Distressed Debt in Hong Kong: An Insolvency Primer for Private Equity
November 3, 2008
By Timothy Loh and Howard Burchfield III
Recent shocks to the financial markets as well as deteriorating economic conditions have brought insolvency issues sharply back into focus. For some hedge funds and private equity funds, insolvency has come unwelcome in the form of a deteriorating financial condition of a portfolio company to whom loans have been made or whose debt the funds have acquired. In this article, we review basic Hong Kong insolvency law concepts and outline debt recovery options.
TIMOTHY LOH | Financial Services & Law Review
Vol. 2 (2008) at p. 23
A private equity fund or hedge fund facing the possible or
actual insolvency of a debtor portfolio company will generally wish to assess its
legal rights under its financing agreements with the debtor company. In this regard, the fund will normally
wish to determine (i) whether it is obliged to make any further advances to the
debtor company, (ii) the validity, priority and sufficiency of any security for
its debt, and (iii) the viability and cost-effectiveness of pursuing any restructuring
of the debt.
If the fund reaches the view that it is in a better
position than the other creditors because it is in a position to recover its
debt in full when other creditors may not be, subject to the desire to maintain
a longer term relationship with the debtor company, it may be advantageous for
the fund to simply accelerate its debt and get out.
However, if the fund reaches the view that it will
be unable to recover its debt in full, it will need to weigh whether its
recovery is likely to be higher by selling the debt, pursuing a restructuring
or simply placing the debtor company into liquidation.
In Hong Kong, where a creditor wishes to place a
debtor company into liquidation, it will begin a procedure known as compulsory
winding-up by petitioning the court for a winding-up order on the basis typically that the
debtor company is unable to pay its debts. When a winding-up order is granted, the order triggers a
statutory regime for the protection and distribution of the assets of the
debtor company. This regime
prevents a first-come first-serve scramble by creditors which would not only
prejudice creditors making late claims but which would also force all creditors
to incur substantial costs in the competitive process of enforcement of their
claims against other creditors.
ENFORCEMENT OF SECURITY
A fund may have a security interest over the
property of the debtor company. In
this case, the security package will typically determine the rights of the fund
including the power of the fund to sell the property subject to the security and the
priority of the fund as regards the proceeds of such sale.
If the sale of this property would be insufficient
to discharge the debt, the fund would be an unsecured creditor in the
winding-up of the debtor company for the balance of the debt outstanding after
the proceeds of the sale had been applied to the debt. If the security interest is subordinate
to a prior security interest, then the fund will need to assess how much of the
proceeds of the sale of the property will be available after satisfying the
claims of creditors ranking ahead.
In the case of a floating charge, by statute, the
claim of the holder of the charge in respect of the proceeds from a disposition
of the property may be subordinated to those of preferential creditors, such as
employees.
Power of Sale
The security package will typically give the fund,
as creditor, an express power of sale, a power which may be exercised without
court proceedings. However, in
exercising such a power of sale, the fund may wish to take possession (if it
does not already have possession) as a precursor to sale so that it can give
possession of the property to the purchaser. Whilst a fund may be entitled to possession, where the
property subject to the security interest is in the hands of the debtor
company, court proceedings may be unavoidable in practice where the debtor
company does not freely deliver possession.
Receivership
The security package may give the fund a right to
appoint a receiver over the property which is the subject of the security
interest. In this case, the
appointment may be made without a court order and the powers of the receiver
will be defined in the security documentation. Typically, in the case of a
security interest over the entire business and undertaking of the debtor
company, these rights will include the right to manage the business of the
debtor company, to collect income from the business to pay the debt and to sell
the business, or parts of it, to discharge the debt.
RESTRUCTURING
Restructuring involves the exchange, replacement or
modification of financial obligations that have previously been issued and that
are now financially burdensome or in default. In the short-term, a restructuring may seek to eliminate
losses at the debtor company through the sale or closure of operations, the
cutting of costs, improving cash control, deferring or postponing payments due
to creditors, negotiation of a reduction in the amount due to creditors or in
the rate of interest, or swapping debt for equity. Over the longer-term, a restructuring may seek to restore
growth and margins in the debtor company.
A fund may wish to support a restructuring to avoid winding-up and to
enable the debtor company to continue as a going concern that can repay its
debts in full.
Absence of Statutory Regime for Restructuring
Unlike many other developed jurisdictions, Hong
Kong law does not explicitly recognize a public policy interest in the restructuring
of insolvent companies so that creditors may benefit from the continued
operation of such companies. There are no statutory provisions to allow for
priority of creditors who lend during the restructuring process, both in terms
of ranking of claims and security. Consequently, a fund that may be interested
in providing fresh financing (so called debtor-in-possession financing) to
enable the debtor company to meet cash requirements and continue as an ongoing
concern is well advised to seek competent legal advice.
Equally, there are no specific statutory provisions
imposing a standstill on creditor proceedings during the negotiation of a
restructuring, thereby enabling any single creditor to derail the restructuring
process by petitioning for winding-up.
Contractual Restructuring
Contractual restructuring allows for private
work-out arrangements to be made between the debtor company and its
creditors. Success is
contingent upon unanimous approval of the plan by creditors. It is therefore best suited to
situations where the debtor company retains real value as a going concern (i.e. is merely undergoing
a temporary liquidity problem) and either has a small number of creditors or
whose creditors are primarily Hong Kong banks.
Hong Kong banks are subject to the Guidelines on
Corporate Difficulties ("HKAB
Guidelines") issued by the Hong Kong Monetary Authority and the Hong
Kong Association of Banks. The
HKAB Guidelines are broadly consistent with the INSOL (International Federation
of Insolvency Professionals) Statement of Principles for a Global Approach to
Multi-Creditor Workouts and provide for banks to be supportive where a debtor
company has approached them in respect of financial difficulties.
Under the HKAB Guidelines, banks should withhold
enforcement action on their debts and ensure that the debtor company has
sufficient liquidity to continue trading until a considered view of its
prospects can be reached. For this
purpose, the banks may appoint a lead bank as well as, in the case of a large
lending group, a steering committee to negotiate with the debtor company.
Standstill Agreement
If the view is taken that a restructuring may be
viable, creditors may enter into a standstill agreement so as to give the
debtor company an opportunity to produce, negotiate and implement a
restructuring plan. Typically,
such an agreement will provide for creditors to freeze their exposures as of a
fixed date, to maintain their existing facilities up to the amount of their
exposures on that date, to withhold action to enforce debts and to maintain
their individual positions
relative to other creditors (e.g. by not taking fresh security or guarantees
that are not available to all creditors.
Conversely, the agreement will restrict the debtor company's business so
as not to adversely affect the prospective recovery of creditors and give
creditors the ability to monitor the cashflow of the debtor company.
If the debtor company and its creditors reach an
agreement as to the terms of a restructuring, the parties sign a restructuring
agreement which is typically implemented by the lead bank or steering
committee.
Provisional Liquidation
If the fund believes that it may be possible to
restructure the debtor company but is unable to reach a consensus with a number
of dissenting creditors to effect a standstill, it may wish to petition for a
winding-up of the company and apply to court for the appointment of a
provisional liquidator with the power to explore a restructuring and carry on
the business of the company in the interim. The fund in this case will however, need to establish a
genuine need for a provisional liquidator to protect the assets of the debtor
company from dissipation to the prejudice of the body of creditors as a whole
and will not succeed in the appointment of a provisional liquidator for the
sole purpose of exploring a restructuring.
If the court appoints a provisional liquidator, the
appointment will automatically stay actions or proceedings against the
company (except with consent of the court), thereby effecting a standstill of in court creditor process that might
prematurely terminate restructuring efforts.
Schemes of Arrangement
Even with a standstill in place, a restructuring
may fail for lack of consensus amongst creditors as to terms. As noted above, a contractual workout
requires the consent of every creditor.
In this respect, smaller creditors may hold out for better terms or the
prospect that a larger creditor will buy out their debt, yielding a higher recovery
than would otherwise be possible on a winding-up.
A statutory scheme of arrangement may be used to
bind all creditors and shareholders to a restructuring even without
unanimity. Because a scheme
over-rides the wishes of dissenting creditors and shareholders, to become
effective, a scheme must first be approved by a majority in number (i.e. 50 per cent.)
representing 75 per cent. or more by value of the members of each class of
creditor and shareholder of the debtor and, if so approved, must then be
sanctioned by the court.
Drawbacks of Schemes
However, a scheme can take months to complete. In the interim period between when the
scheme is proposed and the scheme is sanctioned by the court, the assets of the
debtor company are at risk of dissipation while the liabilities of the debtor
company may be increasing, without any assurance that the scheme will be
approved. At the same time, there
is an ongoing risk that individual creditors will seek to enforce their debt. Secured creditors dissatisfied with the
proposed terms may wield their rights to appoint receivers, to take possession
of secured property or exercise rights of sale. Unsecured creditors may, in the absence of a provisional
liquidation, petition to wind-up the company.
Adding to the risk, the court may refuse to
sanction the scheme if it considers that the classes of creditors and
shareholders have been improperly defined for the purposes of obtaining
approval.
WINDING-UP
Where other options for recovery have been
exhausted, a financial creditor may petition to wind-up a debtor company. The petition is often based on the
grounds that a creditor has served a statutory demand for payment on the debtor
company and the company has not within 21 days satisfied the demand. The petition will typically be heard
in about 2 months and the debtor company may oppose it, as where it bona fide
disputes the debt. On the grant of
a winding-up order, like many other developed jurisdictions, Hong Kong
insolvency law broadly operates on 3 principles.
Protection of Assets
First, Hong Kong insolvency law establishes a
regime for the protection of the assets of the debtor company for the general
benefit of creditors and shareholders as a whole. All court proceedings against the debtor company are stayed
(except with the consent of the court) and any dispositions of the property of
the debtor company are void as from the date of the petition (unless otherwise validated by the court).
The court appoints a liquidator to take custody and
control of the property of the debtor company. The liquidator may disclaim onerous property
of the debtor company and will enquire into the conduct of the affairs of the debtor company
with a view to determining the presence of any impropriety.
Where appropriate, directors of the debtor company
may be prosecuted as may occur where they carried on the business of the debtor
company with intent to defraud creditors or where they frustrate the ability of
the liquidator to enquire into the affairs of the debtor company (e.g. by destroying books
and records of the debtor company).
Equally, where appropriate, the court may void or
declare invalid transactions before the winding-up which have improperly
dissipated assets of the debtor company.
So, for example, the court may declare invalid any transfer of the
debtor company's property within the 6 months prior to the winding-up which has
unfairly put one creditor in a better position than other creditors.
This regime for asset protection does not however,
generally affect the ability of secured creditors (i.e. creditors who have taken a security
interest, such as a charge, over the assets of the debtor) to enforce their
security.
Collective Enforcement of Rights
Secondly, Hong Kong insolvency law establishes a
collective procedure for the enforcement of rights which arose prior to the
commencement of the winding-up.
Under this procedure, all creditors must set-off any mutual credits and
debits between themselves and the debtor company and, in respect of the
remaining claim, submit a proof of debt within prescribed times. The liquidator may admit or reject the
claim. In discharging his responsibilities, the liquidator acts in a
quasi-judicial capacity and is subject to a duty to maintain an even and
impartial hand between all persons interested in the winding-up.
Distribution of Assets
Thirdly, Hong Kong insolvency law establishes a
system of ranking the claims of creditors, giving the highest priority to the costs
of the liquidation followed by the claims of preferential creditors (i.e. creditors who for
public policy reasons are given preference over other creditors), such as
employees, and then claims by holders of floating charges. The claims of the remaining creditors
are generally treated pari passu, meaning that the remaining creditors share
proportionally (i.e.
each creditor receives the same amount on every dollar owed to it). Once all the assets of the company have
been realized, investigations completed and a final dividend paid, the
liquidator may apply to court to be released and eventually, the company may be
dissolved.
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