Whether it’s the kids’ day-care, the family holiday, or that gym membership we eagerly signed up for on the first of January, paying for goods and services before receiving them is the normal practice in many business sectors. It’s also the usual way to buy things off the internet. It’s become so common that we rarely ask what would happen if the business fails to deliver. Fortunately, in Hong Kong this is a question that does not have to be asked often, but as the economic environment gets tougher it may be one that deserves greater attention. Traditionally, in circumstances where an insolvent business closes down, customers who have pre-paid for goods and services will find themselves as creditors in the liquidation, standing alongside other unsecured creditors bound by the collective process that it creates and possibly receiving back only a small fraction of their debt, sometimes several years later. But over the past year, news reports have emerged about the use of consumer protection provisions under the Trade Descriptions Ordinance (Cap. 362) (“TDO”) to obtain some degree of redress for affected customers.

The first widely reported case was in July 2015, when former Hong Kong government official, Sam Chow Tung-shan was charged and convicted of the offence of wrongly accepting payment from students in circumstances when his language school business was already in arrears in its rent and had not generated a profit for years. The business closed down shortly after it accepted the payments, reportedly in the sum of approximately HK$9,000 each, from the two students. Following his conviction, the Court also ordered that he pay compensation to the victims.

A Weapon Against Unfair Trading but not Insolvent Trading

Introduced as part of a raft of new consumer protection provisions, the offence of wrongly accepting payment unders. 13I(2)(c) of the TDO came into force in July 2013. Under this section, it is a criminal offence for a trader to accept payment in relation to a consumer transaction when, at the time of accepting payment, the trader does not have reasonable grounds to believe that they will be able to supply the products in the time specified or, if no time is specified, within a reasonable time. The offence carries a maximum fine of HK$500,000 and up to five years’ imprisonment. Where the offender is a corporate entity, directors and officers and managers may be personally liable for the offence, thereby ensuring that those responsible for the conduct cannot hide behind the corporate veil. In addition, s. 18A and s. 36 provide compensatory mechanisms for those customers affected. The former allows the Court to make orders to pay compensation to victims for financial loss resulting from the offence following the conviction of an offender, while the latter enables the victim to commence an action to recover the amount of loss suffered following a contravention.

Inquiries with the relevant enforcing authority, the Customs and Excise Department, from the commencement of the TDO in July 2013 to May 2016, reveal that there have been a total of 82 investigations into possible offences of wrongly accepting payment. What percentage of these investigations occurred in the context of insolvent businesses is unknown, but media reports about these types of cases almost always appear in the context of the sudden closure of a business. This was the case with two other widely reported business closures – a play centre for kids, My Gym World Development Centre, and the electronics and furniture chain, DSC. While investigations may have commenced, it appears prosecutions remain rare. The 82 investigations initiated have resulted in only one prosecution (seven investigations are ongoing). This may well indicate the difficulty with using consumer protection provisions in an insolvency context, for which they were not designed.

The mischief the offence of wrongly accepting payment seeks to eliminate arises from the information asymmetry that exists between the trader and the customer. A customer has little ability to know whether the trader has the capacity or bona fides to deliver the promised good or service, so s. 13I(2)(c) makes it an offence to receive payment in circumstances where there are no reasonable grounds for the trader to believe he will be able to supply the product. The core element of the offence is the absence of any reasonable grounds for the belief that the goods or services will or can be supplied.

However, in the context of a business in financial distress, this is problematic. During this period, directors may be aware of the difficulties faced by the business such as mounting losses or falling in arrears with payments to suppliers, but they may honestly believe that they can trade out of these difficulties or will be able to secure new lines of credit to tide them over so that they can deliver the promised goods and services. They would legitimately also wish to avoid any outward signals of potential insolvency which might become self-fulfilling, such as by not accepting further pre-payments. The difficult question therefore arises – at what point does it become so unreasonable for them to continue to trade the business and accept payments from customers such that they should be held criminally responsible? Given the criminality of the section, how willing would the Courts be to impose liability in the absence of dishonesty or some fraudulent intent?

This problem of proof also arises with the existing law on fraudulent trading, another mechanism that might be used to seek compensation for creditors in circumstances of a business that has been trading while insolvent. Under the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap. 32) fraudulent trading is both a civil wrong and a criminal offence, and it is defined as carrying on any business of a company with intent to defraud creditors or for any fraudulent purpose, which could potentially cover insolvent trading. However, the application of the fraudulent trading provisions is limited to all but the most egregious cases by the need to prove that the directors of the company were subjectively dishonest (see Aktieselskabet Dansk Skibsfinansiering v Robert John Francis Brothers [2000] HKCFA 49).

Another major shortcoming with the TDO in the context of insolvency is that liability for the criminal offence does not automatically compensate the victims. As noted above, compensatory mechanisms do exist under s. 18A and s. 36. But an order for compensation under s. 18A can only follow a successful prosecution, meaning a customer has little control over it. And while s. 36 permits a customer to commence an action for damages, it requires proof that the conduct complained of constitutes an offence under the TDO – thus importing a high burden of proof on the customer to discharge. Even leaving aside the evidentiary difficulties for the customer, one can also easily imagine that the time, trouble and legal costs of taking those proceedings would probably outweigh the costs of the good or service which hasn’t been delivered to him. Therefore, it is likely the compensation mechanisms under the TDO are only useful following a successful criminal prosecution.

Supplying a Better Solution

With a view to better protecting consumers and counterparties from the risks of businesses that trade when in financial distress, other jurisdictions with legal systems similar to Hong Kong, such as the United Kingdom and Australia, have legislated into law the concept of “insolvent trading” in tandem with a corporate rescue procedure. Insolvent trading (or wrongful trading, as it is also known) imposes a personal liability on directors who continued to incur debts when they knew the company was likely to go into liquidation. While a full exposition on insolvent trading laws is beyond the scope of this article, the key point is that once insolvent trading has been proven to have taken place, a director can be held personally liable for the debt or any resultant loss or damage to the business, providing a direct recourse for creditors.

Being a civil proceeding, proof is required only on the balance of probabilities which avoids the evidentiary problems with fraudulent trading and the compensation mechanisms under the TDO. In the context of businesses accepting pre-payment for goods and services, the onus would be on the liquidator to show on the balance of probabilities, that the debt had been incurred while the company was insolvent as opposed to proving beyond reasonable doubt that there were no reasonable grounds for the trader to believe that the goods or service would be supplied (as would be required for the offence of wrongly accepting payment). Additionally, insolvent trading provisions are liquidators’ actions. They can be commenced by a liquidator who should have resources and experience, and who acts in the interests of the creditors as a whole, to take action against the directors for suspected contraventions. Particularly, where there are a large number of affected customers, but each customer has a relatively small claim, a liquidator taking an action under insolvent trading laws would be a much more effective mechanism by which customers could be ultimately compensated for their losses.

In the United Kingdom and Australia, these laws have become a much more effective tool in encouraging directors to take the appropriate steps to deal proactively with insolvent trading and to consider the interests of all stakeholders before deciding to continue trading.

Following the developments overseas, the Law Reform Commission of Hong Kong recommended that the Government introduce similar legislation in its Report on Corporate Rescue and Insolvent Trading in October 1996. The insolvent trading provisions were to be introduced as part of a package of reforms that included a corporate rescue mechanism. This was an important step as there is no other option presently for businesses in Hong Kong when facing insolvency, except to call in the liquidators. The proposed corporate rescue mechanism, called “provisional supervision”, would have permitted the directors of a company facing financial distress to call in insolvency practitioners to take over the business. Those insolvency practitioners could then, with the benefit of a limited statutory moratorium against creditor actions, work to salvage the business while it continued to trade. This would have also provided a safe harbour for the directors from liability under the insolvent trading provisions. In this way, the insolvent trading and corporate rescue laws balance competing policy aims of discouraging excessive risk taking, that might harm customers and creditors, against saving those good businesses that are suffering only temporary financial distress.

Still On The Way

Following the 1996 Report, the Government introduced a bill into LegCo in 2001 to implement the proposed insolvent trading law and corporate rescue mechanism, but this lapsed following a controversy as to how any outstanding wages to employees should be dealt with once the business is put into provisional supervision. In 2009, a second attempt was initiated after a further round of consultations, and a new proposed mechanism was devised to overcome the earlier controversy, but no further bill has been put before LegCo. According to the Government, it remains on the legislative agenda for the next LegCo session.

When a business closes down suddenly, there is a natural desire to look for means of redress, and while the offence of wrongly accepting payment is a useful tool in the artillery of prosecutors against shady business practices, it is unfortunately not suited for tackling the issues arising from businesses facing financial distress. It can neither address effectively how to compensate victims nor incentivise directors to deal with the problems facing their troubled businesses in an appropriate manner. There is a better solution for Hong Kong than trying to rely on consumer protection provisions, and it’s one that has been pending delivery for 20 years. Like a customer who has pre-paid for goods in hope of fast and reliable supply, we can only hope that LegCo will finally deliver on insolvent trading and corporate rescue laws in 2017.

This article was first published in HK Lawyer Magazine.