At the start of the COVID-19 pandemic, we saw many small to medium sized businesses (SMEs) going into panic mode.  They sought legal advice on how to deal with issues arising from immediate or near immediate cash flow problems and creditors, and at the same time, limit their potential liabilities and protect their assets.

We are now more than 3 months into this new way of life.  In the business world though, for the first quarter of 2020, there are reports of most businesses suffering large percentages of revenue loss.  There are employee lay-offs, salary reductions and in some instances, companies simply closed shop for good. 

Would our legal advice be any different now compared with 3 months ago?  Yes and no.  The laws have not changed but the global spreading of the virus has created further limitations on businesses, e.g. travel limitations have resulted in the cut-off of supply chains.  Such changed or changing circumstances may require a revisit of commercial and therefore legal strategy.  

In Part 2 of this series, we will explore options available to businesses/companies operating in specific sectors of the economy at this juncture.  For now, let’s discuss the basics of insolvency law as many clients appear most concerned about outstanding debts and cashflow problems.

Commercial Considerations 

Directors and shareholders should first and foremost consider whether the business is worth keeping, taking into consideration the current economic climate, business projections and personal preferences.  An all-round risk assessment of the business and its commercial value, along with an analysis of whether short term obligations can be met should be conducted.

Negotiations with creditors

The short-term analysis is highly based on whether creditors (e.g. financial institutions, landlords, suppliers and employees) are willing to give the business a break.  

When entering into negotiations with a creditor, be straightforward and ready to offer a concrete plan of repayment.  Often times, creditors are equally interested in allowing the company to continue, with a view to the company arriving in a better position to settle the debt in the future.  A concrete repayment/fund raising plan will instil confidence in the creditor.
Where the creditor is a bank and the debt arises from a loan, the loan is usually secured against certain assets of the company (e.g. equipment, revenue), assets of the majority shareholders (e.g. landed properties) and personal guarantees of the directors and shareholders.  On the strength of the personal guarantees, bankruptcy could be a real risk faced by directors and shareholders. Successfully working out a deal with the bank is pertinent but it requires skill, especially if the business is an SME with far less bargaining power.

Negotiations with landlords can prove to be fruitful in the current HK economy, in particular where the lease is about to expire.  Extractions of rental reductions are common-place whilst negotiating for a break clause (the right to terminate the lease early), rent abatement clause (the suspension of rental payments upon the happening of certain events), force majeure clause (essentially the termination of the contract upon the happening of certain events beyond the control of the parties), and rent-free periods should be explored.  

Force majeure clauses and how they operate have been discussed by our firm here: https://oln-law.com/are-you-frustrated-by-your-force-majeure-clause.  For what the law allows when dealing with employees, our firm has published an article on this: https://oln-law.com/employment-matters-to-consider-in-economic-downturn. 

Scheme of Arrangement as an alternative to being wound up/liquidated

If negotiations fail and the company otherwise cannot find a way to pay its debts as they fall due, the company should consider entering into a scheme of arrangement which is essentially the company’s proposal on how to compromise with creditors on their respective debts, generally resulting in creditors accepting less than the amount that they are fully owed.  It is an alternative to being wound up.

Once the proposal is completed, the company must apply to the Court to convene a meeting of shareholders and/or creditors to seek their agreement to the scheme of arrangement.  Agreement under section 674 of the Companies Ordinance (Cap. 32) means 75% of creditors’ votes (in person or by proxy) in favour of the scheme.  Upon obtaining such agreement, the scheme must sanctioned by the Court.  In deciding whether to sanction the scheme, the Court will consider the following factors (Re China Singyes Solar Technologies Holdings Ltd [2020] HKCFI 467): 

(1)    whether the scheme is for a permissible purpose;
(2)    whether creditors who were called on to vote as a single class had sufficiently similar legal rights such that they could consult together with a view to their common interest at a single meeting;
(3)    whether the meeting was duly convened in accordance with the Court’s directions;
(4)    whether creditors have been given sufficient information about the scheme to enable them to make an informed decision whether or not to support it;
(5)    whether the necessary statutory majorities have been obtained;
(6)    whether the Court is satisfied in the exercise of its discretion that an intelligent and honest man acting in accordance with his interests as a member of the class within which he voted might reasonably approve the scheme; and
(7)    in an international case, whether there is sufficient connection between the scheme and Hong Kong, and whether the scheme is effective in other relevant jurisdictions.

The implementation of a scheme of arrangement in HK is time-consuming and costly, particularly as it involves separate Court applications and meetings.  Even when a meeting can be conducted, it may be difficult to obtain 75% support, for example, if creditors consider that they may have a better chance of recovery in separate legal proceedings.  Moreover, until the scheme is fully sanctioned by the Court, there is nothing that stops creditors from commencing legal proceedings in the Courts against the company. 

Winding Up

Of all options open to creditors, winding up a company is the most severe.  The process involves a liquidator stepping into the shoes of the company to collect and realize on the company’s assets and settle outstanding liabilities of the company.  The process will almost always involve directors who will be required to assist the liquidator in giving all sorts of information about the company including its financial information and flow of money, sometimes via affidavits and testimonies in Court.

An order for winding up will be made in the following 3 scenarios:

1.    The debtor fails to pay or fails to provide sufficient security for a sum of more than HK$10,000 within 21 days after being served with a statutory demand.
2.    The debtor fails to satisfy wholly or partially a judgment or order of the Court granted in favour of a creditor.
3.    When the creditor proves that the debtor is unable to pay its debts as they fall due (cash flow test) or the assets of the company are not sufficient to meet its liabilities (the balance sheet test).

One of the defences often used to resist an order for winding up is that the debt is the subject of a genuine dispute.  

Commercial transactions to avoid when the company is undergoing difficult times

The liquidator has wide powers to investigate the affairs of the company and the acts of its directors and officers.  

In particular, the liquidator may call into question the following types of transactions:
    
1.    Transactions at an undervalue, defined as where (i) the company makes a gift without receiving any consideration; or (ii) the company enters into a transaction for a consideration that is significantly less than the value of the consideration provided by the company, e.g. selling the company’s shares to a relative at a fraction of the value.  The relevant time frame under scrutiny is 5 years before the date on which the winding up of the company commences (i.e. the time that the winding-up petition is presented).

2.    Unfair preferences, defined as acts of the company that place certain creditors in a better position than they normally would have been, e.g. paying creditors with lower priority before those with higher priority.  For an unfair preference given to a person who is connected with the company (i.e. an associate which includes a spouse of the director or the director’s blood relations), the relevant time frame under scrutiny is 2 years before the date on which the winding up commences.  For an unfair preference given to an unconnected person, the relevant time frame under scrutiny is 6 months.

If a transaction is found to be a transaction at an undervalue or an unfair preference, the liquidator will commence legal proceedings to recover the assets from the current owner.  Once a transaction is found to be a transaction at an undervalue or an unfair preference, the directors of the company may face civil or criminal sanctions for approving/allowing the transaction to take place.  

For the above reasons, directors need to be extremely careful when handling the transactions of a company undergoing difficult times or that is otherwise already trading insolvent.

If you wish to learn more about what options are available to corporate debtors facing the possibility of being wound up, please feel free to speak to our litigation partner, Eunice Chiu.

Eunice Chiu
+852 2186 1885
Partner, Dispute Resolution
Oldham, Li & Nie

Like the rest of the world, Hong Kong is struggling with the impact caused by the Coronavirus in different facets.  The pandemic is not only taking away lives, but also ravaging the economy without mercy.  For business owners, did you rent premises you thought you would be able to afford until the Coronavirus changed everything?  Are you planning to get out of the tenancy agreement by reason of the Coronavirus?  In this article, we will list out some frequently asked questions and provide you with our answers, so that you might have a grasp of what impact a public health emergency (like the Coronavirus) may have on the rights and obligations of landlords and tenants. 

Click to jump to answer

Question 1: Has anyone ever brought a case to Court to terminate the tenancy agreement / get out of his/her rental obligations by reason of a virus outbreak? ↓
Question 2: Does the judgment in Li Chun Wing debar future tenants from claiming frustration by reason of the Covid-19 pandemic? ↓
Question 3: So, how can tenants seek immediate termination of tenancy and request for refund of prepaid rental / deposit? ↓
Question 4: In light of the above, what actions should landlords take? ↓
Question 5: What should I pay attention to if I am contemplating to enter into a new tenancy agreement? ↓
 

Question 1: Has anyone ever brought a case to Court to terminate the tenancy agreement / get out of his/her rental obligations by reason of a virus outbreak?

Answer:
Yes, but in the context of a domestic tenancy.

In 2003, Hong Kong was devastated by the outbreak of severe acute respiratory syndrome (SARS), which infected 8,096 worldwide and killed 744.  Block E of Amoy Gardens (淘大花園), a private housing multi-storey estate in Hong Kong, was unfortunately hard hit in the epidemic as there were 107 people infected there.  In view of the severe situation, the Government imposed a 10-day isolation order on Block E and all the residents therein had to be evacuated.  Subsequently, scientific investigations suggested that the U-traps in the sewage systems had been left dry which allowed the virus to pass from the building sewage system back to the apartments.  

The unfortunate tenants of Block E of Amoy Gardens were faced with a dilemma: given the situation, was there a legal justification for them to terminate the tenancy agreements?  Or should they continue to stay in the premises which seemed to be unsafe for many after the expiry of the isolation order?

This question went before the District Court of Hong Kong in the case of Li Chun Wing v Xuan Yi Xiong [2004] 1 HKLRD 754.  In this case, a tenant of Block E (“T”) terminated the 2-year rental agreement after the isolation order lapsed, and the landlord (“L”) applied for summary judgment against T for the accrued rent and damages arising from the alleged repudiation of the tenancy agreement.  The question for the Court was therefore whether T was entitled to terminate the tenancy agreement. 

The main argument that T relied on was the doctrine of frustration.  The general doctrine of frustration would kick in when there is an supervening event (without default of either party and for which the contract makes no sufficient provision) which so significantly changes the outstanding contractual rights and/or obligations from which the parties could reasonably have contemplated at the time of its execution such that it would be unjust for the parties to further perform the contract.  The supervening event, however, must not merely increase the burden of the contracting parties but must be so substantial to discharge the parties from the contract entirely.   In considering the argument of frustration, the Court in Li Chun Wing commented that the 10-day isolation order in the case was “quite insignificant in terms of the overall use of the Premises”, as the term of the tenancy agreement in question was 2 years.  Therefore, the Court rejected the argument of frustration and held that the lease was not frustrated by the isolation order.

Another argument by T was that there should be an implied covenant for the premises to be fit for human habitation. The Court rejected such argument also because it was unusual for the Court to imply such a term in tenancy, and in any event there was just no evidence to suggest Block E continued to be unsafe for human habitation after the expiry of the isolation order.

Question 2: Does the judgment in Li Chun Wing debar future tenants from claiming frustration by reason of the Covid-19 pandemic?

Answer:
Not necessarily.  

In Li Chun Wing, the Court stressed that “an event which causes an interruption in the expected use of the premises by the lessee will not frustrate the lease, unless the interruption is expected to last for the unexpired term of the lease, or at least, for a long period of that unexpired term.”  

That means, the duration of the epidemic, or more precisely the relative duration of the epidemic comparing to the length of the tenancy, is an important factor for deciding whether a tenancy has been frustrated. As experts of infectious diseases have pointed out, Covid-19 may not go away swiftly and we might have to fight a prolonged war against it.  This may be contrasted with the case of SARS epidemic which hit Hong Kong very hard at first but was swiftly alleviated within weeks. 

For tenants who have short leases, it may therefore be easier for them to claim frustration. However, this does not necessarily mean that long leases could never be frustrated at all as Li Chun Wing is only a decision by the District Court, being a court at a lower level in Hong Kong. On the other hand, in the recent English High Court case of Canary Wharf (BP4) T1 Limited & ors v European Medicines Agency [2019] EWHC 335 (Ch), it was suggested that it is not simply a question about the length of the tenancy. Instead, the Court should adopt a multi-factorial approach by looking at all the circumstances to decide whether the “common purpose” of the contract has been frustrated. This would require us to look beyond the four corners of the tenancy to consider also:-

–    The matrix or context when the tenancy was entered into
–    The parties’ knowledge, expectations, assumptions and contemplations, in particular as to risk, at the time of the contract
–    The nature of the supervening event; and
–    The parties’ reasonable and objectively ascertainable calculations as to the possibilities of future performance in the new circumstances

Question 3: So, how can tenants seek immediate termination of tenancy and request for refund of prepaid rental / deposit?

Answer:
Unless otherwise provided by the contract, generally landlord and tenant do not have the right to terminate the tenancy anytime before the period contemplated in the contract lapses. In most cases, even if force majeure clauses apply, they would only allow rent suspension or abatement but not termination of the tenancy. However, besides the situation that may give rise to frustration as discussed above, under certain circumstances, where a “repudiatory breach” of the contract has arisen, the non-breaching party may have the right to terminate the tenancy.

Generally, a repudiatory breach would only arise if the breach of the contract is sufficiently significant so as to deprive the non-breaching party of “substantially the whole benefit” of the contract.  In the context of tenancy, where the landlord shut down the premises, it may be argued that the landlord has breached the implied covenant of quiet enjoyment where the shutdown is unilaterally decided by the landlord and not authorised by the tenancy.  But where the shutdown is mandated by the government, it is difficult to attribute fault to the landlord and claim there is a breach of the tenancy on the part of the landlord.

Insofar as the issue of prepaid rental or deposit that is advanced by the tenant (e.g. two months’ rent) is concerned, first of all, one must turn to the actual tenancy agreement and check if parties have agreed on how the deposit would be dealt with.  Where the contract is ambiguous or silent on the issue, it requires a case-by-case analysis of the tenancy agreements and the circumstances.  If it is a straight-forward case that the landlord has breached the tenancy agreement so as to give rise to a “repudiatory breach”, the tenant can almost certainly terminate the tenancy and request for refund of the deposit.  In contrast, if the tenant is the defaulting party, the landlord may just apply the deposit to cover the tenant’s default.

However, as discussed above, very often the answer is less than clear and the tenant may not be certain whether he/she is entitled to rescind or terminate the contract on other ground such as frustration (Please refer to the answer in Question 2 hereinabove).  This is where the tenants must be extra cautious because if it was later adjudicated that the breach is not a “repudiatory” one, they may be liable to compensate the landlord, amongst others, the outstanding rents, consequential losses and legal costs.

Question 4: In light of the above, what actions should landlords take?

Answer:
As for landlords, it is important to consider whether your right to collect rental payment has been impacted by Covid-19 before commencing any legal action to collect rent.  As discussed below, there may be contractual provisions (e.g. a force majeure clauses and “material adverse change” clauses) in your tenancy agreement that have contemplated the situation of an epidemic/pandemic and relieve the parties from the performance of the contract.  Of course, the answer would very much depend on the intention of the parties and other circumstantial factors. 

Question 5: What should I pay attention to if I am contemplating to enter into a new tenancy agreement?

Answer:
Besides express contractual provisions regarding termination of contract, parties have to pay attention to force majeure clauses and “material adverse change” (MAC) clauses. 

For a discussion of force majeure clause, please refer to the article written by our Senior Partner, Mr. Gordon Oldham: https://oln-law.com/are-you-frustrated-by-your-force-majeure-clause.  Parties may consider to provide a clear and unambiguous force majeure clause to contemplate the event of epidemic/pandemic.

In addition, very often the contracts would contain a MAC clause which expressly stipulates that certain events that materially change the business, operations, assets, liabilities, condition (e.g. financial condition) of a party may give rise to a right to terminate the agreement. Again, like a force majeure clause, the MAC clause must clearly contemplate the event of epidemic/pandemic if parties wish to rely on it.  If MAC clauses are drafted in a generic way, the Court will tend to construe the clause narrowly by excluding Covid-19 as a MAC event.  In determining whether a MAC clause is triggered, a case-specific analysis of the following circumstances will also have to be conducted:-

–    Intention of the parties
–    What the parties have discussed on the treatment of Covid-19;
–    What the market comparable is for the party’s business; and
–    How the party’s business performance is compared with that of the market comparable.

Concluding thoughts

With the uncertain development of the Covid-19 situation, we believe that there might be upcoming cases testing whether the doctrine of frustration could discharge tenants from tenancy agreements and if so under what circumstances it will happen.  Before a clear guidance is laid down, we suggest both landlords and tenants to keep track of the situation and review key tenancy agreements in order to assess what impact had Covid-19 caused to them specifically.  Similar to most other disputes, the best way of resolution is always to attempt amicable negotiation and discussion by taking into account various commercial reality and practicality. If the tenant finds it inevitable to renege on rental payments, we suggest that he/she approaches the landlord to initiate a discussion and try to sort out whether rental reduction / deferment would be feasible before taking any legal action. 

If you wish to obtain legal advice to assess your current situation, please don’t hesitate to contact any of us (at anna.chan@oln-law.com or martin.tse@oln-law.com) and we will be pleased to answer and assist.

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.