(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.

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