Hong Kong: Recent Developments In Respect Of Unfair Preference Claims

Last Updated: 11 June 2014
Article by Tanner De Witt

HCCW 755/2005 – Re Sweetmart Garment Works Limited (in Liquidation) – Recent developments in respect of unfair preference claims

Introduction

An unfair preference claim is (in theory) a powerful tool for liquidators to recover assets of the company when a creditor's position has been unfairly improved by the company prior to its winding up. However, in practice the tool has rarely been used, and even more rarely been used successfully. This may change following a recent decision of the High Court in which we acted for the liquidators, partners of Grant Thornton.

In a case where the preferred creditor is an "associate" of the company (for instance a director), the onus is on the preferred creditor to show that the company was not influenced by a desire to prefer the creditor over other creditors of the company in taking the steps complained of.

With respect to a "non associate" case, however, the onus is reversed – the liquidators have to show that the company was influenced by a desire to prefer one particular creditor over the other creditors of the company. This has generally proved to be a difficult task. First, understandably, the liquidators usually do not have the relevant personal knowledge of the transactions. Further, even if the officers of the company are willing to give testimony in favour of the liquidators' case, the credibility of such testimony is treated with caution.

In our recent case, the subject company granted a mortgage in favour of a financial institution (i.e. a "non associate") shortly before its winding up. We were successful in obtaining a judgment in favour of the liquidators on 31 January 2008. This article aims to give a summary of the case.

Background

The subject company went into compulsory liquidation on 30 November 2005, the creditors' petition having been presented on 28 September 2005.

A little over a month prior to the presentation of the petition, the company granted a mortgage over a yacht in favour of one of its bank creditors.

The mortgage was granted to secure general credit facilities up to an amount of HK$6.8 million in mid-August 2005. The loan was drawn down three days later and used to repay an existing overdraft of the company with the same bank, payments which had been overdue for some time.

Following the presentation of the petition, the bank exercised its right under the mortgage and took possession of the yacht in November 2005, appointing a receiver in respect of it.

We advised that the mortgage should be set aside on the basis that it constituted an unfair preference.

The liquidators and the bank agreed that the vessel should be sold and the net sale proceeds should be set aside pending the resolution of the disputes between them.

Having been unable to resolve the disputes, the liquidators took out an application in May 2007 for a declaration that the mortgage constituted an unfair preference.

Evidence

It was common ground that the mortgage improved the bank's position as a creditor of the company and that the mortgage was granted within the statutory period of 6 months. It was not disputed that the company was insolvent at the time the mortgage was granted. The sole issue for determination was whether the company was influenced by a desire to prefer the bank over the other creditors of the company in granting the mortgage.

The relevant evidence included the contemporaneous correspondence between the bank and the company in the months leading up to the grant of the mortgage, and the steps being taken by other creditors in recovering the company's debts in the meantime.

The debts owed to these other creditors added up to a sum of almost HK$100 million.

The chain of correspondence between the bank and the company suggested that the officers of the bank and the officers of the company had at least a friendly working relationship. The general tone of the email correspondence was friendly and supportive. The bank was not particularly heavy handed. On the other hand, in the months leading up to the grant of the mortgage, creditors had been pursuing more aggressive recovery actions against the company, including issuing statutory demands against the directors of the company (as guarantors of the company's debts).

Reasons for the Judgment

The Court concluded that:

  1. The bank did not place any real commercial pressure on the company through the course of the correspondence. Although there were complaints regarding non payment, the nature of the complaints was mild.
  2. The Court did not accept that the bank had placed any "moral" pressure. Re Hau Po Man Stanley was distinguished. In that case, the moral pressure arose out of the debtor's desire to preserve family ties. This was clearly not applicable here.
  3. The steps taken by the other creditors were "more concrete, more serious, and instituted much more promptly" than those threatened by the bank.
  4. It does not appear that there could have been any real prospect of the company trading on through its difficulties, given the critical steps taken by the creditors as a whole and the extent of the debts owing to them. Therefore it could not be said that the mortgage was granted to preserve the ongoing commercial relationship with the bank.
  5. The loan granted by the bank against the mortgage did not involve fresh credit being given to the company. Therefore, the company did not benefit in any tangible way from the granting of the mortgage.
  6. Even though bankruptcy proceedings had been threatened against the directors of the company, the directors still elected to offer the vessel as security. This is strong evidence of a desire to prefer the bank.

Based on the indirect evidence, the Court felt comfortable to infer that the company was influenced by a desire of preferring the bank in granting the mortgage in question.

Significance of the Judgment

This case, we believe, will give a boost to liquidators who seek to use the provisions of Sect 266B of the Companies Ordinance. This was a successful unfair preference claim against a bank creditor (being a "non associate"). It is also significant that neither side had direct testimony; the evidence as it was had been second hand.

It has been conventionally accepted that financial institutions are independent entities which do not have connection to or interest in their clients. For this reason, it has been difficult to establish the relevant desire to prefer.

On this occasion, the Court (rightly in our view) adopted a more realistic approach. Although "desire" is subjective and there was hardly any direct evidence, the Court recognised that indirect evidence can be relied on to infer the existence of the relevant desire. This approach should be welcomed.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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