State immunity and third party debt orders after FG Hemisphere Associates LLC v Democratic Republic of Congo and others
A recent Court of Appeal (CA) decision in Hong Kong has flagged the need for careful planning in relation to arbitrations, enforcement of arbitral awards and cross-border M&A transactions. In the case, a distressed debt fund, FG Hemisphere, held the benefit of an arbitral award against the Democratic Republic of the Congo (DRC), which it had purchased from the original claimant. The court allowed FG Hemisphere to enforce the arbitral award in Hong Kong directly against sums owing by a PRC state-owned enterprise in the DRC. Until the decision is overturned or counteracting legislation is introduced, the message to Asian enterprises dealing in Africa is clear: the vulture funds are watching.
The CA’s decision considers the current state of the law of sovereign immunity in Hong Kong, and the tensions that exist under the “one state, two systems” doctrine between common law and the PRC’s governance of acts of state including foreign affairs.
The case also highlights the risks of third party debt orders, in particular, where dealing with a party in a state in which arbitral awards cannot be enforced.
This briefing describes the case and gives some commentary on the state of sovereign immunity in Hong Kong. It also makes some practical suggestions on what techniques parties might use to reduce the risk of becoming subject to a third party debt order.
In the 1980s, a Yugoslav company, Energoinvest, entered into construction contracts to be carried out in the DRC. The DRC defaulted on its repayment obligations, and Energoinvest began arbitration proceedings. The arbitration proceedings took place in Switzerland (a New York Convention country - see below) and resulted in awards in favour of Energoinvest of over US$24 million plus interest. In 2004, Energoinvest assigned the benefit of the awards to FG Hemisphere Associates LLC (FG Hemisphere), a distressed debt fund.
In the meantime, China Railway Group, a PRC state-owned enterprise, had agreed to make an investment in the DRC and, as part of the deal, agreed to pay an Entry Fee to the DRC state companies and/or the DRC. As China Railway Group was investing through a Hong Kong subsidiary and the Entry Fee was considered a debt owed by the Hong Kong company to the DRC, the debt was treated as an asset of the DRC situated in Hong Kong. This meant that FG Hemisphere could enforce the arbitral award against the debt by way of a third party debt order (called a “garnishee” order in Hong Kong), requiring the Hong Kong entities to pay the sum to FG Hemisphere directly.
The New York Convention requires courts of contracting states to give effect to an arbitration agreement, and to recognise and enforce arbitral awards made in other contracting states, subject to specific limited exceptions. The majority of industrialized countries are contracting states, but the DRC is not a signatory to the New York Convention. Thus, despite the DRC having agreed to arbitrate in the original agreement, the enforcement of the awards in the DRC was not a viable option as there would be no right to recognition of the award. FG Hemisphere therefore sought to find assets of the DRC in a New York Convention signatory state, with a view to bringing enforcement proceedings in that country.
Accordingly, FG Hemisphere commenced enforcement proceedings against the DRC in Hong Kong in 2008, targeting the fees contingently payable by Hong Kong subsidiaries of China Railway Group to the DRC as “Entry Fees” (the Entry Fees) under a joint venture agreement between China Railway Group and the DRC/DRC state companies. China is a party to the New York Convention and thus Hong Kong is too by virtue of its status as a Special Administrative Region of China. FG Hemisphere claimed that the Entry Fees were payable to the DRC by the Hong Kong companies and that as a debt from the Hong Kong companies, these fees constituted an asset of the DRC within Hong Kong. By this time, given the interest over the intervening years, the DRC was indebted to FG Hemisphere in the sum of around US$102 million.
FG Hemisphere argued that as the debt (an asset) was situated in Hong Kong, the Hong Kong court should order that the amounts payable to the DRC by China Railway Group be paid to FG Hemisphere in satisfaction of the judgment debt. In doing so, it was relying on:
- the powers of the Hong Kong court to enforce a New York Convention foreign award as if the award were a judgment of the Hong Kong court; and
- the Hong Kong court’s powers to make a third party debt order (i.e. a “garnishee” order) against monies due from a third party to a judgment debtor.
Third party debt orders
According to the Hong Kong Civil Procedure Rules, generally where a person (the judgment creditor) has obtained a judgment or order for the payment by some other person (the judgment debtor) of a sum of money amounting in value to at least HK$1,000, and any other person within the jurisdiction (referred to in the Order as the garnishee) is indebted to the judgment debtor, the Court may order the garnishee to pay the judgment creditor the amount of any debt due or accruing due to the judgment debtor from the garnishee (or so much thereof as is sufficient to satisfy that judgment plus costs).
For there to be garnishee proceedings, it is essential that there exists a present debt, and not merely something that may or may not become a debt in the future, for example, an insurance company’s liability under a motor vehicle policy. The courts have referred to a debt as a ‘sum of money which is now payable or will become payable in the future by reason of a present obligation’. The debt must also be due for payment, and so cannot be conditional.
The judgment debtor must be the sole and beneficial owner of the debt, and the garnishee must be in the jurisdiction for the Hong Kong Court to have the power to make a garnishee order. Unlike England and Wales, in Hong Kong, there is no limitation that the garnished debt must be properly recoverable within the jurisdiction - ie the Hong Kong courts have the capacity to garnishee foreign debts (English courts do not). Having said that, as a matter of discretion the Hong Kong courts will not garnish a debt where, although the garnishee is within the jurisdiction, the debt is recoverable outside the jurisdiction, if to do so may expose the garnishee to the risk of having to pay the debt, or part of it, twice over.
The Court of First Instance did not consider the arguments about third party debt orders in detail, as it found that the DRC had immunity from execution (see below). Consequently, such Court never considered in any detail the complex issues relating to “attachment” in cross-border scenarios. (By contrast, the English courts have considered these in great detail in a number of judgments.) Nor were these points extensively covered by the Court of Appeal, although in finding in favour of FG Hemisphere, clearly it felt that on the facts, such an order was available to it.
Sovereign immunity is the customary international law that, subject to certain exceptions, a state is immune from the jurisdiction of the courts of another state. The general rule is applied in varying degrees throughout different states. The UK position on sovereign immunity applied in Hong Kong prior to 1997 (handover to the PRC) and stipulated that a foreign state is generally immune from the jurisdiction of other states’ courts and arbitration tribunals, subject to certain exceptions such as acts of a private or commercial nature.
This is known as a “restrictive” approach to sovereign immunity.
The PRC adheres to the “absolute” theory of sovereign immunity which provides that a state shall always enjoy immunity from jurisdiction and from execution and cannot be subject to the jurisdiction of a foreign court (whether in relation to commercial acts or otherwise), save where it expressly waives such protection.
Since the PRC regained sovereignty in Hong Kong, the position regarding sovereign immunity has remained unclear. Hong Kong and the PRC operate a “one state, two systems” approach under which Hong Kong has its own common law regime, separate to PRC law, except that the PRC governs Hong Kong foreign affairs/relations.
In the FG Hemisphere case, the Office of the Commissioner of the Ministry of Foreign Affairs of the PRC issued two letters as evidence of the fact that the PRC still follows the absolute immunity approach to sovereign immunity.
The DRC claimed that, as a foreign state, it enjoys sovereign immunity, so the Hong Kong courts did not have jurisdiction to make an order against it. It argued that the doctrine of restrictive immunity is not part of Hong Kong law and therefore the DRC enjoys absolute immunity from both suit and execution. Furthermore, the DRC argued, amongst other things, that the Entry Fees were not payable to the DRC as a debt and that they could not therefore constitute an asset belonging to the PRC within Hong Kong.
The DRC was successful at first instance, but the CA reversed the first instance decision and awarded FG Hemisphere the third party debt order against China Railway Group.
The CA held (by a 2-1 majority) that Hong Kong as a common law system follows the customary international law of a restrictive doctrine of sovereign immunity and that this doctrine had become part of Hong Kong common law prior to 1997 (even though there was no specific Hong Kong case to that effect prior to 1997). This meant that the general rule that foreign states are immune from jurisdiction of the courts applies subject to certain exceptions. The court held that the relevant transaction in question fell into one of the exceptions by reason of the fact that the payment of the Entry Fees that were due to the DRC were for commercial, not sovereign purposes.
The CA gave leave to FG Hemisphere to enforce the arbitral awards and restored the injunction against the DRC from receiving payment of the Entry Fees.
The DRC has recently obtained leave to appeal to the Court of Final Appeal to determine questions regarding sovereign immunity.
Whatever the outcome of the appeal, this case demonstrates the potential to use Hong Kong law and the Hong Kong courts to assist in the enforcement of arbitral awards to recover from third party debts, particularly where a third party is transacting with a counterparty located in a non-New York Convention country. The greatest risk arises when the counterparty is the state itself because the number of outstanding unenforced awards against the state is likely to be much greater than a private company or individual - this also applies to state-owned entities which may be treated as an organ of the state.
Although the risk of third party debt orders applies throughout the common law world and beyond, this recent decision affirming the use of such enforcement methods against Hong Kong-incorporated entities will not have been missed by distressed debt funds. Given the large number of Chinese state-sponsored investments which are currently being made into non-New York Convention countries, particularly in Africa, and the fact that PRC enterprises often use Hong Kong entities for offshore investments, this situation will not be a one-off.
Whilst third party debt orders are awards against the debt payable, not the third party (and ought to discharge the third party’s obligation to pay), in practice this will be of little comfort to such third parties. In reality, particularly in Africa, the Entry Fee may be used to fund the project when no other funds are available. If the money does not make it into the counterparty’s hands, the relationship between the third party and counterparty will be soured, and there would be a very real risk of a practical “double jeopardy”, where the investor may be required to pay twice.
Businesses also need to be aware of the issues of sovereignty that may arise when dealing with a state. The CA’s decision to uphold the restrictive doctrine of immunity as Hong Kong law is significant for Hong Kong. However, the decision is subject to appeal and even if successful, the PRC could amend the Basic Law in Hong Kong to make Hong Kong law on this issue consistent with the PRC’s policy towards other sovereign states (i.e. an absolute theory).
From the perspective of an investor, these are some tips to minimize the risks of these kinds of orders being made against them:
- Due diligence should include a review of other judgments outstanding against the counterparty and, if the counterparty is part of the state (in the wider sense), the state as a whole (by conducting court searches).
- It is likely to be easier for a counterparty to claim sovereign immunity if the payment is structured as a payment for sovereign purposes rather than commercial purposes.
- Given the risk of third party debt orders, parties should be careful about structures which may amount to a debt, e.g. delayed settlement, deferred consideration, further funding commitments, or entry fees.
- If a debt will exist in a high-risk situation, consider using a company incorporated in the country in question as the entity obliged to make the payment. If the Entry Fee had been payable by a DRC incorporated subsidiary of China Railway Group, the asset would have remained in the DRC and therefore difficult to enforce.
- If the risk of a third party debt order exists the parties ought to expressly provide for who bears that risk.
- Parties who may seek to sue state entities should include an express contractual waiver of sovereign immunity, which waives immunity in any forum and relates to both the contract itself and the enforcement of any consequent judgment or award. However, an agreement to arbitrate, where the arbitral body’s rules contain a sovereign immunity waiver, may not be sufficient to waive immunity, particularly where the counterparty is not itself a New York Convention signatory.