Hong Kong: Hong Kong's Insolvency Regime: A Time Of Change

Last Updated: 27 September 2017
Article by Jeremy Leifer

Earlier this year, Hong Kong's insolvency regime turned a corner with the coming into effect of much needed amendments to its corporate insolvency statute, the Companies (Winding Up and Miscellaneous Provisions) Ordinance. These amendments represent the first of two phases of regime changes. This first set of changes has gone some way to strengthening creditor protection particularly for avoidance transactions prior to winding up which breach the pari passu principle, as well as to streamline the winding up process. The second phase, which should start its legislative journey later this year, will however be the 'game changer', and if this phase makes it into law in the shape that the Government is proposing, after a very long wait, Hong Kong will finally have a much needed statutory corporate rescue procedure.1

Hong Kong sits at a pivot point in North-East Asia where it serves as a major centre for financial services for the region, attracting very significant levels of corporate activity, driven by its unique geopolitical position and its cross border treaty arrangements with Mainland China. These and other factors have helped to make Hong Kong a natural focal point for both inbound transactions into Mainland China as well as outbound. Hong Kong is also recognised as having one of the most mature and trusted legal systems in Asia, which accounts for the presence of much of this activity. Given these factors, the process of modernising some of the key aspects of Hong Kong's corporate insolvency regime as a component in the corporate life cycle, is long overdue.

This article will give an overview of the first phase amendments now in force, focusing on the new creditor protection provisions, as well as covering the ground on some of some of the changes to the winding up regime. It will then look very briefly at the proposed second phase amendments, where the detail has yet to be published.

Phase 1 Amendments – Anti-Avoidance Transaction Provisions

Liability of directors and shareholders involved in share redemption or buy-back out prior to winding up

This is a new provision which can require a shareholder or a director to contribute to the assets of an insolvent company. It provides that if a winding up of the company commences within one year after the payment out of capital2 was made by the company for a redemption or buy-back of its own shares, and the company is insolvent, the shareholder involved can be made liable to pay back the amount of the capital payment received from the company. This provision works in parallel to the requirement that a majority of the directors must sign a solvency statement3 as a condition to the effectiveness of the redemption or buy-back. Directors who have signed this solvency statement can be held liable (jointly and severally with the shareholder) to contribute the amount for which the shareholder is liable, subject to a defence that the director had reasonable grounds for forming the opinion expressed in the solvency statement. Prior to the introduction of this provision, it was (and still is) a criminal offence for a director to make a solvency statement without having reasonable grounds for the opinion expressed in it. Following a director's conviction for this offence, the company (and its creditors) would receive no benefit from any monetary fine imposed by the court. This new provision corrects that anomaly.

Transactions at an undervalue voidable in certain Circumstances

This is a new statutory provision in the context of a corporate insolvency.4 Until its introduction, it existed only in the Hong Kong Bankruptcy Ordinance in the context of individual bankruptcy5 but without a corporate equivalent. It provides that if the company goes into liquidation and during the five year period before the winding up commences it has entered into a transaction with a person at an undervalue, the liquidator may apply to the court for an order to set aside the transaction. The court has wide ranging powers to make an order to restore the position to what it would have been if the company had not entered into the transaction.

A transaction entered into by a company with a person is a 'transaction at an undervalue' if:

  1. the company makes a gift to that person, or otherwise enters into a transaction with that person on terms that provide for the company to receive no consideration; or
  2. the company enters into a transaction with that person for a consideration the value of which, in money or money's worth, is significantly less than the value, in money or money's worth, of the consideration provided by the company.

The court must not make an order if it is satisfied that (i) the company entered into the transaction in good faith and for the purpose of carrying on its business, and (ii) at the time the company did so, there were reasonable grounds for believing that the transaction would benefit the company.

Notably, the transaction under scrutiny will only be regarded as a 'transaction at an undervalue' if either (a) at the time of the transaction the company was unable to pay its debts as they fell due, or (b) the company became unable to pay its debts as a result of the transaction. Where the company entered into the transaction with a person 'connected' with the company (excluding an employee), conditions (a) and (b) are presumed to be satisfied, unless the contrary is shown.

Unfair preferences voidable in certain circumstances6

This provision which already existed in the corporate regime legislation is concerned with payments that prefer one creditor unfairly over another during the period before the commencement of winding up. However, unhelpfully, it operated by reference to the equivalent provision for unfair preferences in the Bankruptcy Ordinance. It has now been made a standalone provision for corporate insolvency.

In the context of this provision and the new corporate provisions for transactions at an undervalue (see above), the amending legislation has also clarified some definitional issues under the prior regime; specifically in relation to the meaning of who is a person 'connected' with, and an 'associate' of, a company for the purposes of the length of the look back period prior to the commencement of the winding up when examining prior transactions.7

A company gives an unfair preference to a person if (a) that person is (i) one of the company's creditors, or (ii) a surety or guarantor for any of the company's debts or other liabilities, and (b) the company does anything or permits anything to be done which has the effect of putting that person into a position which, in the event of the company going into insolvent liquidation, will be better than the position that person would have been in if that thing had not been done.

The liquidator will have the right to apply to the court for an order to set aside the preferential payment:

  1. if it is given to a person who is 'connected' with the company (excluding an employee) at a time in the 2 year period before the winding up commences;8 Or
  2. in any other case of an unfair preference (which is not a transaction at an undervalue), at a time in the 6 month period before the winding up commences. Again, the court has a range of orders at its disposal which are generally intended to enable it to restore the entity to the original position as if the transaction had not taken place.

A continuing issue in practice with this provision is the requirement that the liquidator must demonstrate to the court that in deciding to give a creditor an unfair preference, the company was influenced by a desire to prefer that creditor over another. In circumstances in which a company is financially stressed, it can be very difficult for a liquidator to demonstrate this 'desire' e.g. where a payment is made to a firm of accountants to retain their services during a time of financial stress.

Floating charge – potential invalidity

This provision already existed in the corporate regime legislation and addressed the validity of a floating charge granted close to the time of the commencement of winding up. It has been strengthened and clarified by expanding the types of consideration that a company may receive for giving the floating charge, to prevent invalidity, and by introducing a longer claw back period prior to the commencement of the winding up for a person 'connected' with the company.

It provides that if a company creates a floating charge on its undertaking or property in favour of any of the following persons, the charge will be invalid except to the extent of the value of consideration received by the chargor company for its creation if:

  1. in the case of a person connected with the company, the charge was created within the 2 year period before the winding up commenced; or
  2. in any other case, the charge was created within the 12 months period before the winding up commenced, and the company was unable to pay its debts at that time, or became unable to pay its debts as a result of the transaction under which the charge was created.

The consideration referred to will be the value of any money paid to or at the direction of the company, or property or services supplied to the company, at the same time as or after the creation of the charge.

Other Phase 1 Amendments

Streamlining the winding up process

The amending legislation introduced a wide range of other provisions aimed at streamlining the winding up process. The following are some of the highlights.

Voluntary winding up of company by the directors

Under a special procedure the directors of a company have the power under the corporate insolvency regime to place the company into insolvent liquidation (a creditors' winding up). The intended purpose of this procedure is to give to the directors the power to wind up the company and to appoint a provisional liquidator with effect from the commencement of the winding up, thereby accelerating the appointment process in an emergency case. Meetings of creditors and shareholders must then be convened within 28 days of the commencement of the winding up. A majority of the directors' may pass a resolution to commence the winding-up of the company, if they have formed an opinion that the company cannot by reason of its liabilities continue its business. A winding-up statement must then be filed with the Registrar of Companies, at which time the winding up will commence. Safeguards to address concerns that this 'fast tracking' process to appoint a liquidator might be subject to abuse were introduced by restricting the powers of the provisional liquidator appointed by the directors. Whilst the provisional liquidator will have the same powers as a liquidator in a creditors' voluntary winding up, aside from certain powers stated in the legislation,9 the provisional liquidator will now be required to obtain the sanction of the court to exercise his powers.

Liquidator not absolved from liabilities arising from the liquidator's misfeasance or breach of duty or trust

Provisions similar to those in the UK insolvency regime concerning the liabilities of a liquidator have been adopted to enhance the regulation of instances of misfeasance or breach of duty or trust by a liquidator notwithstanding his/her release by the court. Whilst a liquidator may have obtained a court order releasing him/her from office once the winding-up has been completed, interested parties including a creditor or contributory will now be entitled to apply to the court for leave to take legal action against the liquidator after the liquidator's release. This provision is intended to address possible delinquency of a liquidator during the performance of his/her duties.

Streamlining the committee of inspection (COI)

The COI may be appointed by the court in a compulsory liquidation following the determination of meetings of the creditors and contributories of the company. The purpose of the COI is that of supervising and giving directions to the liquidator during the course of the winding-up. Various changes have been made to the procedures surrounding the COI to improve their workings, and these include:

  1. setting the COI's minimum and maximum numbers of members at three and seven. This is subject to variation by a court order on the application of the liquidator;
  2. dispensing with the requirement that the COI should meet at least monthly if the COI failed to set a time for a meeting, and instead providing that it should meet as and when determined by the liquidator;
  3. (c) altering the provisions for filling vacancies on the COI, such that a vacancy need not be filled if the liquidator and a majority of the continuing members agree that, having regard to the position in the winding-up, it is unnecessary for the vacancy to be filled, and the total number of the continuing members does not fall below three (or the minimum number ordered by the court); and   (d) providing for COIs to conduct their meetings remotely (e.g. by video conference) and to make decisions through written resolutions.

Regulatory measures for liquidators and provisional Liquidators

The Phase 1 amendments also strengthen regulation under the winding-up regime by setting out more clearly the powers, duties, the basis for determining remuneration, tenure of office of a provisional liquidator in a court winding-up, the termination and resignation of a provisional liquidator.

Phase 2 Amendments

Given the scale of the changes overall and some political contentiousness connected with some of the amendments, the Government divided the process of making these amendments into two distinct phases. The two major pieces intended to be dealt with in Phase 2 are these:

Provisional supervision

This would create a formal turnaround and rescue regime. Currently, Hong Kong has only a liquidation regime (with rescue being provided through the provisional liquidation route – which was not designed for this purpose – at times combined with schemes of arrangement). The likely framework for provisional supervision (when it appears) is that it could be initiated by a company or its directors or provisional liquidators or liquidators, but not the company's creditors. It would give to the debtor company a moratorium period during which civil proceedings against the company would be stayed, thus giving valuable time to the provisional supervisor to work towards a possible turnaround of the business whilst freed up from the threat of creditor action. Provisional supervision could be used in the case of both a locally incorporated company and a non- Hong Kong company registered under the Companies Ordinance.

Insolvent trading

Hong Kong's insolvency regime has no provision for insolvent or wrongful trading.10 This would make directors and senior management personally liable for the debts of a company which traded while insolvent. The goal of this provision would be to encourage the directors and senior management to initiate provisional supervision much earlier in time, to raise the chances of salvaging the business before a liquidation. The liquidator would be empowered to apply to the court to seek a declaration that a 'responsible person' was liable to the company for insolvent trading at the time it went into liquidation.

It is very much hoped that both of these proposals will arrive on the statute book in the form proposed by the Government. Both would represent a great leap forward, and a significant catching up of the insolvency regime with other legal regimes in Hong Kong. The time for implementing these changes is now long overdue.

Footnotes

1 The corporate winding-up regime, which follows a creditor (rather than debtor) oriented approach, was last subject to major overhaul in 1984. The Government had sought to enact a statutory corporate rescue procedure involving a process of provisional supervision through the Companies (Corporate Rescue) Bill 2001, but owing to a range of concerns raised by members of the Legislative Council which included the question of addressing outstanding entitlements of employees, it was not passed into law.

2 A payment out of distributable profits or the proceeds of a fresh issue of shares for the purpose of the redemption or buy-back, falls outside of this provision.

3 This contains a statement to be made by directors that having inquired into the company's state of affairs and prospects and taken into account all the liabilities of the company (including contingent and prospective liabilities), the director has formed the opinion that (a) immediately after the transaction in question, there will be no ground on which the company could be found to be unable to pay its debts; and (b) (i) if it is intended to commence the winding up of the company within 12 months after the transaction date, the company will be able to pay its debts in full within 12 months after the commencement of the winding up; or (ii) in any other case, the company will be able to pay its debts as they become due during the period of 12 months immediately following the transaction date.

4 Formerly, a liquidator could only challenge a transaction at an undervalue on the basis of, inter alia, fraud, breach of fiduciary duty etc. by a director, and seek restitutionary relief to unwind the transaction.

5 This provision was also drafted with reference to the UK Insolvency Act 1986.

6 Previously referred to as a 'fraudulent preference'.

7 The concept of 'control' of a company has been introduced and is satisfied if (i) any or all of the directors of the company, or of another company which has control of it, are accustomed to act in accordance with that person's directions or instructions; or (ii) that person is entitled to exercise, or control the exercise of, more than 30% of the voting power at any general meeting of the company or of another company which has control of it.

8 This assumes that the unfair preference is not also a transaction at an undervalue. If it were such a transaction, then it would be dealt with as such, rather than as an unfair preference, resulting instead in a five year look back period.

9 These are (a) to take into the provisional liquidator's custody, or under the provisional liquidator's control, all the property and things in action to which the company is or appears to be entitled, (b) dispose of perishable goods and other goods that are likely to diminish in value if not immediately disposed of, and (c) do anything that may be necessary to protect the company's assets.

10 The offence of fraudulent trading exists in the current regime, but the courts have consistently been reluctant to make a declaration for civil liability in the absence of dishonesty.

Hong Kong's Insolvency Regime: A Time Of Change

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