Hong Kong Court Validates Contractual Clause Providing For Exclusion Rights Upon Insolvency.

5 July, 2019

 

Hsin Chong Construction Company Limited [2019] HKCFI 1531 (date of judgment 13 June 2019)

 

Joint venture agreements often contain clauses conferring a right on an innocent party to exclude a defaulting party from the joint venture upon the occurrence of specified events, including the insolvency of the defaulting party. The Court considered in this case whether such a provision should be void.

 

Background

 

In November 2013, Hsin Chong Construction Company Limited (the “Company”) and Build King Construction Limited (“Build King”) entered into a joint venture agreement (the “JV Agreement”) and formed an unincorporated integrated joint venture (the “JV”) for the purpose of submitting a tender for a government construction project in Hong Kong (the “Project”).

 

The interest held by the Company and Build King in the JV are 65% and 35% respectively. The Government awarded the Contract to the JV on 22 June 2016.

 

The Company then went into financial difficulties in about 2017. On 27 August 2018, a winding up petition was issued against the Company.

 

On 13 December 2018, Build King exercised its right under the JV Agreement to exclude the Company from the joint venture on the grounds of insolvency (the “Exclusion Clause”).

 

Build King applied to the Court seeking orders to validate, among others, the exclusion of the Company from the JV.

 

The Exclusion Clause

 

Under the Exclusion Clause, upon the occurrence of any specified events on the part of the defaulting party, the innocent party has an option:

 

i) to exclude the defaulting party from further participation and management of the JV and the Contract and to take over the benefits of the defaulting party in the JV (but without releasing the defaulting party from its obligations to bear its proportionate share of any loss); or

 

ii) to wind up the affairs of the JV.

 

Upon completion of the Project, an independent party will be appointed to determine the amount of profit up to the date of the exclusion due to the defaulting party less the defaulting party’s share of losses.

 

There are five events of default which may trigger the Exclusion Clause, one of which concerns the insolvency of the defaulting party while the other four concerns breaches of contract.

 

The Provisional Liquidators challenged the Exclusion Clause on three grounds, namely, (1) it is a void disposition under s182 of Cap 32; (2) it falls foul of the anti deprivation rule; and (3) it is penalty clause.

 

Void Disposition

 

Under s182 of Cap 32, “…any disposition of the property of the company, including things in action… made after the commencement of the winding up, shall, unless the court otherwise orders, be void”.

 

The Provisional Liquidators argued that the Company’s 65% interest in the profit to be generated by the JV post exclusion was a chose in action belonging to the Company which was stripped away as a result of the exclusion, hence a disposition of the Company’s property. They further argued that but for the exclusion, they would have been able to discharge the Company’s obligations under the JV Agreement.

 

The Court explained that the meaning of “disposition” is broad and “encompasses any dealing in the tangible or intangible assets of a company and any other act that reduces or extinguishes a company’s rights in an asset and transfers value it in to another person”1.  While most dispositions would involve a disponor and a disponee, given its broad meaning, it does not follow that a disponor and a disponee must be present.

 

The Court held that Build King’s exercise of its rights under the Exclusion Clause did not involve any disposition of the Company’s property.

 

Under the JV Agreement, the lead party has to provide head office services, supply personnel with the necessary degree of competence for the execution of the Contract and making payment to them. The Court considered it unrealistic to think that the Provisional Liquidators would be able to discharge such obligations and responsibilities.  As the Company was in no position to perform its contractual obligations due to its insolvency, it was artificial to view a share of future profits as the Company’s existing asset. In the circumstances, Build King’s exercise of its exclusion rights could not be regarded as destroying or dealing with any “asset” of the Company.

 

Anti deprivation rule

 

The anti deprivation rule is a common law doctrine dating back to the 18th century and the leading authority is the English Supreme Court case of Belmont Park Investments Pty Ltd v BNY Corporate Trustee Services Ltd & Anor [2012] 1 AC 383.  The policy behind the rule is that upon bankruptcy, parties cannot deprive the bankrupt of his property which would otherwise be available for creditors.

 

In applying the anti deprivation rule, it is necessary to look at the substance of the agreement rather than its form and to consider whether the provision in question amounted to an illegitimate attempt to evade the relevant bankruptcy law or had some legitimate commercial basis.2 In each case, the “touchstone” is “to consider each transaction on its merits to see whether the shift in interests complained of could be justified as a genuine and justifiable commercial response to the consequences of insolvency.”3

 

Following the approach set out in the Belmont Park and Lomas case, the Court concluded that the Exclusion Clause did not offend the anti deprivation rule because:

 

1. Only one of the five events of default triggering the Exclusion Clause is concerned with insolvency events while the other four are concerned with breaches of contract. This in itself suggests an absence of any deliberate intention to evade insolvency law.
2. The requirement which the defaulting party has to bear its share of post exclusion losses on the Project (which is the Provisional Liquidators’ main criticism of the clause) was fair as claims for latent defects in large construction project tend to emerge upon completion of the Project.
3. Any default by a defaulting party would completely change the innocent party’s risk profile in the Project. The provision is negotiated to protect the innocent party and gives legitimate protection to the innocent party who does not assume 100% of the risk at the time when it enters into the JV.
4. As both parties to the JV are sophisticated and seasoned players in the construction industry, it is sensible and in the interest of the parties to provide for contingency in the event that one of them goes into insolvency. The Court finds that it was a commercial bargain entered into freely by the parties.

 

Penalty Clause

 

The test is whether the Exclusion Clause is a secondary obligation which imposes a detriment on the Company out of all proportion to any legitimate interest of Build King in the enforcement of the primary obligation of the JV Agreement.4 The Court decided that the Exclusion Clause was not a penalty clause:

 

1. The risk profile for a single party to carry out the Project as a result of the defaulting party’s default is significantly different from the shared risk between two parties. Additional protection for the innocent party under the Exclusion Clause was therefore justified.
2. Any deterrent effect of the Exclusion Clause is to prevent the Company from committing breaches and there is nothing inherently penal in nature.
3. The Provisional Liquidators argued that the clause imposes a primary obligation to maintain solvency and the secondary obligation to bear post exclusion losses. That, they argued, was disproportionate to protecting the legitimate commercial interest of Build King. The Court rejected that argument and explained that a breach of a primary obligation leads to right for damages and the mere fact that an insolvent party being identified as a defaulting party does not make it a breach of contract or a breach of a primary obligation.

 

Takeaway point

 

Clauses providing for exclusion rights triggered by specified events (including insolvency) are common in joint venture agreements. It is welcoming to see the Court confirming the validity of the clause in this case. Nevertheless, whether a clause has legitimate commercial basis is often case specific and legal advice is recommended before incorporating them into the agreements.