Can a Payee’s Money be Frozen if Payor Uses Underground Banking without Payee’s Knowledge?

Prior to 2020, transfers of money into Hong Kong through the underground banking system were not “questioned”. Contracts involving such transfers, whilst illegal under PRC law, were enforceable. All that changed due to a trilogy of cases decided by HK’s High Court, with the jury still out on the question of whether the defence of bona fide purchaser for value without notice remains available to passive recipients who played no part in the fraud or underground banking and who could not have suspected that the money originated from such acts. 

The Law Prior to 12 October 2017

As late as 2017, our Court of First Instance in BR CAT International Co Ltd v Hong Kong Proof Import and Export Trading Co Ltd (HCA 1023 of 2014, 22 September 2017) found money originating from a fraudulent act and subsequently transferred through underground banking “legal” in HK as long as the recipient had no actual or constructive knowledge/notice of the fraud or the underground banking.  

The factual circumstances of the case are similar to those of most underground banking cases:

  • A foreign plaintiff (Saudi Arabian company) was duped by an online fraudster into transferring USD1.4 million to bank accounts located in HK belonging to the first layer of recipients.  
  • One of the first layer recipients then transferred a part of that sum, USD323,000, to the account of D8 located in HK.  
  • Separately, D7 needed to convert RMB sitting in its Shenzhen account into USD and transfer it to HK.  D7 sought D8’s help. D8 asked D7 to transfer the money to D8’s accounts in Shenzhen and Fujian. 
  • Rather than actually converting D7’s RMB and wiring it to HK, D8 simply used the USD received from the defrauded plaintiff and sitting in D8’s account in HK, and transferred it onwards to D7.
  • In other words, D8 collected RMB in the PRC but instead of using the same money to do the conversion and transfer to HK, D8 used the sum already sitting in its account which would have remained with the plaintiff but for the fraud.

In deciding that D7 was entitled to keep the converted money which came from proceeds of crime, Madam Justice Bebe Chu decided that the conversion and transfer out of money from the PRC via the underground banking system, though possibly illegal in the PRC, did not render the transaction between D7 and D8 void because D7 had no constructive or actual knowledge about the fraud, i.e. D7 got to keep her money. She stated:

Although the transactions through the “underground banking system” may be considered illegal under the Mainland law, in the present case, there was no reason for Yau to believe that the USD323,000 transfer arranged by D8 to be deposited into D7’s HSBC Account designated by him, would come from a fraudster, or any illicit or improper source, nor was there any evidence to indicate that there was anything obvious or untoward in D8 in transferring the amount to him. There was no sufficient evidence to show that a reasonable person in Yau’s position would have appreciated that the transfer arranged by D8 with whom he had had money exchange transactions in the past was probably fraudulent or improper, or a person in Yau’s position would have made inquiries or sought advice which would have revealed the probability of impropriety.

In other words, Madam Justice Chu did not consider the underground banking feature as a poison pill for D7’s claim and simply considered the question of whether the recipient had knowledge of the fraud in actual terms (she knew) or constructively (as a reasonable person, she should have known, or at least there were sufficient suspicious circumstances that should have caused her to make further inquiries as to the origin of the money).  

The New Approach 

Case No.1 – The High Court first deviated from Madam Justice Chu’s approach in DBS Bank (Hong Kong) Limited v Tian Wen Quan (HCA 3228 of 2016, 12 October 2017). In that case, Mr Justice Anthony Chan had to decide whether to discharge the plaintiff’s injunction to restrain the recipient defendant from dealing with the money in question. The cause of action was in monies had and received. Mr Justice Anthony Chan discharged the injunction because he found that the merits of the case at the interlocutory stage were tilted in favour of the recipient defendant. That said, Mr Justice Chan made a comment in obiter that if the money was received as part of an underground money exchange transaction to circumvent the foreign currency exchange control of the PRC, the recipient defendant’s bona fide purchaser for value without notice defence would fail. Again, Mr Justice Chan did not have to decide this point within the injunction context.

Case No.2 – In Grupo Arbulu S.L. v City Apex Holdings Ltd [2018] HKCFI 1351 (15 June 2018), the cause of action was in knowing receipt. Deputy High Court Judge Keith Yeung, SC ruled that since the underground banking transaction was illegal under PRC law, the defence of bona fide purchaser for value without notice would not be available. A key fact considered by the Court was the defendant’s active participation in the underground banking, namely, it personally engaged a PRC currency exchange agent to convert the money in its HK bank account (which originated from proceeds of fraud) into RMB, then transferred it to the PRC bank account of an aircraft leasing company to settle rental payments owing by itself.  

What would be the result if the defendant had just been a passive recipient?  

Case No.3 – Deputy High Court Judge Blair went even further in DBS Bank (Hong Kong) Limited v Pan Jing [2020] 4 HKC 395 (24 January 2020). He explicitly stated that HK Courts will not enforce a currency exchange contract that is contrary to PRC exchange controls, and that the defendant cannot be considered to have provided any value for the property if it was transferred pursuant to a transaction considered to be illegal under PRC law. In other words, Justice Blair appears to be saying that the defence of bona fide purchaser for value without notice is not at all available in enforcing contracts/transactions where underground banking has been used. Justice Blair further held that the defence of change of position would also not be available in such circumstances due to public policy reasons:

It is correct that the facts are different, in that the defendants in those cases were the parties that received and distributed the stolen funds in the course of a business, whereas the defendant in this case received the funds as the final leg of the exchange transaction. But otherwise, the cases are indistinguishable, because the courts refused to allow a change of position defence where the relevant acts were illegal, as they are in this case. The defendant’s submissions fail for the same reasons that ruled out the bona fide purchaser defence, namely that it is not necessary for the bank to show that the defendant knew of the fraud because the money was transferred pursuant to a transaction that was itself illegal, and the evidence does not support the proposition that the defendant did not know how the exchange would be effectedI conclude that the court should follow the decisions in Barros Mattos and Arrow ECS Norway v Yang Trading. 

I would have followed the result of these decisions even if (as some commentators consider) the judge in Barros Mattos put the test too high in suggesting that if the recipient’s actions in changing position are treated as illegal, the court will more or less automatically refuse to contemplate a change position defence. Whether or not this is correct, in my view, the result is justified on the basis of public policy considerations regarding breach of exchange control regulations (see Virgo, cited above, at p 693), which apply equally, if not more so, in the present case.

Again, the defendant in the above case was an active participant in the foreign currency exchange. Would the Court have decided differently had the defendant been a mere passive recipient?  

Case No.4 – Tti Global Resources v Hongkong Myphone Technology Co Ltd [2021] HKCFI 306 (10 February 2021) involved an appeal of a decision to dismiss the plaintiff’s summary judgment application against D2 and D4, both of whom actively engaged in underground foreign currency exchange and received proceeds of fraud in the course of those exchange transactions. In the same vein as Deputy High Court Judge Blair in the Pan Jing case, Justice To allowed the appeal and entered judgment against D2 and D4 on the basis that the transactions were illegal as a matter of PRC law and in any event, D2 and D4, being active participants, could not be considered to be acting with bona fides.  

The position of a passive recipient of funds – relevant point in time for requisite knowledge

The above cases beg the question: where funds came through underground banking in contravention of PRC law, if the recipient merely played a passive role with no evidence that he knew of the source of funds or the manner in which the funds arrived, or ought to have so known based on suspicious circumstances, is the defence of bona fide purchaser for value without notice available? 

It was this exact question that was faced by the High Court in Lesnina H. D.O.O. v Wave Shipping et all (HCA 154/2020). On 25 March 2021, Deputy High Court Judge Dawes, SC heard the plaintiff’s application for summary judgment. Judgment has been reserved. The facts were as follows: The plaintiff was defrauded into transferring EUR1,879,726 from its Croatian bank account to D1’s HSBC account in HK. Upon receipt, D1 converted EUR1,875,461.68 into USD2,077,399.16 and transferred part of that sum, USD320,000, to D8’s HSBC account in HK. At around the same time, D8 received a similar amount of money in its HSBC account from an unrelated 3rd party to whom D8 supplied healthcare products. Simply put, D8 was a proper business that had zero knowledge of the fraud and no connections with the fraudster or D1. It appeared that the 3rd party might have instructed D1 to pay D8, although it was quite clear that money owed to D8 by the third party did not originate from money defrauded from the plaintiff.  

Plaintiff’s Counsel argued that in a case of knowing receipt, the relevant point in time in assessing whether a recipient had the requisite knowledge was at the time of transfer and subsequent to that, for example, when D8 received the Writ of Summons. D8’s Counsel disagreed and relied on Lewin on Trusts, 20th edition (para 42-083) for the principle that a defendant’s knowledge must be assessed at the time of receipt of money (para 42-083, Lewin on Trusts), rather than afterwards which is strictly speaking “after-acquired knowledge”. Alternatively, the relevant point in time for knowledge should be at the time consideration is given by the recipient of money.

It remains a live question whether all transactions involving underground banking are categorically unenforceable, regardless of bona fides. Underground banking appears to be a fact of life in business in the current economic environment. If you are a victim or know a victim of fraud or underground banking, or wish to avoid being deprived of funds duly owed in the normal course of business, please feel free to speak to our disputes partner, Eunice Chiu.

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

20 April 2021