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