HK CA Considers Insolvency Proceedings And Arbitration

Phillip Rompotis reviews the 2 August 2019 decision from the Hong Kong Court of Appeal in But Ka Chon v Interactive Brokers LLC [2019] HKCA 873, where the CA dealt with an appeal against the High Court’s decision not to set aside a statutory demand against Mr But for significant foreign exchange trading losses.

Mr. But had sought to set aside the statutory demand on two grounds: first, that IB made misrepresentations relating to its risk management policies or obligations on its webpage, which he had relied on to enter into a Customer Agreement and they turned out to be false; second, that the parties’ dispute should be arbitrated and the arbitration clause provided a ground for the court to exercise its residual discretion to set aside the statutory demand pursuant to rule 48(5)(d) of the Bankruptcy Rules, by which the court is empowered to do so upon being “satisfied, on other grounds, that the demand ought to be set aside.”

Prior to the 2 March 2018 decision of Harris J in Re Southwest Pacific Bauxite (HK) Ltd [2018] 2 HKLRD 449 (“the Lasmos case”), the generally accepted position under Hong Kong law was that the fact that an agreement contained an arbitration clause would not prevent the presentation of a winding-up petition pursuant to the Hong Kong compulsory winding up regime, and that where a winding-up petition was issued, an arbitration clause in an agreement covering the debt in question was usually considered to be irrelevant to the court’s exercise of discretion to make a winding-up order.

In Lasmos, the Court acknowledged the development of Hong Kong law – which encourages party autonomy in resolving their disputes – and departed from the approach in earlier Court decisions. By the new approach in Lasmos, it was held that a petition to wind up a company on insolvency grounds should “generally be dismissed” when the following three requirements are met:

  • if a company disputes the debt relied on by the petitioner;
  • the contract under which the debt is alleged to arise contains an arbitration clause that covers any dispute relating to the debt; and
  • the company takes the steps required under the arbitration clause to commence the contractually mandated dispute resolution process (which might include preliminary stages such as mediation) and files an affirmation in accordance with r 32 of the Companies (Winding-up) Rules, Cap 32H, demonstrating this.

As noted by Harris J, the effect of this approach is that the company is entitled to have the petition dismissed without having to show that the petitioning debt is bona fide disputed on substantial grounds, such that where there is an arbitration clause, it is sufficient to show that the debt is “disputed” and for that it is sufficient to show the debt is not admitted (Eco Measure Market Exchange Ltd v Quantum Climate Services Ltd [2015] BCC 877 at §10).

See the earlier Post in relation to the Lasmos case.

First Instance

At first instance, the Court held that the misrepresentation claim was without merit as Mr. But had failed to show a bona fide defence.

On the arbitration issue, the Court:

  • noted that the Harris J’s decision in Lasmos made a substantial departure from previous authorities at first instance in Hong Kong (Hollmet AG & Anr v Meridian Success Metal Supplies Ltd [1997] HKLRD 828, Rogers J; Re Sky Datamann (Hong Kong) Ltd, HCCW 487/2001, 29 January 2002, Yuen J; Re Jade Union Investment Ltd, HCCW 400/2003, 5 March 2004, Barma J; Re Southern Materials Holding (HK) Co Ltd, HCCW 281/2007, 13 February 2008, Kwan J; and Re Quiksilver Glorious Sun JV Ltd [2014] 4 HKLRD 759, Harris J) and followed the approach of the English Court of Appeal in Salford Estates (No 2) Ltd v Altomart Ltd (No 2) [2015] Ch 589.
  • decided that irrespective of which approach was followed (whether Lasmos or the previous authorities), it would exercise its discretion to dismiss the application to set aside the demand as the third requirement in Lasmos was not satisfied since Mr But had not taken any steps to commence arbitration and he had no genuine intention to commence arbitration.

The Court of Appeal

Misrepresentation

The CA upheld the decision of the first instance Court in relation to the misrepresentation claim, finding that Mr But did not meet the threshold requirements for setting aside the statutory demand under rules 48(5)(a) and (b) of the Bankruptcy Rules, which provide that “The court may grant the application if – (a) the debtor appears to have a counterclaim, set-off or cross demand which equals or exceeds the amount of the debt or debts specified in the statutory demand; (b) the debt is disputed on grounds which appear to the court to be substantial; …”

Arbitration

In relation to the claim under rule 48(5)(d) – that it would be unjust to allow a bankruptcy petition to be presented as the dispute should go to arbitration pursuant to clause 33B in the Customer Agreement – the CA held that the first instance Court was clearly right in holding that the third requirement of Lasmos had not been complied with and that regardless of whether the approach in Lasmos or the previous authorities was to be adopted, there was no basis to interfere with the exercise of the discretion under rule 48(5)(d) that the application to set aside the demand should be dismissed.

The above was sufficient to dispose of the appeal. However, the CA noted that while it was not strictly necessary to decide whether the approach in Lasmos should be adopted in an application to set aside a statutory demand, in view of the importance of this issue to insolvency proceedings, it made the following observations on an obiter basis.

  • Article 8 of the UNCITRAL Model Law (which has effect by virtue of s.20 of the Arbitration Ordinance), requires a court, before which an action is brought in a matter which is the subject of an arbitration agreement, to refer the parties to arbitration unless it finds that the agreement is null and void, inoperative or incapable of being performed. A petition (whether for winding up or bankruptcy) does not come within the wording of Article 8(1) in that it is not “brought in a matter which is the subject of an arbitration agreement”; the insolvency proceeding is not a matter which is the subject of an arbitration agreement, rather it is the underlying contract or transaction which is the subject of an arbitration agreement. Since an insolvency petition is not covered by Article 8(1) of the Model Law, there is no automatic, mandatory or non-discretionary stay under that provision.
  • Since there is no automatic, mandatory or non discretionary stay under the arbitration legislation, the courts consider that there is a discretionary power to be exercised under the insolvency legislation whether to dismiss or stay a petition where the alleged debt arises out of a transaction containing an arbitration agreement. This has been the position pre-Lasmos; for example, in Re Sky Datamann (Hong Kong) Ltd, HCCW 487/2001, 29 January 2002, it was held at §12 that it is “a matter for the discretion of the court in each case. In exercising its discretion, the court will consider all relevant circumstances, including the financial position of the company, the existence of other creditors, and the position taken by them.”
  • Lasmos decided that the discretion under the insolvency legislation should be exercised only one way: the petition should “generally be dismissed” save in “exceptional” or “wholly exceptional” circumstances, upon satisfaction of the three requirements. The CA stated that it had “reservations” whether the discretion under the insolvency legislation should be exercised only one way since a statutory right is conferred on a creditor to petition for bankruptcy or winding up on the ground of insolvency, and it is contrary to public policy to preclude or fetter the exercise of this statutory right. Hence, while the Lasmos approach may not be regarded as totally precluding a creditor from invoking the insolvency jurisdiction of the court, it is a substantial curtailment of his statutory right and there was no evidence to indicate any legislative intent to change the insolvency legislation when the Arbitration Ordinance was enacted.
  • The authorities in Hong Kong before Lasmos had given various reasons why insolvency proceedings should be treated differently from an ordinary writ action, see Hollmet at 831H; Sky Datamann at §§7, 11; Jade Union at §§18, 19, 26 – that insolvency proceedings are not the means of enforcing a contract, that the petitioner invokes a class remedy available to all of the creditors, that there is no adjudication as to the parties’ respective rights and liabilities as between themselves.

The CA did acknowledge, however, that considerable weight should be given to the factor of arbitration in the exercise of the discretion, otherwise the policy underlying the arbitration legislation would inevitably encourage parties to an arbitration agreement to bypass the arbitration agreement and the arbitration legislation by presenting a winding up petition, and acknowledged that it may well be that insufficient weight had been given to the arbitration factor pre-Lasmos.

How the HK High Court deals with the CA’s observations remains to be seen. On the one hand, courts are right to be concerned about the risk that parties would be tempted, as a standard tactic, to bypass their arbitration agreement and present a winding up petition instead. Further, there is a compelling argument that courts should respect party autonomy as manifested in the contractual bargain. That said:

  • there appears to be a reasonably strong argument to support the proposition that it is not necessary to strip the winding up jurisdiction of its discretionary status by requiring that it be exercised in one way in the absence of “wholly exceptional circumstances”; arguably, that introduces an inflexibility which appears to be the very antithesis of a discretion;
  • it seems unnecessary to alter long-established rules of practice by which the court controls its own procedure, either by requiring the debtor company only to show that the debt is not admitted (as opposed to it being disputed in good faith on substantial grounds), or by requiring the petitioner to establish “wholly exceptional circumstances”;
  • The development of the rule of practice that the court will not wind up a company in circumstances where the petition debt is disputed in good faith on substantial grounds, with the additional penalty of an order to pay costs appears is arguably sufficient to prevent (or punish) any abuse. 

Given the frequent use of arbitration clauses in commercial contracts, it is perhaps not surprising that cases dealing with the interplay of insolvency proceedings and arbitration clauses are coming before the courts. The overwhelming legal commentary points to a preference for the pre-Lasmos position.

See the comprehensive review by Tanner De Witt, who acted for Interactive Brokers, the successful party in the appeal. They comment:

“Although the Court of Appeal’s comments on the Lasmos approach are obiter, it is nonetheless likely to be highly persuasive in the future. Whilst it is acknowledged that a party’s agreement to arbitrate should be given some significance, and that arbitration is encouraged to relieve time constraints on the judiciary, it is submitted that the observations in But Ka Chon are a welcome moderation of the Lasmos approach. It is anticipated that a petitioner will not be required to establish “exceptional circumstances” in order to present a petition where there is an arbitration clause, albeit that the Court will likely place more emphasis on the existence of an arbitration clause and steps that the debtor has taken to initiate or commence arbitration when exercising its discretion to stay or dismiss a petition.”

Baker McKenzie conclude:

“The position taken by Kwan VP is consistent with the pre-Lasmos position (where there is an arbitration clause) and the general position when setting aside petitions for winding-up or bankruptcy scenarios, namely, that an opposing debtor is required to prove there is ‘a bona fide defence on substantial grounds to the underlying debt’ to set aside a petition or the statutory demand under r.48(5) of the Bankruptcy Rules (Cap.6A)…Given the comments by the CA, the future treatment of Lasmos remains to be seen.”

RPC conclude:

“The Court of Appeal’s comments clearly favour the traditional pre-Southwest Pacific Bauxite (HK) Ltd position; namely, that a debtor contesting a winding up petition (or trying to set aside a statutory demand in a bankruptcy matter) must establish, with evidence, that there is a genuine defence to the debt based on substantial grounds. It is simply not enough to rely on an arbitration agreement, and merely allege that the debt is disputed.”

“The Court of Appeal pointed out that creditors have a statutory right to present a winding up or bankruptcy petition, and that the approach adopted in Southwest Pacific Bauxite (HK) Ltd was “a substantial curtailment” of that right. The Court of Appeal appears to have considered that the earlier decision was a shift too far in debtors’ favour, albeit that it recognised that earlier cases had not, perhaps, given adequate weight to the factor that the parties had agreed to arbitrate their disputes.”

See also the review by Herbert Smith Freehills, who conclude:

“The Court’s obiter comments indicate the Court already has the tools it needs to deal with the tension between the creditor’s right to petition for a debtor’s bankruptcy and the parties’ rights to agree to arbitration in a contract. Vice-President Kwan’s analysis suggests that she believes that the Lasmos Case propounded an overly one-sided exercise of the Court’s discretion. She has reiterated that, where the Court is satisfied there is no bona fide dispute on substantial grounds, the discretion should not invariably be exercised in favour of the creditor.”

See also the following Singapore High Court cases:

  • BWF v BWG [2019] SGHC 81, where the court held that the relevant standard applicable for determining whether an injunction to restrain the commencement of winding up in favour of arbitration should be granted was that of a bona fide prima facie dispute. (This case is on appeal to the Singapore Court of Appeal).
  • VTB Bank (Public Joint Stock Co) v Anan Group (Singapore) Pte Ltd [2018] SGHC 250, which considered the Salford approach too extreme insofar as it emphasises the absolute primacy of the arbitration agreement and that the approach represents an unprecedented fettering of the court’s broad discretion to order a winding up.

About Phillip Rompotis

Phillip practices as a barrister and arbitrator in Hong Kong. He has over 25 years’ litigation and arbitration experience in commercial disputes relating to construction & engineering, financial services, joint venture & shareholders agreements, technology, trusts, property and landlord & tenant. He is a Fellow of the Chartered Institute of Arbitrators, the Singapore Institute of Arbitrators, the Malaysian Institute of Arbitrators, and a member of various lists/panels of arbitrators.

View

Leave a Reply

Your email address will not be published. Required fields are marked *