Insider dealing restrictions under the Hong Kong SFO can raise practical problems for hedge fund and private equity managers
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March 5, 2020
By Timothy Loh and Mary Lam
During economic downturns, even businesses with strong long term prospects may face real short term working capital challenges and the ensuing prospect of corporate bankruptcy. In this article, we explore some of the options available under Hong Kong corporate bankruptcy laws to address liquidity deficiencies and how a company restructuring and the potential use of a provisional liquidator under such bankruptcy laws may be helpful in avoiding insolvency.
Hard economic times may place financial pressure on businesses as revenues and liquidity dry up but contractual commitments including, for example, obligations to pay rent and payroll continue to burn working capital. In these circumstances, even businesses with sound business models may face the risk of corporate bankruptcy.
Though businesses may seek to sell assets to raise capital or to terminate contracts which provide an option for them to do so, in many cases, businesses simply wish to postpone or otherwise manage down those commitments until business conditions improve. While Hong Kong corporate bankruptcy laws do not offer businesses an insolvency regime that is designed to allow businesses to temporarily suspend such contractual commitments, it does offer a framework for businesses established in the form of a Hong Kong incorporated company to implement a restructuring of such commitments.
The Companies Ordinance (“CO”) enables a company incorporated in Hong Kong to enter into a scheme of arrangement with its creditors to restructure its debts and other liabilities. A scheme of arrangement may be deployed, for example, to write-down the value of liabilities owed by a company to its trade creditors so that trade creditors will only receive, say, 60 cents on each dollar owed or to defer payment obligations by, say, half a year.
Once approved by a court, a scheme of arrangement binds all creditors to which the scheme applies, even if those creditors object to the scheme. This does not, however, mean that Hong Kong bankruptcy laws enable a company to unilaterally and arbitrarily impose the terms of a restructuring upon its creditors.
Under Hong Kong corporate bankruptcy laws, a scheme of arrangement can only bind creditors affected by the scheme where a majority of those creditors agree to the scheme. For this purpose, a majority in number of those creditors representing 75 per cent. in value of the liabilities owed to those creditors must agree to the scheme. Then and only then, do Hong Kong corporate bankruptcy laws bind the other creditors, whether dissenting or otherwise, to the scheme.
As a result, at the heart of every scheme of arrangement lies a consensus, by a majority of the creditors to be bound to the scheme, that the restructuring benefits them. The scheme then operates to eliminate minority dissent.
Given the foregoing, it is important for each business proposing a restructuring to identify the commercial benefits which will accrue to creditors in any proposed scheme of arrangement. In some cases, the benefit may be that the creditors will be able to recover more under a scheme than they would in a liquidation on a winding-up of a company.
A business may, for example, be viable over the longer term and if allowed to survive, the business may be able to repay its debts in full and continue to provide creditors with a long term source of business. However, if this same business were to enter a liquidation today, it may not only be unable to repay its creditors in full but would also no longer provide a future stream of revenue for its current creditors.
Hong Kong corporate bankruptcy law allows a company to select the creditors that it wishes to bind to a scheme of arrangement. If those creditors hold different legal rights against the company, they must be grouped into different classes in accordance with the nature of their rights. Ultimately, the legal rights of each class must not be so dissimilar that members of the class cannot consult together.
To put a scheme of arrangement into motion, a company will convene a separate meeting of each class with each class voting separately on the scheme.
Whilst some class distinctions are obvious, such as those as between secured and unsecured creditors, others might be less so. Specific circumstances will dictate the specific class groupings and it may, for example, be possible to constitute a class comprised solely of trade creditors.
Once the company has obtained the requisite approval from each class of creditor to be bound by the scheme of arrangement, it must apply for the court to sanction, i.e. approve, the scheme. Until court sanction is given, the scheme has no binding effect under Hong Kong corporate bankruptcy laws. The court will take into account various factors, including:
whether each class has been properly constituted, in that creditors of the same class have sufficiently similar legal rights to be able to consult together;
whether the creditors have been given sufficient information about the scheme of arrangement to enable them to make an informed decision as to whether to support it; and
whether the scheme of arrangement is one that an intelligent and honest person acting in respect of his interests as a member of the creditor class in which he votes might reasonably approve.
A scheme of arrangement will generally take some months to implement. Given the drawbacks in terms of court time and costs, a company may wish to persuade creditors to agree to the restructuring on a voluntary basis.
If the company is able to reach a unanimous or, in some cases, near unanimous consensus amongst the creditors who would otherwise be bound to a scheme, it can achieve its restructuring objectives without the court process.
Commercially, a minority of dissenting creditors might be persuaded to agree to a voluntary restructuring under the threat of a scheme, on the basis that the former may provide higher recoveries than those available under a scheme.
In general, a voluntary restructuring provides a higher degree of certainty as compared to a court led restructuring as there is no risk that a court will refuse to sanction the scheme.
A concern for any company is that, before the company is able to restructure its debts, creditors acting in their own interest will wind-up the company, place the company into receivership, seize the assets of the company or otherwise take action that would frustrate the company restructuring. As noted above, Hong Kong corporate bankruptcy laws have no formal mechanism by which a company can stop creditors from taking such action.
Pending a possible corporate restructuring, a creditor may seek to wind-up a company with a view to pressuring the company into repaying its debt in priority to the debts of other creditors.
In a typical scenario, the creditor serves a statutory demand for payment, meaning a demand for payment complying with prescribed requirements under the Companies (Winding-up and Miscellaneous Provisions) Ordinance (“CWUMPO”). If the company does not pay within the standard 3-week payment period prescribed by law, the company may be deemed to be unable to pay its debts and on this basis, the creditor may file a winding-up petition against the company with the court.
The presentation of a winding-up petition by itself, even before a court orders a winding-up, can have serious consequences.
Each petition must be advertised and once advertised, banks may freeze accounts even before any winding-up order is made because under Hong Kong corporate bankruptcy laws, any disposition of a company’s property is void during a winding-up unless the disposition is made with the approval of the court and once a winding-up order is made, the winding-up is deemed to date back to the time of the winding-up petition.
For the same reason, astute trade creditors may stop supplying a business once they become aware of the winding-up petition.
Given the serious consequences of a winding-up petition, it is important for any company receiving a statutory demand to manage the process carefully.
Dispute the Statutory Demand or Winding-up Petition - If there is any reason to challenge the creditor’s right to the sum demanded in the statutory demand on the basis of a bona fide dispute on substantial grounds, the company may wish to consider an urgent application to the court to set aside the statutory demand or to stay the winding-up petition once filed. This is because under Hong Kong corporate bankruptcy laws, a winding-up petition is intended to begin a collective process of discharging the debts of a company on a rateable basis and is not intended as a means to resolve disputes between a creditor and a debtor.
Adjourn the Winding-up Order to Enable a Restructuring - Even if there is no basis to stay the winding-up petition, the presentation of a petition does not mean that a winding-up order is imminent. Courts in Hong Kong have the discretion to adjourn a winding-up order to allow a company to pursue a scheme of arrangement if the company can demonstrate a viable scheme with evidence of adequate support. In other words, so long as the company can show that there are reasonable prospects of obtaining majority approval, or that the groundwork for a proposed scheme is sufficiently advanced, a court may be inclined to adjourn any hearing to make a winding-up order. As a result, a company receiving a statutory demand should consider expediting plans for a corporate restructuring as the further along the restructuring has progressed, the more likely it is that a court would defer any winding-up order to allow the company to pursue the scheme of arrangement.
For larger scale restructurings, where a creditor is keen to wind-up a company, it may be worthwhile to consider appointing a provisional liquidator to pursue a restructuring.
Under Hong Kong corporate bankruptcy laws, the appointment of a provisional liquidator prevents any action or proceeding from being commenced or continued against the company, thereby creating a statutory moratorium on creditor actions through the courts to enforce debts owed.
Whilst at one point it was thought that a company could appoint a provisional liquidator solely for the purpose of pursuing a restructuring, more recent caselaw has clarified that this is not the case. The appointment of a provisional liquidator now requires 3 conditions to be satisfied:
Grounds for Winding-up – First, there must be a good prima facie case for a winding up order. For this purpose, the petitioner (i.e. the person petitioning for the winding-up) will have to show, for instance, that the company is unable to pay its debts and so there is a reasonable prospect that a winding-up order would be made against the company at the petition hearing.
Asset Jeopardy or Investigation of Misfeasance – The company will then need to demonstrate that there is a need to safeguard the status quo of the company, preventing the dissipation of assets before winding-up and preventing anyone from obtaining priority over other creditors. So, for example, a court may be prepared to appoint a provisional liquidator where there is a risk that certain creditors might disrupt the company’s operation or improperly seize assets and upset the prescribed order of distribution of the company’s assets under insolvency law.
Empowering Provisional Liquidator – Assuming that a case for an independent investigation or the protection of the company's assets is made out to justify the appointment of a provisional liquidator, the company might apply to court to extend the powers of the provisional liquidator to carry out a corporate rescue. The court might be willing to so allow a provisional liquidator to carry out a restructuring if, for instance, the company can demonstrate that a restructuring would allow the company to continue as a going concern and thus enable certain assets to be realized at a higher value (rather than to be disposed of at a low residual value in the event of a winding-up) and offer better returns to the creditors than would be possible in the event of a winding-up.
Businesses experiencing a liquidity crunch will often face significant pressure to meet repayment obligations on loans. In this light, businesses may view their banking relationships in a hostile manner.
However, banks provide an obvious source of liquidity in times of distress and businesses should consider reaching out to their bankers at an early stage to proactively manage a working capital deficit, bearing in mind that it is in the bank’s interest to see debts due to it be repaid in full with interest over the longer term rather than to see a debtor fail to meet its commitments.
In this regard, the bank is more likely to receive any proposal from a business more positively before debts fall into arrears as the act of reaching out to the bank rather than having the bank chase for payment demonstrates a desire to meet obligations rather than a desire to avoid obligations.
In this context, in 1999, the Hong Kong Monetary Authority (“HKMA”) and the Hong Kong Association of Banks (“HKAB”) issued guidance for banks in Hong Kong in the form of the “Hong Kong Approach to Corporate Difficulties” (“Guidelines”). The Guidelines set out the basis upon which banks should deal with borrowers in difficulties where the borrower is dealing with multiple banks.
Though the Guidelines are voluntary, meaning that banks are not bound to follow them, the HKMA and the HKAB strongly support them and “expect all members of HKBA to use their best endeavours to follow them on the basis that they represent accepted practices of the banking community”.
The Guidelines operate on the premise that it is in the interests of all stakeholders that a business “should survive if there is a reasonable possibility that it may be viable” and that only where a business is not viable or where it proves difficult to form such a view should it be liquidated.
Under the Guidelines, where a business acknowledges its difficulties, banks should work with the business first to assess the viability of the business. During this period, banks should not:
“withdraw facilities or hastily put the borrower into receivership, or issue writs demanding repayment. Instead, they should endeavour to ensure that the borrower has sufficient liquidity to continue trading until a considered view of its prospects can be reached.”
In this context, though many businesses may be reluctant to do so out of fear of being stigmatized, as alluded to above, where the business experiences distress, it is incumbent upon the business to reach out to its bankers before the situation becomes dire and to share information with all affected banks so that the banks can understand the situation and respond to it. It may be necessary for a business in this situation to engage an independent financial adviser (or bear the cost of one for the banks) to report on the longer term prospects of the business and its working capital requirements, to prepare a liquidation analysis against which any restructuring plan would be benchmarked, to advise on restructuring options and to monitor the financial condition of the business.
Under the Guidelines, the banks should avoid gaining an unfair advantage over other banks. To this end, the bankers may consider a standstill on “repayments of outstanding principal and possibly, also of interest, to allow the borrower to formulate a restructuring plan.” However, in exchange, the business should be prepared to accept restrictions on its business and the monitoring of its cashflow.
At the same time, banks should seek to make collective decisions rather than individual ones in their own interest. These decisions may include, for example, lending new money to the business if commercially sound. However, where appropriate, given time urgency, a bank may provide new money on a bilateral basis, taking security as appropriate, so long as it does not prefer itself to other lenders in respect of old monies advanced before.
In October, 2019, the HKMA established a coordination mechanism (“Mechanism”) to support small and medium sized enterprises (“SMEs”). The Mechanism complements the Guidelines, providing guidance for smaller scale bilateral banking relationships. Under the Mechanism, the HKMA recognizes that SMEs are a “major pillar of the Hong Kong economy” and encourages banks to “provide funding support to SMEs as far as their credit policies and risk management principles allow”. In this regard, banks should:
enhance communications with customers in financial difficulties; and
not withdraw credit lines hastily or take other action that would adversely affect business operations of customers;
as far as risk management principles permit, proactively consider allowing customers to extend or reschedule their repayment obligations, including through moratoriums in payments of principal.
The SME Financing Guarantee Scheme (“Scheme”), managed by HKMC Insurance Limited, guarantees loan facilities extended to Hong Kong based SMEs and non-listed enterprises from participating lenders. The Scheme offers an option for a business in distress to obtain working capital.
In general, the guarantee is from 50% to 70% for loan facilities up to HK$12 million, 80% for loan facilities up to HK$15 million and 90% for loan facilities up to HK$6 million.
At the management level of a company, the pressure from liquidity or insolvency crisis may be intensified by time factors and a lack of objectivity to assess the underlying problems and best ways forward.
Whilst many may choose to wait and see, it is important for businesses to take a proactive approach to acknowledge the need to address financial problems and formulate appropriate strategies in order to be able to respond before corporate bankruptcy emerges.
When in doubt, it is prudent for businesses to obtain professional advice to look into debt restructuring and financing options and any other means available under Hong Kong corporate bankruptcy laws to cope with financial difficulties.
Insider dealing restrictions under the Hong Kong SFO can raise practical problems for hedge fund and private equity managers
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