No Respite for Distressed Companies in Hong Kong

In Hong Kong, a company that is financially distressed may generally only avoid being liquidated or wound up if it:

  1. reaches a non statutory arrangement with its creditors;
  1. achieves a compromise with its creditors under section 166 of the Companies Ordinance;
  1.  effects a corporate restructuring by a provisional liquidator appointed under section 193 of the Companies Ordinance in the course of winding-up proceedings.

At the outset, it is important to recognize that many companies that are financially distressed and facing winding-up proceedings should not be rescued. In those instances, there is really no point in seeking to delay the inevitable.

However, where a rescue is a viable alternative, apart from resorting to the options described above, there is no quick and relatively straightforward mechanism in place under Hong Kong law, whereby a company may, for a temporary period, enjoy immunity from the demands of its creditors so that it may consider and work towards a possible reorganization, which once implemented will spare the company from being wound up and all the negative consequences arising therefrom. While the options described above may, with some creativity, ultimately achieve a corporate rescue, none of them are specifically geared towards granting the company any immunity from its creditors during the period leading up to the corporate rescue. As such, there is always the risk that any one of the company’s creditors may, without much effort, scupper the corporate rescue proposal at any stage leading up to the finalization of such a proposal. Not surprisingly, this may deter white knights from coming forward and incurring the time and cost to explore a possible restructuring of the distressed company, quite simply because any creditor (large or small) is capable of derailing the entire process.

United States and United Kingdom

In the U.S., Chapter 11 of the Bankruptcy Code allows a financially troubled company to continue its business while formulating a reorganization plan with its creditors. A Chapter 11 filing triggers an automatic stay, which prevents creditors from taking further action against the insolvent company and its property to enforce security interests or liens or to collect debts. The existing management usually continues to manage the company’s affairs and finances as a “debtor in possession”. The Code does not generally limit the duration of the Chapter 11 proceedings. The time taken depends on the type and complexity of the company.

In the U.K., the 1986 Insolvency Act provides a procedure where a company may be rescued or reorganized or its assets realized under the protection of a statutory moratorium. This can be achieved either by petitioning the court to appoint an administrator or through an out-ofcourt route, which is a quicker, cheaper and less bureaucratic route than the court route. From the time an application for an administration order is made, an interim moratorium will take effect. Any petitions for the winding up of the company are dismissed. The great advantage of the administration process is that the statutory moratorium usually applies to give the company in administration a breathing space from creditors. The moratorium is effectively a freeze on creditors taking action against the company and means the administrator can get on with the reorganization of the company and/or the realization of the company’s assets without having to deal constantly with the attempts of secured or other creditors to enforce their rights.

Provisional Supervision for Hong Kong

As mentioned above, Hong Kong law includes no process similar the U.S.’s Chapter 11 or the U.K.’s administration procedures. However, in view of the prevailing global financial turmoil to which Hong Kong has not been immune, in October this year the Hong Kong government introduced a consultation paper to gauge the views of the public on the conceptual framework relating to a corporate rescue model, known as provisional supervision. An earlier attempt to introduce a corporate rescue framework was made in 2000. This failed largely because the framework that was contemplated, required, as a prerequisite to the commencement of a corporate rescue, that employees’ entitlements be accorded priority by setting up a dedicated trust account to cover their entitlements up to a certain level. Many captains of industry regarded such a requirement as too onerous for financially-distressed companies and would effectively act as a major obstacle to invoking provisional supervision.

Under the current proposal, provisional supervision will operate by imposing a moratorium against creditor actions (including winding-up petitions etc.). The appointment of the provisional supervisor would normally be made by the directors and would not require approval of the court. The initial moratorium period would be set at 45 days with the ability for the period to be extended by up to six months from the commencement of the provisional supervision. All extensions would need to be approved by the creditors.

Employees

Regarding the issue of employees’ entitlements, the current alternatives contained in the government’s consultation paper include exempting current or former employees, to whom wages or other entitlements (such as severance payments) are due, from the moratorium. The government has stated that the objective of this approach is to encourage the company to find the money to settle all employees’ outstanding wages and other entitlements so as to eliminate any uncertainty that may arise due to the employees’ exemption from the moratorium.

An alternative option is to accord priority to employees’ debts. Under this alternative, the arrears of wages and other entitlements owing before the commencement of the provisional supervision, would be treated as “employees’ protected debts”. There would be no requirement for the company to actually settle those debts before initiating the provisional supervision. However, any proposal put forward by the provisional supervisor for approval to the creditors would need to include in the proposal provisions that (a) any outstanding employees’ protected debts will be paid by the company in cash before or by the time the voluntary arrangement comes into effect; and (b) the remaining employees’ debts will be paid within 12 months thereafter.

Furthermore, in case it proves necessary to extend the moratorium period beyond the initial 45 day period, an extension could not be made unless the company would settle all outstanding “employees’ protected debts” within 14 days of granting the extension.

Insolvent Trading

A further important feature of the government’s proposal is the introduction of the concept of insolvent trading, which is intended to be applicable to companies in general and not only in the context of provisional supervision. This was attempted in 2000 but also failed. Insolvent trading occurs when a responsible person, such as a director, allows a financially distressed company to continue trading when he or she knew or ought reasonably to have known the company was insolvent or that there was no reasonable prospect that the company could avoid becoming insolvent.

In such circumstances, the responsible person might incur personal liability if the company is in fact liquidated. Quite remarkably, there is no concept of insolvent trading under Hong Kong law and, as a result, the incentive on the part of senior management to cease incurring further liabilities when the company’s prospects are dire, is absent.

As mentioned above, an attempt to introduce legislation to address insolvent trading in 2000 failed. The government is hoping to do so on this occasion, with some variation to what was proposed in 2000. Firstly, insolvent trading would apply only to directors and shadow directors but not to “senior management”. Secondly, the government proposes that the threshold to establish liability for insolvent trading should be higher than the standard proposed in 2000. In this regard, a responsible person would only be held liable if he knew or ought reasonably to have known the company was insolvent or knew or ought reasonably to have known that there was no reasonable prospect that the company could avoid becoming insolvent. A reasonable suspicion of the company’s insolvency would not suffice.

Conclusion

There can be no assurance that the government will muster sufficient support to introduce corporate rescue legislation in Hong Kong. The sensitivity regarding the treatment of employees, whom trade unions insist should be afforded maximum protection, risks derailing the legislation yet again, or, at least, diluting the efficacy of the legislation to such an extent that the legislation will be of no practical use.

However, there should be no further excuse to delay introducing legislation to address insolvent trading. Historically, directors of Hong Kong companies that have been wound up have, save in the most egregious circumstances, escaped any responsibility for the plight of the companies they have managed. Where their conduct during the period leading to the company’s insolvency is improper, there is no reason for them to be immune from sanctions that apply as a matter of course in other jurisdictions such as the U.S., the U.K. and Australia, to name but a few.