Insights

Debt Collection Post-Covid-19: Force Majeure, Frustration and Winding-Up in Hong Kong

March 30, 2020
By Timothy Loh, Gavin Cumming and Mary Lam

Businesses who wish to take aggressive action to enforce contractual obligations may consider a statutory demand as a means to pressure a counterparty into performance. A statutory demand may result in the winding-up of the counterparty, resulting in the liquidation and dissolution of that counterparty. However, the counterparty may resist the winding-up, disputing that the obligation is in fact owed. The present coronavirus pandemic may provide a basis for the counterparty to argue that it should be excused from performing its obligations through the doctrine of frustration and force majeure. In this article, we explore the nature of a winding-up, how it may be used for debt collection and whether the present pandemic may provide a basis for resisting a winding-up.
 

The coronavirus (Covid-19) pandemic has wrought significant damage in the 1st quarter of 2020 to a Hong Kong economy already battered by political unrest and a reset in relations between the United States and the People’s Republic of China and is expected to wreak even greater damage in the 2nd quarter of 2020 and onwards. With North America and Europe beginning full or partial shutdowns of their economies for the sake of public health and the People’s Republic of China still shutdown at least in part, Hong Kong businesses face the prospect of substantially reduced revenues and cashflow. In these circumstances, history suggests that Hong Kong will see a rising number of cases where bills go unpaid.

Creditors, some under their own pressure to collect bills and service their own liabilities, may wish to take aggressive action to pursue debtors. For unsecured creditors, such as the typical trade creditor, such action may include petitioning to wind-up those debtors. For their part, debtors may choose to resist a winding-up petition and may choose to dispute liability.

The Nature of a Winding-Up

A winding-up is a court process by which a debtor is placed into liquidation. The process aims to collect together all the available assets of the debtor and ensure that all the liabilities of the debtor are satisfied rateably amongst all unsecured creditors from those assets. In the case where a debtor is insolvent, a rateable distribution would mean that all unsecured creditors receive the same number of cents for each dollar owed from the disposition of the available assets.

Benefits for Creditors

For a creditor, despite the fact that, once begun, a winding-up gives no preference to the petitioning creditor, a winding-up offers 2 key benefits. First and foremost, the threat of a winding-up applies enormous pressure on the debtor to pay out the petitioning creditor in preference to other creditors to stave off a winding-up. This is because if not stopped at an early stage, a winding-up may end with the dissolution of the debtor.

Secondly, it is relatively cost effective. Although there is a cost to begin the process, once the process has begun, a debtor’s liabilities are satisfied without the creditor having to himself fund the process of collecting the assets of the debtor. Though the available assets of the debtor are applied to fund the process and hence, the creditor rateably shares in the cost of the process, the creditor need not personally fund the process (though in some circumstances he may choose to do so).

Commencement of Winding-Up

In a typical scenario, a creditor begins this process by serving on the debtor a demand for payment commonly known as a “statutory demand”. This is a demand for payment which complies with the requirements prescribed in the Companies (Winding-up and Miscellaneous Provisions) Ordinance (“CWUMPO”).

If the debtor does not pay or otherwise settle the amount outstanding within a 3-week payment period prescribed by law, it may be deemed to be unable to pay its debts and on this basis, the creditor may file a winding-up petition against it with the High Court.

However, due to the current public health situation, the High Court Registry has been closed since late January to non-urgent business including the filing of winding-up petitions. It re-opened briefly in early March but will close again from March 23 until at least April 5.

Publicity

Once filed, a creditor must serve the petition on the debtor and advertise the petition. As discussed in our earlier article titled “Surviving the Covid-19 Virus: Debt Restructuring for Businesses Facing a Liquidity Crunch”, the presentation of a winding-up petition can have serious consequences as the debtor’s bankers are likely to freeze bank accounts and other creditors, such as suppliers, may stop providing trade credit.

Winding-Up Order

A winding-up petition will normally take a number of weeks to proceed to a winding-up order. A winding-up order has a major effect on the debtor, including:

  • Management Power Vests in Liquidator – A winding-up order terminates the powers of the directors to manage the debtor’s affairs. Instead, the power to manage the debtor will vest in the liquidator.

  • Moratorium on Creditor Proceedings – A winding-up order will stay all existing court proceedings and prevent new proceedings from being commenced against the debtor, unless permitted by the court.

  • Avoidance of Property Dispositions – Any disposition of the debtor’s property (including payments) dating back to the time of the winding-up petition is void, unless such disposition is made with the approval of the court.

The winding-up order will trigger a process for the realization of the debtor’s assets (if any) and the distribution of its assets to the creditors who have proved their claims. In the former regard, the liquidator will realize the company’s assets and, where appropriate, take steps to pursue any legal remedies against third parties on behalf of the debtor.

The liquidator has the power to investigate the conduct of the company’s directors and officers and, where appropriate, may work with the Official Receiver to pursue potential prosecution actions against relevant persons for misconduct or insolvency related offenses (e.g. failure to keep proper accounting records, acting with intent to defraud creditors by giving or concealing the company’s property etc.) under CWUMPO and the Companies Ordinance.

Bona Fide Dispute on Substantial Grounds

Given the existential threat posed by a winding-up petition, debtors may seek to challenge a winding-up on the basis that there is a “bona fide dispute on substantial grounds” as to the alleged debt. A winding-up is intended to begin a collective process of collecting up the assets of a debtor and distributing those assets to creditors rateably. It is not intended as a means to resolve disputes. As a result, if a debtor can demonstrate a genuine and substantial dispute as to the debt, the winding-up cannot proceed. A bona fide dispute on substantial grounds may relate to the existence of a debt or its amount.

In broad terms, a bona fide dispute on substantial grounds is measured objectively by the court on the available evidence. The debtor’s honest belief as to a ground is insufficient. The debtor must put forward sufficiently precise factual evidence which the court finds credible given that it is not uncommon for debtors to raise a cloud of objections.

The categories of disputes which debtors may raise are infinite. They may include, for example, the fact that an alleged debt is not presently due or is a contingent debt or the fact that goods delivered or services rendered so as to give rise to the debt were not properly delivered or rendered. In the context of the present pandemic, we are already seeing debtors argue that they should be excused from performance of their contractual obligations given that the pandemic has resulted in travel bans, the lockdown of cities, mandatory quarantines and, in some instances, the forced closure of businesses.

Force Majeure Clauses

One possible option for debtors to explore is whether their contracts are subject to force majeure provisions and if so, whether those provisions may apply. If so, a debtor may be able to contest liability for performing a contract and hence, may be able to raise a bona fide dispute on substantial grounds to challenge a statutory demand or a winding-up petition.

Depending on the drafting, a force majeure clause may allow the parties to be excused from performing the contract (in whole or in part) or to claim an extension of time for performance, provided that a pre-defined event or circumstance beyond the control of the parties has occurred. These events are commonly referred to as “acts of God” and may be specified (e.g. “natural disasters”, “strikes”, “war”, “embargo”, “legislative or administrative interference”) or unspecified (e.g.events due to natural causes”, “causes beyond the parties’ control”). A debtor can only rely upon a force majeure to excuse performance of a contractual obligation if the contract contains an express force majeure clause which applies. A debtor cannot excuse his own performance on the basis of force majeure in the absence of an applicable force majeure clause.

The burden is on the debtor seeking to rely on a force majeure clause to show that:

  • an event referred to in the force majeure clause has occurred;

  • such event has prevented, hindered or delayed (as the case may be) the party from performing the contract; and

  • there have been no reasonable steps that the party could have taken to avoid or mitigate the event or its consequences (or for that matter, the party has already taken reasonably steps for mitigation purpose).

Whether a force majeure clause applies or not depends upon the construction of the clause. For example, some contracts may provide relief only when a force majeure event has rendered performance of an obligation physically or legally impossible. In this case, a creditor may oppose the debtor being relieved from performance, arguing that such performance has merely become unprofitable or otherwise more difficult than the debtor originally contemplated.

Frustration

In the absence of an applicable force majeure clause, a debtor may argue that its performance of a contractual obligation was frustrated and thus, that it is excused from performance of the contract. At common law, frustration terminates a contract and discharges the parties from their respective obligations.

In general terms, frustration may be invoked where a circumstance emerges after the formation of a contract and, taking into account the nature of the contract and the circumstances surrounding it when the contract was entered into, the obligations under it are no longer capable of being performed or performance of those obligations will be radically different from what was originally contemplated. Frustration will only provide relief if the party seeking to rely upon it is without blame or fault.

Courts do not readily find frustration. Frustration is not lightly to be invoked to relieve contracting parties of the normal consequences of imprudent commercial bargains. The mere fact that the circumstance impairs the economic viability of performance of a contractual obligation is insufficient to frustrate a contract. If contracting parties wish to avoid hardship from circumstances outside of their control, it is open for them to make specific provision in the contract through force majeure provisions.

Conclusion

Businesses faced with recalcitrant counterparties unwilling to meet their obligations may consider the possibility of issuing a statutory demand to pressure those counterparties into performance. However, they should be prepared for possible challenges by those counterparties on the basis of a bona fide substantial dispute, with the present pandemic providing a new and untested context for arguing force majeure or frustration. Though debtors have historically faced difficulties succeeding with these arguments, it is unclear how the courts will respond.




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