30 August, 2019
Section 182 of the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap. 32) states that after the commencement of winding up proceedings, any disposition of the property of the company is void unless the Court otherwise orders. The purpose of this section is to prevent the improper disposition of the company’s assets that may otherwise be available for pari passu distribution to the company’s creditors.
The recent decision of Deputy High Court Judge Le Pichon in Re Hsin Chong Construction Company Limited [2019] HKCFI 1531 considered the possible effect of section 182 upon a clause in a Joint Venture Agreement allowing one of the parties to exclude the other party from the joint venture upon the other party’s insolvency. The Court held that the exercise of rights under the clause did not constitute a “disposition” under section 182, and confirmed the validity of the exclusion clause.
Background
Build King (BK) and Hsin Chong (the Company) entered into a Joint Venture Agreement in relation to a government design and construction project in Kowloon. A clause in the Joint Venture Agreement provided that upon the occurrence of one of five specified events, the innocent party had a right to exclude the defaulting party from further management of the Joint Venture, and to take over the benefits of the defaulting party in the Joint Venture. One of the five specified events of default was the insolvency of one of the parties to the agreement.
On 27 August 2018, a winding up petition was issued against the Company. In December 2018, BK exercised its right under the clause to exclude the Company from the Joint Venture. Following the exclusion, BK acquired the Company’s residual rights by way of a Supplemental Agreement which included a payment of HK$53.6 million being made to the Company.
The Provisional Liquidators appointed on the Company sought to invalidate the clause. The four issues before the Court were whether (i) the clause was a disposition under section 182; (ii) the clause offended the anti-deprivation principle; (iii) the clause was a penalty clause; and (iv) the Supplemental Agreement transaction was valid.
First issue – disposition within section 182
The Provisional Liquidators tried to argue that the profit generated by the joint venture was a chose in action belonging to the Company which was stripped away from the Company as a result of the exclusion clause, and was thus a void disposition of the Company’s property.
They further argued that but for the exclusion, the Company would have been able to discharge its obligations under the Joint Venture Agreement.
The Court held that since the Company was insolvent, it was in no position to perform the Company’s contractual obligations in return for a share of future profits under the Joint Venture Agreement. Thus, the Court ruled that it was artificial to view a share of future profits as an existing “asset” of the Company. The Court also said that it might be unrealistic to think that the Provisional Liquidators have the necessary resources to discharge the Company’s obligations under the Joint Venture Agreement. As a result, BK’s exercise of rights under the clause did not involve any disposition under section 182.
Second issue – the anti-deprivation principle
In deciding whether the clause offended the anti-deprivation principle (which provides that parties cannot contract out of insolvency legislation), the Court relied on the English Supreme Court decision in Belmont Park Investments Pty Ltd v BNY Corporate Trustee Services Ltd & Anor [2012] 1 AC 383, which held that it is necessary to look at the substance of the agreement rather than its form in considering whether a provision amounted to an illegitimate attempt to evade the relevant bankruptcy law, or had some legitimate commercial basis. The Court also followed the approach in Lomas v JFB Firth Rixson Inc [2012] 2 All ER (Comm) 1076 which held that it was necessary 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”.
Following the approach set out in the above two cases, the Court decided that the clause in this case did not offend the anti-deprivation principle, for the following reasons:
- Only one of the five events of default which trigger the clause was an insolvency event. The remaining four events of default concerned breaches of contract.
- It was sensible and in the interest of the parties to provide for the contingency that one of the parties went into insolvency.
- This was a commercial bargain entered into freely by the parties.
- It was fair that the Company had to bear its share of post-exclusion losses until the completion of the project, given that in large construction projects, claims for latent defects tend to emerge upon completion of the project.
In light of the above, the Court viewed that it was difficult to discern that the clause contained any deliberate intention to evade insolvency law. Thus, the clause did not offend the anti-deprivation rule.
Third issue – penalty clause
The Provisional Liquidators also argued that the clause served no legitimate commercial purpose and only served to punish the Company. The Court found that it was not unreasonable to protect BK’s interest to require the Company, as a defaulting party, to maintain its risk of loss because the risk profile for a single joint venture partner to carry out the project on its own as a result of the default is significantly different from the shared risk between two parties. Further, the Court said that if the clause deterred the Company from committing breaches, there was nothing inherently penal in the provision. It would in fact encourage the parties to achieve the commercial objectives in completing the project. As such, the Court held that the clause was not a penalty clause.
Fourth issue – validation of Supplemental Agreement
Finally, the Court exercised its discretion under section 182 to validate the Supplemental Agreement transaction. The Court held that there was nothing to suggest that the agreed consideration was unfair or an undervalue, with the basis of valuation being clear, and such transaction would normally be validated. The Court noted that the payment was made to a nominee at the Company’s request; but any misapplication of the proceeds was not a matter for BK, which had entered into an arm’s length commercial transaction. Hence there was no good reason for the Court not to validate the transaction.
Conclusion
This helpful decision shows the criteria that the Court will adopt in determining whether clauses in agreements which confer exclusion rights on innocent parties upon the party’s insolvency are valid. It is particularly worthy of note that the Court held a share of future profits is not an existing “asset” of the Company, and as a result, the exercise of exclusion rights does not involve any disposition under section 182.
For further information, please contact:
Richard Hudson, Partner, Deacons
richard.hudson@deacons.com.hk
