1. Introduction

Under Hong Kong law, a company shall be deemed to be unable to pay its debts if a creditor, to whom the company is indebted of at least HKD 10,000 (around USD 1,290), has served on the company a demand requiring the company to pay and the company has not done so within three weeks. A creditor may then petition to wind-up the debtor.[1] Other common law jurisdictions have very similar concepts.[2]

Where the debt falls within the ambit of an arbitration clause in a contract, the question is in what circumstances should the court stay or dismiss the petition in favour of arbitration? It is settled law that in such a case the mandatory stay proviso under Article 8(1) of the UNCITRAL Model Law [3] (and its equivalents in various common law jurisdictions) does not apply to a winding-up petition; instead the courts have a discretion as to whether to stay or dismiss the petition.

The question of whether the court should exercise its discretion in favour of arbitration engages competing policy objectives. On the one hand, the tactical bypassing of an arbitration clause by filing a winding-up petition to pressurise a debtor to pay a genuinely disputed debt should be discouraged. On the other hand, the courts must be mindful of opportunistic insolvent debtors relying on an arbitration clause to require the creditor to incur the cost of obtaining an award and to prevent the creditor from exercising its statutory right to petition for the winding-up of a debtor who fails to pay a debt that is not genuinely disputed. In striking the balance, courts have grappled with achieving coherence in deciding in what circumstances to exercise the discretion in favour of arbitration.

In Dayang (HK) Marine Shipping Co, Ltd v. Asia Master Logistics Ltd,[4] the Hong Kong Court of First Instance (CFI) held that the court’s discretion was not fettered by the parties’ arbitration agreement and made a winding-up order. In the view of the judge in Dayang, the current state of Hong Kong law on this issue is as follows:

  • Where a debtor intends to dispute the existence of a debt, it must show that there is a bona fide dispute on substantial grounds. A mere denial is not sufficient.
  • The court has a discretion as to whether to stay or dismiss the winding-up petition; the existence of an arbitration agreement is irrelevant to the court’s exercise of its discretion. However, the fact that arbitration proceedings have or would be commenced may be relevant evidence that there is a bona fide dispute, but this alone is not sufficient to prove the existence of a bona fide dispute on substantial grounds.
  • If the creditor presents a winding-up petition knowing that there is a bona fide dispute over the debt on substantial grounds, it runs the risk of being liable to pay the debtor’s costs on an indemnity basis. In addition, it would also be at risk of liability under the tort of malicious prosecution.

The finding in Dayang that a debtor must show a bona fide dispute on substantial grounds deviates from the CFI’s earlier position in Re Southwest Pacific Bauxite (HK) Ltd (aka the Lasmos case)[5] as well as the positions in England and Singapore. In this article, we consider the position in England, Hong Kong’s departure from the English position and the decision in Dayang. We also briefly compare the positions in Hong Kong and Singapore.

  1. The winding road from Salford to Dayang

In Salford Estates (No 2) Ltd v Altomart Ltd (No 2),[6] the English Court of Appeal held that section 9(1) of the English Arbitration Act 1996 (“AA“) does not apply to a winding-up petition where the debt arose out of a contract containing an arbitration agreement.[7] The court further held that irrespective of the substantive merits of the defence, it was sufficient to constitute a dispute within the AA where a debt fell within the terms of the arbitration agreement and was not admitted. The following points of the court reaching this conclusion are noteworthy:

  • Where a winding-up petition is filed on the ground that the company is unable to pay its debts, the issue is whether the debt is outstanding and due. If so and the debt is undisputed, the failure to pay is itself evidence of inability to pay.
  • A winding-up petition is not a claim for payment of the debt. The making of a winding-up order might or might not result in the right to payment. By contrast with a claim for a debt, where a debtor genuinely disputes the debt, it is an abuse to present a winding-up petition to pressurise the debtor into paying.
  • The court has a discretionary power to wind-up a company. Save in wholly exceptional circumstances, it is appropriate to exercise the discretion consistently with the legislative policy embodied in the AA. Central to the court’s analysis was the importance of protecting the parties’ agreement as to the proper dispute resolution forum and the desire to avoid proceedings whereby the court would conduct a summary judgment type analysis of liability where a debt is not admitted.

The Hong Kong courts in Lasmos and several subsequent cases originally followed the English approach in Salford. In Lasmos, the CFI held that save in exceptional or wholly exceptional circumstances, a winding-up petition would generally be dismissed where (i) the debtor disputes the debt, (ii) the arbitration agreement covers any dispute relating to the debt, and (iii) the debtor has taken steps to commence the dispute resolution process in accordance with the arbitration agreement (this is often referred to as “Salford-Lasmos Approach”). Accordingly, a debtor does not need to show a bona fide dispute on substantial grounds when seeking to stay or dismiss a winding-up petition.

In Sit Kwong Lam,[8] doubt began to be cast on the strict application of the Salford-Lasmos Approach in Hong Kong. In that case, there was no arbitration clause that covered the dispute relating to debt. However, the court noted that even if there was an arbitration clause and it precluded the parties from invoking the court’s bankruptcy or insolvency jurisdiction prior to the commencement or completion of the arbitration process, the clause would be contrary to public policy and not enforced; a creditor’s statutory right to petition for bankruptcy or insolvency could not be restricted or fettered by contract.

Less than four months later, Kwan J of the Court of Appeal in But Ka Chon v Interactive Brokers LLC[9] expressed, in passing, reservations about the Salford-Lasmos Approach, including whether the court’s discretion should be exercised only one way to substantially curtail the statutory right of a creditor to present a petition.

So lay the land in Dayang.

  1. The judgment in Dayang

The underlying dispute between the petitioner and the debtor-company arose out of a charterparty evidenced by a fixture note with an arbitration clause that provided for arbitration in Hong Kong. The petitioner served a statutory demand on the debtor for unpaid hire of around USD 360,000. The debtor failed to pay within 21 days and the petitioner presented a winding-up petition.

The debtor did not deny that it owed the debt, but raised a counterclaim against the petitioner in relation to an alleged breach of the fixture note. The arbitration clause clearly covered the disputes relating to the debt as well as the counterclaim. The debtor relied heavily on the Salford-Lasmos Approach, submitting that the winding-up proceedings should be stayed or dismissed.

The judge made the usual winding-up order against the debtor for the following reasons:

  • The existence of an arbitration clause, or commencement of arbitration, does not by that very fact or act prevent the court from considering whether or not the debtor had established the existence of a bona fide dispute of substance in relation to the debt.[10]
  • Where a debtor opposes a petition on the basis that it has a genuine and serious cross-claim greater than or equal to the debt, the test is very much the same as for deciding whether a debt is disputed bona fide and on substantial grounds: (i) the debtor must prove that its cross-claim is genuine, serious and of substance, and (ii) there must be supporting relevant details to demonstrate that the cross-claim is based on substantial grounds. The debtor had failed to pass the test because its counterclaim consisted of pure allegations without any precise factual evidence substantiating the claims. In contrast, under the Salford-Lasmos Approach, it would have been sufficient for the debtor to dispute the debt.
  • Even if the Salford-Lasmos Approach applied, the order would still be made on the facts, as the debtor had taken no steps to commence arbitration. The judge reminded parties that the “mere gauge of an interest” to resolve a dispute by arbitration was not a valid commencement.

The judge did not stop here, but went on to make helpful observations on the Salford-Lasmos Approach. These observations include in particular the following:

  • The real issue is how the discretion to stay or dismiss a winding-up petition is to be exercised in a principled manner. Traditionally, the debtor may apply to dismiss or stay the petition on the ground that there is a bona fide dispute on substantial grounds. The mere denial, without more, of the existence of the debt was not enough to establish a bona fide dispute on substantial grounds.
  • Determining whether the debtor has a bona fide dispute on substantial grounds does not undercut the parties’ freedom to contract and the policy of the AO.[11] Since the presentation of a winding-up petition does not have the effect of determining the dispute, it does not come within the scope of the parties’ obligations to arbitrate. Rather, the court simply determines whether there is a genuine dispute to ensure that spurious or frivolous defences are not allowed to defeat a statutory demand. It was thus not necessary to give more “weight” to the fact that the dispute over the debt was subject to an arbitration agreement because the commencement of winding-up proceedings did not come within its scope.
  • If the court exercises its discretion in favour of a winding-up order and the liquidator subsequently rejects a creditor’s proof of debt,[12] it is untested in Hong Kong whether the creditor can refer the dispute with the liquidator over the debt to arbitration.[13] Notably, the English Court of Appeal in Salford stated that if the petition proceeded, there could not be a reference to arbitration of the debt because the making of a winding-up order brought into effect the statutory scheme for proof of debts which superseded any arbitration agreement.
  • There is nothing against public policy for a creditor to voluntarily agree, by contract, to fetter its own rights to file a petition for winding-up of a debtor. Notably, in Sit Kwong Lam, the CFI took the opposite view.[14]
  • A winding-up petition can put considerable pressure on the debtor to being strong-armed into settlement or to pay in lieu of arbitration. However, where a creditor abuses the process where the debt is disputed bona fide on substantial grounds, this risk can be mitigated by the court’s powers to punish such an abuse.
  1. The Singapore position

Unlike the CFI in Dayang, the Singapore Court of Appeal has recently appeared to adhere to the Salford-Lasmos Approach. In AnAn Group (Singapore) Pte Ltd v VTB Bank (Public Joint Stock Company),[15] the court held that a lower prima facie standard of review applies: the debtor only needed to show that there was a dispute in relation to the debt that fell within the scope of a valid arbitration agreement. An analysis of the decision in AnAn by our Singapore colleagues can be found here.

Notably, the court provided a qualification to prevent the lower prima facie standard from abuse by debtors: “indications” that a debtor’s alleged dispute is not raised bona fide (e.g., the debtor belatedly disputes the debt, having previously admitted both liability and quantum) would be a reason to find that there is an abuse of process that militates against the exercise of the court’s discretion to dismiss the petition.

Based on the decisions in Dayang and AnAn, the key difference in approach is as follows: in Hong Kong a debtor must show a bona fide dispute on substantial grounds, whereas in Singapore, the debtor merely needs to dispute in which case the burden shifts to the creditor to show that the debtor has raised the dispute purely as an abuse of process. Given that both the Hong Kong and Singapore courts have suggested that the Salford-Lasmos Approach is unsettled and may be revisited, it is likely that further developments on the issue will be forthcoming in both jurisdictions.

  1. Takeaway points

The need for a carefully balanced approach is underscored by the many businesses that are in a precarious financial position whilst navigating the recovery phase following the disruptions caused by COVID-19. However, while the judge in Dayang may have adopted a balanced approach, he did not formally overturn the Salford-Lasmos Approach; instead, he added to the growing chorus of observations against the strict application of the Salford-Lasmos Approach.

Pending clarification of the precise legal position in Hong Kong, where a creditor serves a statutory demand on the debtor with the prospect of commencing winding-up proceedings in lieu of arbitration proceedings, creditors and debtors alike may wish to consider the following points:

  • If a creditor petitions for the winding-up of the debtor, it is unclear whether the debtor has to show a bona fide dispute on substantial grounds (Dayang) or it is sufficient to merely dispute the debt and show that it has commenced arbitration (Salford-Lasmos Approach).
  • Hence, in deciding whether to go down the arbitration or winding-up route regarding a debt that is outstanding and due, a creditor should lay a paper trail to show the opportunities the debtor had been given to explain why it genuinely disputes the debt, and to carefully consider any grounds for non-payment relied upon by the debtor.
  • Filing a winding-up petition to pressurise a debtor into paying a genuinely disputed debt in lieu of arbitration can result in punishment by the court. Conversely, where the debtor does not react to a statutory demand or merely denies the debt, without more, the creditor may consider filing a petition to avoid having to go through arbitration proceedings which could deprive the creditor of all tangible remedies if the debtor’s assets have been dissipated in the meantime.

A debtor who receives a statutory demand for a debt which it disputes should be prepared to produce in winding-up proceedings precise factual evidence substantiating its position and to show that it has referred the dispute to arbitration by then. Otherwise, the debtor runs a significant risk of facing a winding-up order which can potentially cause irremediable damage to it (e.g., the winding-up order may constitute an event of default under the debtor’s various other transactions).

 

[1] See section 178(1)(a) (Hong Kong companies) and section 327(4)(a) (non-Hong Kong companies) of the Companies (Winding Up And Miscellaneous Provisions) Ordinance (Cap 32)

[2] See, for example, sections 122(1)(f) and 123 of the English Insolvency Act 1986

[3] Article 8(1) has been adopted under section 20(1) of the Hong Kong Arbitration Ordinance (Cap. 609) (“AO“). It provides that where a court action is brought in a matter which is the subject of an arbitration agreement and a party requests the court not later than when submitting its first statement on the substance of the dispute to refer the parties to arbitration, the court must do so, unless it finds that the arbitration agreement is null and void, inoperative or incapable of being performed.

[4] Dayang (HK) Marine Shipping Co, Ltd v. Asia Master Logistics Ltd [2020] HKCU 494 (date of judgment: 12 March 2020)

[5] Re Southwest Pacific Bauxite (HK) Ltd [2018] 2 HKLRD 449

[6] Salford Estates (No 2) Ltd v Altomart Ltd (No 2) [2015] Ch 589

[7] The regime under section 9 AA is substantially the same as the regime under Article 8(1) of the UNCITRAL Model Law. The judge at first instance had stayed the petition notwithstanding his conclusion that the debtor had failed to raise a substantial dispute in good faith and on substantial grounds. He did so because he felt bound by two earlier court decisions which had the effect that the mere raising of a defence or dispute was sufficient to bring into play the stay provisions in section 9 AA.

[8] Sit Kwong Lam [2019] 2 HKLRD 924

[9] But Ka Chon v Interactive Brokers LLC [2019] 4 HKLRD 85

[10] This is consistent with the English position in Salford

[11] This is one justification for the Salford-Lasmos Approach, the other being that the traditional approach was said to be out-of-step with developments in other common law jurisdictions and specifically with the English Court of Appeal’s decision in Salford which the CFI tried to follow in Lasmos.

[12] When assessing de novo whether to accept a proof of debt, the liquidator acts in a quasi-judicial capacity. However, when the liquidator defends the decision to reject a proof, the liquidator is no longer acting in a quasi-judicial capacity but in the role of an adversary in defending the assets available for distribution.

[13] In Tanning Research Laboratories v O’Brien (1990) 169 CLR 332, the High Court of Australia held that a liquidator could be bound by an arbitration clause between the debtor and the creditor insofar as the liquidator’s rejection of proof is based on the general law; this was because a liquidator who defends its rejection of a proof is no longer acting in a quasi-judicial capacity.

[14] In But Ka Chon , Kwan J of the Court of Appeal made a similar observation as the CFI in Sit Kwong Lam.

[15] AnAn Group (Singapore) Pte Ltd v VTB Bank (Public Joint Stock Company) [2020] SGCA 33; this decision was handed down after Dayang.

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