Hong Kong – CFA Returns To Basics As It Overturns CFI And CA Decisions In Re Hsin Chong Construction CO Ltd.

Facts
 

Joint Venture
 

In 2013, Hsin Chong Construction Co. Ltd (the Company) as the majority shareholder and Build King Construction Limited (BK) as the minority shareholder entered into a joint venture agreement (the JVA) to form and operate a joint venture (the JV) in respect of a government construction project in Kowloon.
 

In August 2016, the government entered into a contact with the JV for the construction project (the Contract). Subsequently, the Company ran into financial difficulties in around 2017/2018. The government decided to terminate its agreement with the JV with respect to the construction project in July 2018, and a winding-up petition was presented against the Company on 27 August 2018 by one of its creditors.
 

The Company’s insolvency constituted an ‘event of default’ under the JVA and BK exercised its right to exclude the Company from further participation and management in the JV and to take over the benefits of the Company in the JV. Nevertheless, the Company was still entitled to some residual rights to receive profits under the terms of the JVA up to the date of its exclusion.
 

These residual rights would only be exercisable upon BK’s completion of the Contract, upon which an accounting exercise would be conducted to determine the Company’s entitlement to any accrued profit (the Final Accounting).
 

Supplemental agreement
 

Preferring to have greater freedom in completing the Contract, BK offered to acquire all of the Company’s residual rights under the JVA for a consideration of HK$53.6 million (payable in two instalments of HK$20 million and HK$33.6 million respectively) (the Consideration). BK proposed that the Company would be released from any future obligations under the JVA (the Proposal). Such terms were in fact advantageous to the Company since (i) it would have received accelerated payment in the form of pre-exclusion profit, which would only be available after completion of the Final Accounting; and (ii) the Consideration was calculated to include ‘projected profits’, which would not have been available to the Company under its residual rights in the JVA.
 

Accordingly, on 17 December 2018, the parties entered into a supplemental agreement giving effect to the Proposal (the SA).
 

As it is normal practice for banks to freeze a company’s bank accounts upon presentation of a winding-up petition, the SA provided that the Consideration was to be paid to the Company’s sister entity, Cogent Spring Limited (Cogent Spring), instead of to the Company.
 

In accordance with the SA, on 17 December 2018, BK advanced the first instalment of HK$20 million (the first instalment) to Cogent Spring. Controversially, the first instalment was later applied not only to settle various outstanding payments of the Company, but also the expenses of other related entities under the same corporate group.
 

Issues
 

It is a longstanding rule that any disposition of the property of the company, including things in action, and any transfer of shares, or alteration in the status of the members of the company, made after the commencement of the winding up (ie after the presentation of the winding-up petition), shall, unless the court otherwise orders, be void (section 182 of the Companies (Winding Up and Miscellaneous Provisions) Ordinance Cap. 32 (CWUMPO)).
 

Accordingly, since the SA was executed after commencement of the winding up of the Company, BK’s payment to Cogent Spring was prima facie a void disposition of the Company’s property. As such, BK applied to the court to retrospectively validate the SA after the payment of the first instalment to Cogent Spring. This was met with great resistance from the provisional liquidators of the Company who challenged the SA as a void disposition.
 

Validation of the SA by the Court of First Instance and the Court of Appeal
 

One of the issues before the Court of First Instance (CFI) was whether the court should exercise its discretion to validate the SA under s.182 of the CWUMPO.
 

The CFI noted that, had BK made the payment directly to the Company rather than to Cogent Spring, the court would undoubtedly exercise its discretion to validate the SA. In any event, the CFI decided to exercise its discretion to validate the SA because:
 

• the subsequent misapplication of the first instalment to Cogent Spring was a matter internal to the Company over which BK had no control; and
   

• CFI found that BK had no ulterior purpose or agenda in paying the first instalment to Cogent Spring.
   

On appeal, the Court of Appeal (CA) also refused to interfere with the CFI’s exercise of its discretion as the allegation against BK having actual or constructive notice of the Company’s misapplication of the first instalment funds was uncorroborated by evidence. The provisional liquidators of the Company then appealed to the CFA.
 

The CFA Judgment
 

The CFA held that, in determining whether to validate a void disposition under s.182 of the CWUMPO, the court must treat the interests of the general body of creditors as of central importance and ensure that their interests are not prejudiced: see Re Gray’s Inn Construction Co Ltd [1980] 1 WLR 711.
 

The Company’s 'property' that was wrongfully disposed of in this instance was the right to the payment of HK$53.6 million and to receive the first instalment as consideration for its residual rights under the JVA. The lower courts were wrong to hold that in making the payment to Cogent Spring, BK was merely discharging its contractual obligations as a payor under the SA. As a matter of principle, BK was not entitled to use such 'contractual clothing' to refurbish a transaction which was in effect, a void disposition.
 

The question of whether a disposition has taken place is one of substance and not form. The focus is on what happens to the value of a company’s assets as a result of the transaction in question.
 

It was clear the Company never pocketed the first instalment but the sums went entirely to Cogent Spring instead. As a result, the first instalment was dissipated in favour of various third parties to the prejudice of the Company’s unsecured creditors. The CFA also held that the lower courts were wrong to put the blame of misapplication solely on the Company because the Company never received the first instalment from BK in the first place, and it could not have possibly misapplied the funds.
 

Further, s.182 of the CWUMPO is concerned with preserving a company’s property for proper distribution to its creditors, and the section itself does not require any breaches of duty to be proven before a disposition is rendered presumptively void. Therefore, for the purpose of applying s.182 of the CWUMPO, it was irrelevant that BK had no ulterior purpose in making payment to Cogent Spring despite that the lower courts found that to be the case.
 

In view of the above, the CFA declared the SA void under s.182 CWUMPO and the Company was required to revert to a claim against BK for the value of its residual rights under the JVA upon Final Accounting.
 

Avoiding the s.182 CWUMPO pitfall in joint ventures
 

Joint venture agreements often include exit mechanism provisions in case there is a defaulting party. It is also not uncommon for a joint venture partner to buy out the other insolvent partner’s interests especially when the JV remains lucrative.
 

In these situations, the partner wishing to buy out the other must ensure that the consideration is to be made directly to the exiting partner and not to any other related or unrelated third parties notwithstanding the exiting partner’s request.
 

In order to be properly advised on and protected against legal risks and unnecessary costs, we recommend parties to seek legal advice on all types of joint venture transactions, particularly where there are conflicting third-party interests concerned.