Hong Kong corporate bankruptcy and insolvency laws enable secured creditors to enforce their security and create a collective mechanism for the distribution of assets after secured claims are satisfied. This collective mechanism is administered by a liquidator, to whom preferential and unsecured creditors must prove their claims in order to be entitled to a distribution by the liquidator from the assets remaining after security has been discharged. In this article, we provide an overview of the corporate bankruptcy and insolvency regime in Hong Kong.
Table of Contents
- Modes of Winding Up a Hong Kong Company
- Voluntary Winding-Up
- Compulsory Winding-Up
- Statutory Demand
- Process for Compulsory Winding-Up
- Moratorium on Creditor Proceedings Before Winding-Up Order
- Provisional Liquidator Before Winding-Up Order
- Winding-Up Order
- Meeting of Creditors and Contributories After Winding-Up Order
- Investigations by Liquidator During Winding-Up
- Realization of Assets by Liquidator in Winding-Up
- Resisting a Winding-Up Petition
- Policy Basis for Bona Fide Dispute Defence
- Meaning of a Bona Fide Dispute on Substantial Grounds
- Secured Creditors
- Floating Charges Subordinate to Preferential Claims
- Security Insufficient to Discharge Claim
- Invalidity of Security Constituting Unfair Preference
- Invalidity of Security Constituting Fraudulent Conveyance
- Invalidity of Floating Charge
- Unsecured Creditors
- Extortionate Credit Transactions
- Transaction at an Undervalue
The terms "insolvency" and "bankruptcy" refer to a state of financial distress where a person is either unable to meet their debts as they fall due or where the person's liabilities exceed their assets. The latter is known as balance sheet insolvency. Under Hong Kong corporate bankruptcy laws, the focus is on the former, meaning that a Hong Kong company is liable to be wound up by a creditor and a liquidator appointed to realize and distribute its assets where it is "unable to pay its debts".
Corporate bankruptcy is a complex area of law requiring specialized knowledge, particularly for debtor companies wishing to navigate out of financial difficulties.
Modes of Winding Up a Hong Kong Company
A winding-up is a corporate bankruptcy process by which a liquidator is appointed to take custody over all the available assets of a debtor company and to dispose of them. The object is to satisfy the secured debts with the secured assets, to satisfy the statutory preferential liabilities of the debtor company and then to satisfy the unsecured liabilities of the debtor company with the remaining assets. Where the proceeds from the disposition of such assets are insufficient to discharge all the unsecured liabilities, the company is balance sheet insolvent. This means that, subject to statutory preferences, the liquidator will distribute the proceeds from the sale of assets on a rateable basis. In other words, all unsecured creditors will receive the same number of cents for each dollar owed to them. However, where the proceeds from the disposition of such assets fully discharges all unsecured liabilities, the liquidator distributes the surplus to the shareholders of the debtor company.
Under Hong Kong corporate bankruptcy laws, a Hong Kong company may be wound up either by a voluntary winding-up or by a compulsory winding-up.
A voluntary winding-up takes 2 forms, namely a members' voluntary winding-up and a creditors' voluntary winding-up.
- Members' Voluntary Winding-Up - A members' voluntary winding-up begins when 2 things happen. First, the members of the company pass a special resolution to wind-up the company. Secondly, the directors issue a certificate of solvency to the effect that, after having made a full inquiry into the affairs of the company, in their opinion the company will be able to pay its debts in full within 12 months from the commencement of the winding-up. Given this certificate, a members' voluntary winding-up is not an insolvency situation.
- Creditors' Voluntary Winding-Up - A creditors' voluntary winding-up may begin either: (i) by the members of the company passing a special resolution to wind-up the company in circumstances where the directors cannot or do not issue a certificate of solvency, or (ii) by a majority of the directors certifying that the company cannot continue its business by reason of its liabilities and that it is necessary for the company to be wound up but is not reasonably practicable to be commenced otherwise. Unlike a members' voluntary winding-up, a creditors' voluntary winding-up is a potential insolvency situation.
A compulsory winding-up begins with a petition to the High Court of Hong Kong to wind-up a company. In the context of corporate bankruptcy, normally, the petitioner is a creditor of the company and the petition is made on the ground that the company is unable to pay its debts.
The petition to wind-up the company is typically preceded by a demand for payment commonly known as a "statutory demand". This is a demand for payment which complies with the requirements prescribed in the Companies (Winding-up and Miscellaneous Provisions) Ordinance ("CWUMPO"). If the debtor company does not pay or otherwise settle the amount demanded within a 3-week payment period prescribed by law, it may be deemed to be unable to pay its debts and, on this basis, the creditor may file a winding-up petition against the debtor company with the High Court of Hong Kong.
Under Hong Kong corporate bankruptcy laws, for a creditor, the issuance of a statutory demand offers 2 key benefits even though such a demand is geared towards a winding-up and a winding-up may result only in a rateable distribution with no preference to the petitioning creditor:
- Threat of Winding-Up Pressures Debtor to Pay- The statutory demand is a fast and simple means of placing a company into the hands of a liquidator where there is a real possibility of the company's insolvency. This threat applies enormous pressure on the debtor company to pay out the petitioning creditor in preference to other creditors to stave off a winding-up.
- Cost-effective - The statutory demand is relatively cost effective. Although there is a cost to begin the winding-up process, once the process has begun, the liquidator rather than the petitioning creditor incurs the costs of collecting the assets of the debtor company to satisfy liabilities. The creditor need not himself fund the process (though in some circumstances he may choose to do so).
Process for Compulsory Winding-Up
Under Hong Kong corporate bankruptcy laws, once a winding-up petition is filed by a creditor, the creditor must serve the petition on the debtor company and advertise the petition. As discussed in our earlier article titled "Debt Restructuring: Avoiding Corporate Bankruptcy in Hong Kong", the presentation of a winding-up petition can have serious consequences as the debtor's bankers are likely to freeze bank accounts and other creditors, such as suppliers, may stop providing trade credit.
Moratorium on Creditor Proceedings Before Winding-Up Order
Once a winding-up petition has been filed and even before a winding-up order has been made, the debtor company or any creditor or contributory (i.e. shareholder) may apply to court to stay any action pending against the company.
Provisional Liquidator Before Winding-Up Order
At any time after the presentation of a winding-up petition, the High Court of Hong Kong may appoint a provisional liquidator. Such an appointment may be made even before a winding-up order on the basis that such a liquidator is necessary to protect the assets of the debtor company or to investigate the affairs of the debtor company. Where these pre-conditions are satisfied, the court may empower a provisional liquidator to pursue the possibility of a restructuring with a view to enabling the debtor company to escape bankruptcy.
Creditors may wish to appoint a provisional liquidator to pursue a restructuring because under Hong Kong corporate bankruptcy laws, the appointment of a provisional liquidator imposes an automatic moratorium on all actions or proceedings against the debtor company. There is no need to make a specific application in respect of specific proceedings. This moratorium protects the debtor company from litigation against it by creditors while it pursues the restructuring.
At the same time, upon the appointment of a provisional liquidator, the directors of the debtor company must submit a statement of affairs to the provisional liquidator, showing the assets and liabilities, the names of creditors and details of security held by creditors.
The provisional liquidator may be the Official Receiver or, in the case where creditors apply for the appointment of a provisional liquidator, an insolvency practitioner nominated by the creditors, or any other person the court considers to be fit.
A winding-up petition may take several weeks before the High Court of Hong Kong issues a winding-up order. A winding-up order has a major effect on the debtor. Under Hong Kong corporate bankruptcy laws, these effects include:
- Appointment of Liquidator - If no provisional liquidator was appointed prior to the winding-up order, upon the winding-up order being made, the Official Receiver becomes the provisional liquidator until such time as another person becomes the liquidator. If, however, a provisional liquidator was appointed prior to the winding-up order, this person will continue as the provisional liquidator following the winding-up order.
- Management Power Vests in Liquidator - A winding-up order will automatically terminate the powers of the directors to manage the debtor company's affairs. Instead, the power to manage the debtor company will vest in the liquidator. The liquidator will be the agent of the debtor company and his actions will bind the company.
- Moratorium on Creditor Proceedings - A winding-up order will automatically stay all existing court proceedings and prevent new proceedings from being commenced against the debtor company, unless permitted by the court. This moratorium protects the debtor company from lawsuits and claims by creditors, thus giving the liquidator the time to collect up and realize the assets of the debtor company for the benefit of the preferential and unsecured creditors.
- Avoidance of Property Dispositions - Any disposition of the debtor' company's property (other than such property to the extent subject to security in favour of secured creditors) (including payments) dating back to the time of the winding-up petition is void, unless such disposition is made with the approval of the High Court of Hong Kong. The retroactive avoidance of property dispositions protects the assets of the debtor company to the intent that the liquidator can effect an equitable distribution of assets without worrying that certain creditors have been preferred at the outset.
Meeting of Creditors and Contributories After Winding-Up Order
Unless the value of the debtor company's property is unlikely to exceed HK$200,000, following a winding-up order, Hong Kong corporate bankruptcy laws require the provisional liquidator to summon a separate meeting of creditors and contributories (i.e. shareholders). These meetings are for the purpose of determining whether an application will be made to the court for appointing a liquidator and for appointing a committee of inspection to act with the liquidator. A committee of inspection comprises creditors and contributories.
Investigations by Liquidator During Winding-Up
Under Hong Kong corporate bankruptcy laws, once a winding-up order has been made, the directors of the debtor company must submit to the liquidator a statement of affairs showing the assets and liabilities of the company, identifying the creditors and providing details of any security given to the creditors. In turn, the liquidator must investigate and report to the court on the company's assets and liabilities, the causes of failure of the company and whether further enquiry is desirable as to any matter relating to the failure of the company or the conduct of its business.
Where appropriate, the liquidator may work with the Official Receiver to pursue potential prosecution action against relevant persons for misconduct or insolvency related offences (e.g. failure to keep proper accounting records, acting with intent to defraud creditors by giving or concealing the company's property). As a result, it is prudent for directors to understand the duties imposed upon where their companies are approaching insolvency to avoid the possibility of director disqualification or other personal liabilities for insolvent trading.
Realization of Assets by Liquidator in Winding-Up
Once appointed, the liquidator will collect up and realize the debtor company's assets. In doing so, where appropriate, the liquidator will take steps to pursue any legal remedies against third parties on behalf of the debtor company.
Following collection of the assets of a debtor company, the liquidator will make distributions from the proceeds of the disposition of such assets to meet the proven claims of creditors. In this regard, Hong Kong corporate bankruptcy laws establish a system of ranking the claims of creditors. Under this system, the highest priority goes to the costs of the liquidation followed by:
- the claims of preferential creditors (i.e. creditors who for public policy reasons are given statutory preference over other creditors), such as employees and the government, and then
- claims by holders of floating charges, and finally
- claims of the remaining creditors, which are generally treated pari passu, meaning that the remaining creditors share rateably (i.e. each creditor receives the same amount on every dollar owed to it).
Once the liquidator has realized and distributed all the assets of a debtor company and has completed all investigations, the liquidator may apply to court to be released and the company may be dissolved.
Resisting a Winding-Up Petition
Given the existential threat posed by a winding-up, debtor companies may seek to challenge a winding-up petition on the basis that there is a "bona fide dispute on substantial grounds" as to the alleged debt. Such a dispute may go to the existence of a debt or its amount.
Policy Basis for Bona Fide Dispute Defence
The reason that a bona fide dispute on substantial grounds as to a debt can be used to resist a winding-up is that under Hong Kong corporate bankruptcy laws, a winding-up is intended to begin a collective process of collecting up the assets of a debtor and distributing those assets to creditors rateably. It is not intended as a means to resolve disputes. As a result, if a debtor can demonstrate a genuine and substantial dispute as to the debt, the winding-up cannot proceed.
Meaning of a Bona Fide Dispute on Substantial Grounds
In broad terms, a bona fide dispute on substantial grounds is measured objectively by the court on the available evidence. The debtor's honest belief as to a ground is insufficient. The debtor must put forward sufficiently precise factual evidence which the court finds credible given that it is not uncommon for debtors to raise a cloud of objections.
The categories of disputes which debtors may raise are infinite. They may include, for example, the fact that an alleged debt is not presently due or is a contingent debt or the fact that goods delivered or services rendered so as to give rise to the debt were not properly delivered or rendered.
Secured creditors generally stand outside the winding-up to the extent of their security, meaning that they are entitled to enforce their security notwithstanding any winding-up proceedings. Any surplus remaining from the proceeds of the sale of the security upon enforcement must be returned to the company.
Floating Charges Subordinate to Preferential Claims
However, as alluded to above, the claims of holders of floating charges are subordinated to those of preferential creditors, meaning that, in an insolvency, upon enforcement of a floating charge against a debtor company or its assets, the creditor must pay the proceeds from the enforcement first to the preferential creditors of the company before using the proceeds to discharge any amount due to him.
Security Insufficient to Discharge Claim
Where the security held by a secured creditor is or may be insufficient to meet the liabilities owed to the secured creditor, the secured creditor may file a proof of debt with the liquidator for the balance owed. In so doing, the secured creditor must estimate the value of his security, failing which, unless a court otherwise orders, Hong Kong corporate bankruptcy laws will deem him to have surrendered his security.
Invalidity of Security Constituting Unfair Preference
The grant of security by a debtor company may be invalidated if the grant of security constitutes an unfair preference. In this context, Hong Kong corporate bankruptcy laws provide that an unfair preference may arise where the debtor company gives security to a creditor at any time in the 6 month look back period prior to the commencement of the winding-up. However, a court must be satisfied that the giving of the security was influenced by a desire to put the creditor receiving the security into a better position in the event of the insolvency of the debtor company.
Where the creditor receiving the security is an associate of the company (e.g. a person having more than 30% of the voting power at a general meeting of the company) or its director, the 6 month look back period is extended to 2 years and the requisite desire to put the receiving creditor into a better position is presumed.
Invalidity of Security Constituting Fraudulent Conveyance
A court may void the grant of security by a debtor company to a creditor where the security was granted with intent to defraud other creditors. The power is not restricted to the context of a winding-up.
Invalidity of Floating Charge
Under Hong Kong corporate bankruptcy laws, in a winding-up, a floating charge given by a debtor company to a creditor may be invalidated to a certain extent if both of the following conditions are satisfied:
- Look Back Period - the floating charge was given in the 12 month period prior to the commencement of the winding-up; and
- Insolvency - either the debtor company was unable to pay its debts at the time the floating charge was given or the debtor company became unable to pay its debts in consequence of the transaction under which the charge was given.
If both these conditions are satisfied, the floating charge is valid only to the extent that it secures the aggregate of the following, plus interest capped at 12% per annum: (i) money paid to the debtor company, plus (ii) money paid at the direction of the debtor company, plus (iii) the value of property and services supplied to the debtor company at the same time as or after the grant of the charge. It follows that the floating charge is invalid to the extent it secures any amount outstanding prior to the giving of the charge.
Where the floating charge is given to a person connected with the debtor company, the look back period is extended to 2 years prior to the commencement of the winding-up. At the same time, in this case, there is no need to show that the debtor company was unable to pay its debts at the time the floating charge was given or the debtor company became unable to pay its debts in consequence of the giving of the transaction under which the floating charge was given.
In a winding-up, unless otherwise ordered by a court, each unsecured creditor must file with the liquidator a proof of debt to pursue its claim against the debtor company. The liquidator has the discretion to admit or reject any proof of debt in whole or in part and may require further evidence in support of any proof of debt before determining whether to admit or reject it. Only unsecured creditors whose debts the liquidator has admitted may receive a distribution from the liquidator from the realization of the assets of the debtor company.
An unsecured creditor may appeal to the court if it is dissatisfied with the liquidator's decision in relation to a proof of debt.
Extortionate Credit Transactions
Under Hong Kong corporate bankruptcy laws, on an application to court by the liquidator of a company being wound-up, the court may set-aside or vary the provisions of any loan agreement or other credit transaction by which credit was extended to the company in the 3 year period prior to the winding-up order. The court may do so if it considers the transaction to be extortionate.
For this purpose, a transaction is "extortionate" if having regard to the risk borne by the creditor, the terms require grossly exorbitant payments in respect of the provision of credit or the terms otherwise grossly contravene ordinary principles of fair dealing.
In general, Hong Kong corporate bankruptcy laws mandate the set-off of mutual debits and credits, meaning that sums owed by a creditor to the debtor company must be set-off against sums owed by the debtor company to the creditor. However, no set-off is available where at the time the creditor extended credit to the debtor company it was aware that a winding-up petition had already been presented.
Transaction at an Undervalue
Where a company is being wound-up, the liquidator may apply to court to set aside a transaction at undervalue, for example where the company makes a gift or there is an inequality of exchange of consideration in the transaction. The court however, will not set aside a transaction where the company entered into the transaction in good faith for the purpose of carrying on its business and at the time of transaction, there were reasonable grounds for believing the transaction would benefit the company.
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.