China: Derivative action based on the New York Convention not recognised in Hong Kong

On the 14th June 2012, the judgment of Xiamen Xinjingdia v Eton Group & Ors was handed down in the Hong Kong High Court. It held that an order enforcing a foreign arbitral award under the New York Convention cannot be used as a derivative action to claim damages not considered in the original award through importing the law of the enforcing court. It sends a stark message of the difficulties which parties will face when they do not consider how an award in their favour can be enforced, even if they are successful.

The Background

The case arose out of contract between the plaintiff and the first and second defendants, the Eton Group, for the sale of land and apartments in the PRC. The owner of the land was the fourth defendant, whose entire shareholding was held by the first and second defendants. It was anticipated that the sale contract would be completed in three steps. First, the first and second defendants would give up their possession of the land in return for the plaintiff paying RMB120 million. Secondly, the plaintiff would construct apartments on the land. Thirdly, once the apartments were completed, the first and second defendants would transfer their shareholding in the fourth defendant to the plaintiff. Unfortunately for the plaintiff, the first and second defendants reneged on the contract and instead entered into a contract with the fifth defendant, who in turn built the apartments on the PRC land.

The CIETAC Arbitrations

The contract in question contained an arbitration clause. Accordingly, the plaintiff filed for arbitration in CIETAC against the first and second defendants alone. The plaintiff essentially claimed specific performance of the land sale and construction contract in return for the payment of RMB120 million, a sum which remained unpaid. The plaintiff won the first reference, obtaining an award allowing specific performance of the land sale and construction contract.

However, the arbitral panel had failed to have its attention drawn to the fact that the first and second defendants had undergone a restructuring by relinquishing their interest in the fourth defendant to the third defendant, a subsidiary of the fifth defendant. The restructuring was the subject of a second CIETAC arbitration. This time it was the first and second defendants filing for the arbitration. They claimed that the first award should be set aside because the sale was no longer possible because of the restructuring. The second arbitral award again held in favour of the plaintiff.

Enforcement in the Hong Kong courts

The plaintiff brought two sets of proceedings in Hong Kong; (a) New York Convention enforcement proceedings and (b) Enforcement Extension proceedings.

The New York Convention enforcement proceedings

These proceedings were simple. They sought to allow enforcement of the first arbitral award requiring the completion of the PRC land sale and construction contract. The High Court allowed the enforcement proceedings under sections 2GC and s40B of the previous Arbitration Ordinance (Cap.341), which still exists in substantially the same form under the new Ordinance. The High Court unsurprisingly allowed the enforcement of the award against the first and second defendants. The Court of Appeal considered an application for leave to appeal against this judgment. Leave to appeal was refused. It was held that the "impossibility" created by the defendants "was self-inflicted" and "the Eton Group went ahead with the restructuring notwithstanding that the arbitration had commenced. It took a calculated risk and must bear the consequences." The first and second defendants were therefore subject to a Hong Kong order which required that they compel the fourth defendant to transfer its interest in the PRC land and apartments to the plaintiff.

However, as considered above, the fourth defendant no longer had any interest in the land in question. The plaintiff therefore seemed to have a recognised award which could not be enforced in practice. This was because the fifth defendant could not be compelled to transfer its interest in the PRC land to the plaintiff because this was a further party who was not subject to the first CIETAC arbitral award.

The Enforcement Extension proceedings

Nonetheless, the plaintiff brought the second set of proceedings essentially to extend the first CIETAC arbitral award, which allowed specific performance of the land sale and construction contract against the first and second defendants to nine additional defendants. The third to fifth defendants were related corporate entities of the first and second defendants and the sixth to ninth defendants were individuals related to the first and second defendants. These proceedings consisted of so-called derivative and original actions.

The derivative action

The derivative action sought to claim that the judgment allowing the enforcement of the New York Convention enforcement proceedings could be used to claim damages against the first and second defendants in lieu of specific performance of contract. Even more controversially, the re-characterised specific performance claim could be invoked against the third to eleventh defendants, as well as the first and second defendants, under the Court's statutory, common law and equitable jurisdiction to grant enforcement remedies to a party deprived from obtaining specific performance. This was despite the fact that none of these parties were bound by the original land sale and construction contract which stated that disputes should be referred to arbitration.

The attempt to recast the arbitral award allowing specific performance as a claim for compensation so as to extend that award against all eleven defendants was swiftly dismissed. The Honourable Mr Justice Stone refusing to allow "palm tree justice" through the recasting of the CIETAC arbitral award in a Hong Kong Court. This was on the uncontroversial and firmly established basis that the nature of the New York Convention procedure is simply a mechanistic process of registering and enforcing a foreign award against the parties to the arbitration agreement. It does not allow the subverting of the original award, or any other intrusion upon the thought-process of the arbitrators. Nor could it be used to apply the substantive law of a foreign enforcing court. This presented an absolute bar to using a derivative action to claim damages against the eleven defendants based on an arbitral award allowing specific performance of a contract against two defendants.

The original action

Several free standing claims were made against all the defendants essentially alleging that the restructuring of the companies in Hong Kong was a conspiracy to evade enforcement of the CIETAC arbitral award. In addition to the conspiracy claim, there were also claims based on economic torts and the creation of constructive trusts arsing due to the fraudulent conduct of the defendants. These claims were all dismissed. Mr Justice Stone concluding that a Hong Kong Court did not have jurisdiction to consider the claims. Further, even if the Court did have jurisdiction, Hong Kong Law did not apply because the land sale and construction contract chose PRC Law, and there were no equivalent causes of actions relied on by the plaintiff. Moreover, even if Hong Kong Law applied, the factual background to the restructuring in fact suggested there was no basis for the conspiracy claim. In summary, the plaintiff's claims failed on every single ground even alternative submissions which were considered in this through judgement.

Comment

The judgment sends out an important message to parties that it will not be possible to extend an arbitral award by using the substantive law of another jurisdiction to extend its terms to create alternative causes of actions, and to expand the scope of the award to make claims against non-parties. In this respect, the judgment is reassuring for its sounds application of legal principles which are firmly established within the context of the enforcement of arbitral award under the New York Convention. The basic principle that only parties which are subject to an arbitration agreement are bound by its terms will apply in enforcement proceedings in Hong Kong. It reminds all that the Hong Kong courts can be relied upon to apply determined legal principles although this may sometimes not achieve the rule-bending palm tree justice sometimes adopted by common law courts.

Yet, there does not appear to be solution to this case. In this respect, it should be noted that the defendants filed for a further arbitration in CIETAC in which they sought clarification as to how the defendants could comply with a term of the land sale and construction contract, which stated that the parties should use an 'alternative approach in order to meet the purpose of the agreement'. This further application was, however, dismissed. Nonetheless, the Honourable Mr Justice Stone commented that it was still open for the plaintiff to go back to CIETAC to request clarification on how the contract could be performed. This seems to be the final remedy open to the plaintiff; although it may come almost five years after the original land sale and construction contract was signed in October 2007.

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