Guide for 2020. 

This guide is an effective tool and resource, providing valuable and critical information on legal requirements to operate in respective jurisdictions including our jurisdiction of Hong Kong, one of the freest economies in the world.

Please find the following link for the brochure: Globalaw Doing Business in Asia Pacific Guide 2020

Dynasty Trust – How can it be used to preserve family assets across generations?

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Dynasty trust, is an increasingly popular tool to pass on family wealth to the next generation. As its name suggests, trust assets are intended to live through dynasties across generations within the family. Contrary to an outright gift to your kids, a dynasty trust allows you to control (even after your passing) how and when the kids can receive, enjoy and use the family assets. It can also ensure that certain core assets are retained within the family generation after generation. If the same thoughts have crossed your mind, a dynasty trust may be for you.

Despite the fancy label of a “dynasty” trust, it still shares most features of, serve mostly the same purposes with, and requires almost the same pre-set up considerations as normal trusts.

What are the advantages of setting up a trust?

In general, trust is a useful tool, if structured properly, in achieving multiple purposes, including succession planning, tax planning, protection of assets in case of matrimonial disputes, and protection from creditors’ claims.

  1. Fast-tracking “inheritance”

A trust can help bypassing the otherwise cumbersome and time-consuming process of getting a Grant of Probate. As an illustration, if there is no trust in place, the process of the probate of the 1st Generation can take anywhere from months for simple estate matter, to years for complicated estate matter (which is not uncommon for high-networth individuals). Worse still, in certain jurisdictions such as the US, the deceased’s assets would be frozen until a Grant of Probate is obtained. Assuming it takes month to complete the process and consequently a huge amount of cash sat in the estate’s account frozen, the cash would not then be available for injection into the family business.  This might pose problem if the family business requires urgent cash flow or interim liquidity.

  1. Succession planning

A trust is useful in minimizing the risk of families mired in ugly spats over succession and control of business units, when there are assets and/or family business to be managed following the death of a family member. With a trust in place, a settlor can transfer property during his lifetime into the trust, setting out in clear terms as to how his properties and any family business shall be managed in a letter of wishes, and entrusting a reliable trustee to manage the trust assets. When he passes away, the trustees can still hold the reigns over the family properties in the trust in a timely manner, and provide for beneficiaries according to the settlor’s wishes.

  1. Tax planning

Trusts are recognized instruments for tax planning especially when a beneficiary is resident of a high tax regime where world-wide income or assets might be subject to heavy taxes. With the setting up of a trust, the trust can be carefully designed such that taxes are only imposed when there is trust distribution to beneficiaries, and can be tailor-made based on needs of the settlor and the beneficiaries.

A significant advantage to beneficiaries is that, beneficiaries can manage when trust distribution and hence taxable income is required to be paid. The beneficiaries’ income tax obligation is “deferred” in that sense. That being said, settlors still need to beware of any “throwback tax” and penalizing interest charge that may be imposed for distribution of any accumulated net income (“UNI”) of a trust in some jurisdictions, for example, distributions of UNI to beneficiaries in the United States under a foreign non-grantor trust.

For certain jurisdictions, recognized trust structures might assist beneficiaries to save enormous sum of tax. If you are interested to find out more, please go to:-

  1. Trust treatment in divorce

If you are going through a rough patch in your marriage, you might be concerned whether your assets will have to be divided with your estranged spouse, leaving your children with less financial provision than they would need. Some may therefore have their assets settled into a trust to avoid being pooled into the matrimonial pool when it comes to division of assets in a matrimonial proceeding. A trust with sophisticated set-up and carefully drafted trust deed may well serve such purpose and protect the trust assets from the attack of ancillary relief claims.

However, in certain circumstances, the court might declare the settlement of the relevant trust void, if the trust documents are not carved carefully enough by professionals. In the case of Kan Lai Kwan v Otto Poon, [2014] 6 HKC 111, the trust fund was held to be included in the marital pot to be divided between spouses, because the drafting of the trust documents showed that the supposed beneficiary (the daughter) actually did not have fixed beneficial interest in the trust fund: the trustee was generally deferential to the settlor, such that the trustee has insufficient managerial role over the assets. Precedents have set out various landmines in making a trust “façade” like what happened in the Otto Poon case, which settlors and their legal advisor shall be aware of.

  1. Protection from creditors’ claim

Setting up of trusts is also an effective way to protect assets from hostile claims. On the presumption that a trust is properly set up, the trust assets would remain intact from the reach of creditors even if a settlor becomes bankrupt.

However, one shall note that any disposition (including settlement of trust assets) may be subject to the claw back rules under the relevant local insolvency rules. For example in HK, the Bankruptcy Ordinance (Cap. 6), and the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap. 32), and the Conveyancing and Property Ordinance (Cap. 219) set out circumstances where liquidators have power to claw back certain non-arm’s length transactions, for example, if such disposition happens within a certain timeframe before the commencement of the bankruptcy or liquidation proceedings.  

When should I set up a trust?

It is a good idea to set up a trust and segregate certain assets for the benefit of your next/future generations when you are formulating your estate planning.  

It is also a popular option nowadays in Hong Kong for people to migrate to other jurisdictions. If your destination country has in place a high-tax regime, you may consider setting up trusts to manage your tax affairs. For example, in Canada, one of the most popular destinations where Hong Kong people are keen to migrate to, their aggressive tax avoidance laws have substantially restricted the room for tax structuring. However, if an offshore trust is set up properly, its worldwide income may not be taxable under Canadian tax regime. For details, you may refer to our article series on “Emigration from Hong Kong: The Importance of Pre-Migration Tax Planning”.   

Who should be acting as trustee?

Choosing trustees is an important decision which should not be taken lightly. Trustees shoulder responsibilities, and their duties are often statute-regulated, as is the case in Hong Kong. Below are the some of the common choices of trustees for settlors:-

  1. Friends and families: Most people like to consider friends and families as trustees, but might have failed to consider whether or not they are qualified to make financial decisions in the management of trust estate and their limited lifespan.
  2. Professional trustees: This may be a more appropriate option compared to friend and families for the sake of prudence. In Hong Kong, professional trustees have to be licensed under a new licensing regime for trust and company service provides, under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615 of the laws of Hong Kong) and be statutorily regulated to ensure that professional trustees are well qualified to manage assets.
  3. Offshore trustee companies: This may be the case if offshore trusts are set up, for example in Cayman Islands or the British Virgin Island. However, the costs of engaging offshore trustee companies can be significant compared to onshore ones. The relatively higher set up cost and annual maintenance fee might be a concern for cost-sensitive individuals.
  4. Banks: Many banks also offer trustee services. However, banks can be particularly critical in accepting trust assets when compared to trustee companies, and may only take wealth management products issued by themselves, or fixed deposit or real estate properties as trust assets. In particular, banks are generally reluctant to take shares in private company as trust assets, partly attributed to the increasingly stringent due diligence requirements imposed on banks these days in accepting funds or new clients, for anti-money laundering purposes. Therefore, banks are less preferred by businessmen who wish to settle their family business into trust structure.
  5. Other professionals: Solicitors and accountants who have worked with your business may also serve as trustees. Since they know the businesses in depth, they are likely to provide a bespoke service to your businesses and tailor-made the necessary trust documents. It is another plus if you prefer trustees with more flexibility than institutional trustees. 

What should a settlor take into account before deciding on the jurisdiction of a dynasty trust?

You might have heard of trusts in Jersey, the BVI, Guernsey and other offshore jurisdictions but how a settlor shall choose among the many jurisdictions? There are indeed various factors you would have to take into account:-

  1. Settlor’s reservation of powers

A valid trust requires the alienation of the trust property by the settlor. However, in many cases settlors would wish to retain powers to manage the trust, so as to ensure proper maintenance and growth of trust assets. Accordingly, a settlor may need to consider the statutes of the relevant jurisdiction to ensure that reservation of power by him is allowed in that particular jurisdiction, if he intends to reserve any power. So far as the statute in Hong Kong is concerned, the Trustee Ordinance (Cap. 29) specifically allows for reservation of powers by the settlors, which usually includes power of investment and asset management. However, it is important to note that any provision in the trust documents regarding reservation of powers by the settlor shall be carefully drafted, so as to avoid a trust being declared “façade” in light of the principals as set out in the Otto Poon case.

  1. Rule against perpetuities

An old common law principle, the “rule against perpetuities,”[1] prohibits trusts that could potentially last forever. The principle provides for trusts to be valid only for certain number of years, depending on the rules of different jurisdictions. To preserve wealth for generations and allow for long-term and strategic wealth planning, settlors who wish to set up dynasty trusts should take note of the legal position of different jurisdictions on the rule against perpetuities, and may need to avoid those jurisdictions which still uphold the common law rule. For example, in Hong Kong, the Perpetuities and Accumulations Ordinance (Cap. 257) abolished the rule against perpetuity and excessive accumulations for trusts created on or after 1 December 2013. This should prove an attraction to settlors who wish to create a high value dynastic trust lasting many generations.

  1. Trustee’s statutory duty

Trustees owe a duty of care that originates from common law. Precedent cases have also prescribed boundaries of trustees’ fiduciary duties owed to beneficiaries. In some jurisdictions, this duty has been codified into statutory laws to better protect trust assets and beneficiaries, such as by way of limiting certain exclusion of trustee liabilities to the advantage of beneficiaries, which is preferred by settlors.

In Hong Kong, trustees’ duties and powers are codified into the Trustee Ordinance (Cap. 29). The Trustee Ordinance requires a trustee to exercise reasonable care and skill, having regard to any special knowledge or experience that the trustee has or holds himself out as having, and (if he is a professional trustee) to any special knowledge or experience reasonably expected. This statutory duty has shed light on the ambit of trustee’s duty and provided clearer guidance on the standard expected, thus safeguard the interest of settlors and beneficiaries.

  1. Beneficiaries’ right to remove trustees

Beneficiaries’ right to remove trustees is a crucial check and balance against the trustees’ power. Where this is codified into statutes, it can become a nuclear weapon for beneficiaries who are dissatisfied with the trust administration to remove the trustee. Statutes may provide for a simplified, hassle-free procedure for the removal, which can often save time and cost compared to instigating court proceedings to effect such removals.

In Hong Kong, the Trustee Ordinance confers on beneficiaries the right to remove trustees from the administration of the trust by giving a written direction for the trustee to retire[2], subject to certain criteria. Such mechanism offers a degree of flexibility and eliminates dependence on the court’s discretion, which are not available in some other jurisdictions. For example, in Singapore there is no such statutory provision allowing beneficiaries to remove trustees by direction, thus beneficiaries have to apply to the court for a court order to substitute trustees instead.

  1. Trustee’s power to delegate

Under common law, trustees have a duty to act personally and cannot delegate their functions unless authorized to do so. However, some trustees may wish to appoint agents to provide professional assistance in trust asset management.  

In the past, one of the least satisfactory aspects of Hong Kong trust law was the difficulty in trustees appointing discretionary fund managers to manage the trust portfolio. Now, the position in Hong Kong has conferred broader discretion on trustees, which allows trustees to delegate some aspects of their duties for a maximum of 12 months under a power of attorney. That being said, some core duties of a trustee including distributions to beneficiaries, the decision whether a payment should be made out of capital or income, appointment of new trustees, and any further delegation by agents still cannot be sub-delegated.

  1. Dispute resolution

This factor is often neglected by settlor during peaceful time. Jurisdiction for dispute resolution could become problematic when there are disputes arising from the trust such as whether a piece of document is discoverable. For offshore trusts, even if all beneficiaries and trustees are physically in HK, the dispute might still have to be fought over on the other side of the world.  It is equally important to choose a jurisdiction with predictable and reliable judicial system in place. Taking Hong Kong as an example, Hong Kong has a well-established judicial system which follows the common law regime and doctrines of equity.  In addition, trusts in Hong Kong are governed by statutes including the Trustee Ordinance and the Perpetuities and Accumulations Ordinance. With its robust regulatory environment and mature legal system, disputes arising from trusts established in Hong Kong can be properly resolved under settled principles of law. 

  1. Administration fees, tax and double tax agreements (“DTA”)

The initial set up costs, as well as annual maintenance fees will add to the expense of the trust. It is also essential to consider whether a jurisdiction has a favourable tax system so that the trust can enjoy low tax rates on dividend, interest and royalty etc. arising from the businesses of the trust. Exemptions offered by DTA will help the trust to avoid international double taxation of income and property, and will save cost/expense for the trust.     

Hong Kong is world renown for having in place a favorable tax regime. Dividend income, bank deposit income, certain types of non-bank interest and bond interest are tax-exempt in Hong Kong. Rent and gains from foreign real estate, capital gains and foreign-sourced profits are also non-taxable. A resident Hong Kong trust which owns foreign assets can remit income and profits from such assets to the trust without incurring any taxes in Hong Kong. In addition, Hong Kong has an extensive network of DTAs with other jurisdictions. Trust income will not be taxed twice in the source jurisdiction and residence jurisdiction (known as source-residence conflict), if those jurisdictions have in place a DTAs with Hong Kong. This helps break down the tax barriers that obstruct cross-border flow of investment by trusts, and trusts in Hong Kong may claim relief from taxes paid overseas under DTAs.    

What are the ways a dynasty trust can be challenged, and how to avoid them?

As can be seen from the Otto Poon case, there can be instances where the trust assets in a dynasty trust might be considered necessary financial income for a spouse, hence be included in the matrimonial pot. This shall be considered in light of section 17 of the Matrimonial Proceedings and Property Ordinance (Cap. 192) in Hong Kong, which provides that where a disposition took place less than 3 years before the date of application of the spouse to set aside the same, the Court may presume that such disposition is done with the intention of defeating the applicant’s claim for financial provision.

Another possible challenge faced by dynasty trusts is when a trust estate as originally constituted had come to an end and has subsequently been “resettled” into a new trust i.e. new trusts are declared over the trust property with the result that its use or application is modified.

Therefore, to avoid a dynasty trust being challenged, the settlor is advised to carefully carve the terms of distribution in the trust deed, give due consideration to the timing of setting up a dynasty trust and avoid some the legal landmines which may make a trust “façade”. It would also be advisable to provide clearly as to trustee’s power in administration and management of trust assets so as to minimize disputes relating to such management, which can sometimes result in resettlement of a trust.

  Conclusion

Given the sound judicial system and favorable tax treatments, Hong Kong could be one’s ideal jurisdiction for the establishment and operation of a dynasty trust. Considerable rights, powers and protections are conferred on settlors, trustees and beneficiaries to enable better management of the dynasty trust. As long as trusts are structured properly to avoid challenges, family wealth can be preserved for generations to come. 

If you have any question regarding the topic discussed above, please contact our partner Anna Chan at anna.chan@oln-law.com or associate Barbara Kwong at barbara.kwong@oln-law.com for further assistance.

Disclaimer: This article is for reference only. Nothing herein shall be construed as Hong Kong legal advice or any legal advice for that matter to any person. Oldham, Li & Nie shall not be held liable for any loss and/or damage incurred by any person acting as a result of the materials contained in this article.

[1] It requires that future trust interests (i.e. interests that do not take effect immediately), must be certain to vest within a defined period of time known as the perpetuity period.

[2] Section 40A, the Trustee Ordinance.

Priority freebies given to in-house lawyers!

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Join us for a webinar (3 CPD points) presented by our disputes partner, Eunice Chiu, on dealing with vexatious litigants.  

  • Date: 17 July 2020 (Friday)
  • Time: 2:30pm – 5:45pm (15 mins break)
  • Level: Elementary / Intermediate / Advanced / Updates
  • Language: English
  • CPD Points: 3
  • Course Code: L20CP03
  • Venue: Webinar via ZOOM
  • Host: Lex Omnibus

See flyer: Dealing with vexatious litigants in civil and administrative proceedings

Limited freebie spots – priority given to in-house lawyers. Email us if you’re interested: marketing.oln@oln-law.com

OLN Ranked by Benchmark Litigation Asia-Pacific 2020

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Oldham, Li & Nie is pleased to announce that Benchmark Litigation Asia Pacific has recognized the firm in the publication’s 2020 rankings. 

OLN ranked “Recommended Firm of 2020” by Benchmark Litigation Asia-Pacific in the following Practice Areas:

  • Commercial and Transactions – Tier 3
  • Family and Matrimonial – Tier 2
  • Private Client – Recommended

About Benchmark Litigation

Benchmark Litigation, the definitive guide to the region’s leading dispute resolution firms and lawyers, was first published in 2008 covering the litigation and disputes markets in the United States and Canada and has broadened its coverage to include Asia – Pacific, Europe and Latin America – becoming a truly global guide.

Lasmos and Beyond: Have the Cake and Eat It Too?

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(This article was published in the May 2020 Issue of Hong Kong Lawyer: http://www.hk-lawyer.org/sites/default/files/e-magazines/HKL-MAY-2020/viewer/desktop/index.html?doc=917CC81E9107138E6C05E7B46F3C9397#page/30)

How should the court deal with an insolvency petition founded solely on an alleged debt that is the subject of an arbitration clause? The dynamics between arbitration clauses and insolvency petitions has recently given rise to conflicting judgments in the common law world. Although it is generally accepted that insolvency proceedings are not arbitrable hence there is no automatic, mandatory or non-discretionary stay of insolvency proceedings in favour of arbitration, courts in different common law jurisdictions have taken different approaches to the exercise of discretion in deciding whether to stay or dismiss an insolvency petition where an arbitration clause is involved. In particular, the different approaches are that:

  1. the petition should only be stayed or dismissed if the alleged debt is disputed on genuine and substantial grounds (the Traditional Approach);
  2. the petition should be stayed or dismissed, save in wholly exceptional circumstances, without investigating whether the alleged debt is bona fide disputed on substantial grounds at all (the Salford Estates Approach);
  3. the petition should generally be dismissed, subject to exceptional circumstances, on condition that the debtor has taken steps required under the arbitration clause (the Lasmos Approach).

The major differences of the above approaches have been thoroughly set out elsewhere (see for example, “The Effect of Arbitration Clauses on Winding Up Petitions: Arbitration Come What May?”, Hong Kong Lawyer, November 2019) and need not be repeated here. This article will instead critically examine the Lasmos Approach and suggest how the various approaches may be reconciled. It will be argued that to allow the court to decide whether an alleged debt governed by an arbitration clause is genuinely and substantially disputed when it has no jurisdiction to do so is to “have your cake and eat it too”. Finally, it will be respectfully submitted that the Salford Estates Approach is the only logical approach that should be adopted in Hong Kong.

The Lasmos Approach

It will be recalled that in Re Southwest Pacific Bauxite (HK) Ltd [2018] 2 HKLRD 449, Harris J in the Court of First Instance departed from the Traditional Approach and held that an insolvency petition should generally be dismissed, save for exceptional circumstances, if three conditions are satisfied:

  1. The company disputes the alleged debt.
  2. The contract giving rise to the alleged debt contains an arbitration clause that covers any dispute relating to the debt.
  3. The company takes the steps required under the arbitration clause to commence the contractually mandated dispute resolution process.

(the Lasmos Approach)

The first two requirements are uncontroversial. The third requirement deserves closer attention as it represents an innovative compromise between respecting parties’ choice of dispute resolution mechanism and preserving a creditor’s right to petition on the strength of a debt that is the subject of an arbitration clause in restricted circumstances. Whilst Harris J clearly recognised that the court should normally not wind up a debtor company on insolvency grounds when the arbitral tribunal has actually seised the subject dispute, winding-up procedure may still proceed where the company has taken no steps under the arbitration clause. Under this new formulation, it is still not good enough to dispute the debt by “simply pointing at the arbitration clause”.

Observations by the Court of Appeal

The Lasmos Approach has been reviewed by the Court of Appeal in two bankruptcy judgments thus far. On both occasions, the appeal was dismissed because the requirements in the Lasmos Approach were not fully complied with. Though not formally adopted in both cases, the Lasmos Approach essentially lays down the necessary conditions for an insolvency petition to be stayed or dismissed where an arbitration clause is involved. For present purposes, the observations by the Court of Appeal appear intriguing.

In But Ka Chon v Interactive Brokers LLC [2019] 4 HKLRD 85, it was observed that a statutory right is conferred on a creditor to petition for winding-up on the ground of insolvency. It is contrary to public policy to preclude or fetter the exercise of the statutory right by requiring the creditor to prove exceptional circumstances upon satisfaction of the three requirements. The Court of Appeal appears to suggest that, notwithstanding the commencement of arbitration, the court may still determine whether the alleged debt is genuinely and substantially disputed. Further, insolvency proceedings were said to be different from ordinary writ actions in the sense that the former are merely to invoke a class remedy which does not involve enforcing a contract or adjudication of parties’ rights and liabilities, so it would not be anomalous for the court to consider a winding-up petition solely on the ground of an unadmitted debt which is the subject of arbitration. Whilst acknowledging that the Traditional Approach may not have given sufficient weight to the arbitration clause, the Court of Appeal did not state clearly how much weight will indeed be sufficient.

In Sit Kwong Lam v Petrolimex Singapore Pte Ltd [2019] HKCA 1220, the third requirement was said to be “sensible” as it demonstrates to the court that the debtor has a genuine intention to arbitrate, without which “it would make no sense to dismiss or stay an insolvency petition on the mere existence of an arbitration agreement”. Where the debtor has no substantive claim against the creditor, the Court of Appeal suggested that the debtor should still commence an arbitration and seek a declaration of non-liability in order to demonstrate “a genuine intention to arbitrate”.

Critique

The adoption of the third requirement in Lasmos is not without problems. Firstly, its origin is unclear.

Secondly, this requirement oddly reverses the usual burden on the creditor-plaintiff to commence the contractually mandated dispute resolution process and places the same on the debtor-defendant, contrary to the common defence strategy to do nothing but wait for the plaintiffs to take action. Query why this requirement exists at all, especially when Harris J took the view that the objection to requiring a creditor to arbitrate a dispute without first determining whether the debtor company has a bona fide defence is unjustified. It is also unclear what rule of law specifically obliges the debtor to take steps under the arbitration clause at any particular time before the expiry of the relevant limitation period.

Thirdly, and perhaps most importantly, there appears to be no logical justification for this requirement. Even if the burden is on the debtor to demonstrate that the debt is in fact bona fide disputed on substantial grounds, as held by Barma J (as he then was) in Re Jade Union Investment Ltd [2004] HKEC 306, the existence of an arbitration commenced pursuant to an arbitration clause is irrelevant as it could not by itself discharge that burden. In any event, even if the debtor company fails to take active steps to arbitrate, it does not necessarily follow that it has no genuine intention to dispute the debt when the arbitration is actually commenced by the creditor.

If, as suggested by the Court of Appeal in But Ka Chon, the court may still determine that the debt is indeed not bona fide disputed on substantial grounds despite the commencement of arbitration, then there appears to be no good reason why the creditor should not take the initiative to commence arbitration and petition to wind up the debtor company in parallel. Just as the Court of Appeal in But Ka Chon criticised the debtor for taking no steps to commence arbitration over a period for more than four years, the same could be said of the creditor as well, and much time would have been saved if the creditor took the initiative to commence arbitration, which plaintiffs would normally do anyway. Apparently the court appreciates the sensitivity in interfering with the arbitration once commenced, and hence arbitrarily requires the debtor to seek a declaration of non-liability by way of arbitration, thereby preserving the creditor’s right to petition against the debtor solely on the strength of a debt that is the subject of an arbitration clause.

Does it make sense to dismiss or stay an insolvency petition on the mere existence of an arbitration clause? Perhaps the sense is this. Where an insolvency petition is made on an alleged debt, ultimately the court must consider whether the company is insolvent (Hollmet AG v Meridian Success Metal Supplies Ltd [1997] 4 HKC 343). If there is no debt, there could be no insolvency. Hence, it would make no sense whatsoever for a court to wind up a company on the ground of insolvency solely on the strength of an alleged debt that is subject to arbitration, when the arbitral tribunal could determine that there is no such debt at all. It simply defies logic to allow the court to decide whether the alleged debt is bona fide disputed on substantial grounds when it has no jurisdiction as to the substance of the alleged debt. The creditor-petitioner cannot have the cake and eat it too.

On the other hand, Jinpeng group Ltd v Peak Hotels and resorts Ltd BVI HCMAP 2014/0025 and 2015/0003 has been cited as an example where a court exercised the discretion to appoint liquidators despite the commencement of arbitration. True as it may seem, upon closer examination, the case actually does not support the perceived conclusion.

It should be noted at the outset that the application for the appointment of liquidators in Jinpeng was made on just and equitable grounds (and not on insolvency grounds). Although the Eastern Caribbean Court of Appeal examined the debt and held that it was not disputed on genuine and substantial grounds, the commencement of arbitration was accepted as “a factor that favours granting a stay of the Originating Application pending the outcome of the arbitration”. Jinpeng therefore demonstrates that it would be a waste of time to examine whether the alleged debt was disputed on genuine and substantial grounds especially when arbitration has been commenced, because balancing that determination with the commencement of arbitration (or the arbitration clause) would not justify the winding-up. In the end, it was the unacceptable circumstance that most of the loan proceeds have gone missing and unaccounted for which ultimately justified the appointment of liquidators. Therefore, Jinpeng is actually consistent with, rather than distinguished from, Salford Estates (No 2) Ltd v Altomart Ltd (No 2) [2015] 3 WLR 491. The unacceptable circumstance in Jinpeng could be said to be “exceptional” (in the language of the Salford Estates Approach) in the sense that it was unconnected with the subsistence of the alleged debt.

Conundrum

Given the statutory right to petition to wind up on the ground of insolvency and that there is no automatic stay of insolvency proceedings in favour of arbitration, how should the court deal with a winding-up petition founded solely on a statutory demand for an alleged debt over which it has no jurisdiction? This conundrum seems to arise from the fact that the court accepts an alleged debt stated in a statutory demand too readily. This is most apparent in Hollmet when Roger J (as he then was) said that “it seems to me that until it is properly established that there is a dispute, the debt would exist”. With respect, there is no logic in this statement. A debt exists not because the debtor properly establishes that there is a dispute, but because the creditor discharges his burden to prove the debt.

Though not applicable in the winding-up context, section 9 of the Bankruptcy Ordinance (which provides that at the hearing the court shall require proof of the debt of the petitioning creditor) and rule 70 of the Bankruptcy Rules (which requires that any matters which the debtor has given notice to dispute shall be proved) would lend support to the above proposition that the burden to prove the debt lies on the petitioning creditor (Re Glory Garment Factory [1985] HKEC 475).

As recognised by Harris J in Lasmos, whilst the question of whether or not a winding-up order should be made is not arbitrable, it does not follow that a dispute between a petitioner and a company over the debt relied on to establish locus to present a winding-up petition is not. Where an alleged debt is the subject of an arbitration clause, it is not up to the court to decide whether a petitioning creditor has discharged the burden to prove the alleged debt, simply because the court has no jurisdiction over it. The real issue for the court to decide then is, leaving aside the alleged debt, whether there is any other circumstance that justifies a winding-up order (i.e. the exceptional circumstances in the Salford Estates Approach).

Solution

The obvious solution to this conundrum is to adopt the Salford Estates Approach, which is logically irresistible. Nevertheless, there is no universal agreement in the common law world at the moment.

No doubt there are some hesitations about the Salford Estates Approach, because it places creditors to an arbitration clause at a disadvantage compared to other creditors, thereby making arbitration less attractive (see “The Effect of Arbitration Clauses on Winding Up Petitions: Arbitration Come What May?”, supra). However, there is no legal policy dictating that arbitration should be the most-favoured dispute resolution mechanism. By agreeing to an arbitration clause that takes away the court’s jurisdiction over an alleged debt, the parties should accept all the logical consequences that come with it.

In any event, as demonstrated by Jinpeng, it is still possible to justify winding-up on just and equitable or general insolvency grounds. The creditors to an arbitration clause would only have to found the petition on the right grounds and put forward evidence and circumstances other than the non-payment of the alleged debt that is the subject of an arbitration clause to justify the winding-up order. It is hoped that the Court of Final Appeal will take the logical approach when a suitable case comes before it.  

Postscript

As this article was going to publication, two relevant decisions were made in Hong Kong and Singapore.

In Re Asia Master Logistics Limited [2020] HKCFI 311 (published on 12 March 2020), DCHJ William Wong SC effectively affirmed that Traditional Approach that the debtor company must demonstrate that the debt governed by an arbitration clause is bona fide disputed on substantial grounds in order to stay or dismiss the winding-up proceedings. The strongest argument advanced for the Traditional Approach was that the Court makes no determination on the merits of the alleged debt in insolvency proceedings, such that there is no breach of the arbitration clause. Whilst this is technically correct, with respect, this provides no justification for the logical contradiction that a company may be wound up on the basis of an alleged unpaid debt (governed by an arbitration clause) which may be determined to be non-existent by the arbitral tribunal.

In Anan Group (Singapore) Ptd Ltd v VTB Bank (Public Joint Stock Compan) [2020] SGCA 33 (published on 7 April 2020), the Singapore Court of Appeal changed course to adopt the Salford Estates Approach. This decision should be welcomed and the elaborate reasoning applauded. However, the Court seems to suggest that it has a wide discretion to wind up a company on an alleged debt governed by an arbitration clause because of the lack of bona fides of the debtor company or abuse of process. With respect, the correctness of such a suggestion is doubted. To use the example given in the case, where a debtor genuinely disputes a debt which it has expressly and repeatedly admitted on previous occasions, the issue should be whether the debtor may revoke such previous admissions, and that issue should be determined by arbitration. It is respectfully submitted that, unless the winding-up petition is founded on general insolvency or just and equitable grounds (not on the sole basis of a statutory demand of a particular debt governed by an arbitration clause), the court should generally stay or dismiss the petition if the alleged debt is not admitted.

Acknowledgment

The author would like to thank Professor Anselmo Reyes for his helpful comments. Any errors, omissions and mistakes remain the sole responsibility of the author.