Mark Reed and Alexander Tang provide a detailed analysis of the legal framework regulating the restructuring market in Hong Kong, and identify flaws in current legislation applicable to cross-border insolvency issues.
1. What trends, in terms of activity levels, affected industries or investor focus, have you seen in the restructuring and insolvency market in your jurisdiction over the last 12 months?
The local insolvency market is not as flourishing as it was a decade ago. The number of companies wound up in Hong Kong per year has been quite steady in the past four to five years and is at an all-time low in the last 15 years.
There have been more failing company groups in the shipping industry worldwide over the last 12 months, and they have provided opportunities for Hong Kong restructuring and insolvency practitioners, including lawyers. Increasingly, we have seen more company groups owned by parties from mainland China (listed in Hong Kong or otherwise) requiring restructuring advice or services. These company groups cover a wide range of sectors, such as energy, iron and steel, as well as shipping. Many Hong Kong listed companies are offshore companies, and when schemes are implemented, they are often run in parallel in a number of jurisdictions.
2. What is the market view on prospects for the coming year?
We envisage that in the short term the market will be more or less the same as in the previous year.
It is not easy to predict the prospects for the coming year as it is affected by the global economy, including the economy in mainland China. There has been recent news about decreasing property prices and rentals, which seems to suggest a declining economy. However, widespread default in repayment of mortgage loans is yet to be seen, this is probably due to the present low interest rate. The increase in the US Federal Reserve benchmark interest rate in December 2015 may have some impact on the interest rate in Hong Kong, but that usually takes effect after several months, at least.
3. What are the key tools available in your jurisdiction to achieve a corporate restructuring – are they primarily formal, court-driven processes, or are informal out-of-court restructurings possible? Do you feel that the tools you have available are effective in terms of providing speedy, fair and predictable outcomes?
There is no formal mechanism in Hong Kong for corporate restructuring. The main restructuring tool available is the scheme of arrangement, which can be used for both insolvent and solvent companies. Outside the insolvency context, schemes have often been used to enable privatisation, re-domiciling foreign companies, mergers and takeovers.
At least two Court hearings will be required. The first one is to get the Court’s approval to convene meetings and the other one is to get the Court’s approval of the meetings’ results. The Court will only summon meetings to consider the scheme if the terms of the scheme are fair and could be supported by creditors/members exercising reasonable judgment. Only creditors/members with similar rights will be put together within a class for meetings. There have been difficulties in the past regarding correctly constituting different classes for holding meetings, as well as issues about preferential claims. These issues have now been mainly resolved by case laws.
For a creditor scheme, it is necessary to obtain for every relevant class a majority of 75% in value and more than 50% in number to approve the proposed scheme. Secured and preferential creditors can be included as part of the scheme, but they would be in classes separate from unsecured creditors. If there are assets located in more than one jurisdiction, parallel schemes are often implemented in jurisdictions which have a similar scheme as in Hong Kong to ensure that all creditors are bound.
The lack of a statutory moratorium means that dissenting creditors may still take out enforcement actions as well as winding up proceedings after a scheme of arrangement has been initiated. For insolvency cases, provisional liquidators can be appointed at the time of initiating a scheme of arrangement to create a moratorium. Creditors are not allowed to commence actions against the company once provisional liquidators are appointed except with the Court’s permission. The initial period is between the presentation of a winding up petition and the first call over hearing in which a winding up order may be made (which is about six to eight weeks) and this will be subject to further extensions as allowed by the Court. Case law in Hong Kong has established that restructuring alone is not a valid ground for the appointment of provisional liquidators and an applicant has to show that there is jeopardy to the company’s assets. This has deterred parties from appointing provisional liquidators to assist the implementation of a scheme where the risk is lacking or not apparent.
A dissenting creditor will be bound after the relevant meetings are convened and approved by the requisite majority votes of different classes of creditors/members, and upon the scheme being approved by the Court.
A judge decides whether meetings should be convened and whether the scheme should be sanctioned even after the requisite majority votes in different classes have been obtained. This ensures fairness. Principles developed in case laws have ensured a high degree of certainty in complex issues such as constitution of different classes. A sanctioned scheme binds all parties with little scope of future modification. These make the outcome highly predictable. The diary of the Companies Court is always busy and it takes at least eight weeks from the initiation of a scheme to reach a sanction hearing (which is about the same time between the presentation of a winding up petition and the first call over hearing in which a winding up order may be made).
Informal out-of-court restructurings are possible and common in Hong Kong. One common form is debt-rescheduling (or work-out) in which a debtor company enters into a contractual arrangement with all or some of the bank creditors. Debt-rescheduling is sometimes used in conjunction with scheme of arrangement as a fall-back. The Hong Kong Association of Banks and the Hong Kong Monetary Authority have jointly issued non-statutory guidelines covering how banks should deal with borrowing companies in financial difficulties (the “Guidelines”). The Guidelines encourage a standstill process in order for the banks to reach an informed decision as to the borrower’s long-term future. A collective decision should be made by the banks and a lead bank and/or a steering committee should be appointed to head up negotiations with the company. It also encourages the banks to act in a co-operative and expeditious manner in order to agree a restructuring plan. The Guidelines have been in use since 1999 and appear to have been well received by the banking sector. The main limitation of the Guidelines is that they are only applicable to banks. Hence, non-bank creditors including bondholders, private equity firms and hedge funds, as well as other trade creditors, may take out enforcement actions or winding up proceedings while the banks are working out a restructuring plan with the company. In addition, the Guidelines do not have any statutory force and are not legally binding on any bank.
Another form of restructuring is to “hive down” the company, and this is only feasible in cases where at least some of the business operation(s) are making a profit. The company is placed into liquidation (or in appropriate cases, receivership) and the profitable business operation(s) and contract(s) will be transferred by liquidators/receivers of the company to a wholly-owned subsidiary. The debts will remain with the company. The shares of the subsidiary will be sold to the highest bidder and the purchase money received by the liquidators/receivers will become part of the company’s assets used to pay creditors (in liquidation cases), or the debenture holder (in receivership cases).
4. In terms of intercreditor dynamics, where does the balance of power lie as between shareholders and creditors, and as between senior lenders and junior/mezzanine lenders? In particular, how do valuation disputes between different stakeholders tend to play out?
Creditors always get an upper hand over shareholders in both restructuring and insolvency cases. Members of liquidation committees appointed to oversee liquidators’ work in insolvency cases predominantly consist of creditors. The Court will exercise its independent judgment when sanctioning a scheme to ensure fairness to creditors. There has been decision [Note: Le Pichon J in Rhine Holdings Limited] where the Court refused to sanction a scheme because the return of shareholders in the scheme was disproportionately larger than that the shareholders may get if the company goes into liquidation.
The law favours senior secured lenders over junior/mezzanine lenders. Junior or mezzanine lenders may challenge the validity of the security, and the most likely grounds of challenges concern registration. Registration requirements for security are clear and not complex. Generally speaking, it is not an easy task to challenge the validity once a security is registered.
There are rare instances in which valuation disputes have arisen in this jurisdiction.
5. Have there been any changes in the capital structures of companies based in your jurisdiction over recent years caused by the retreat of banks from loan origination? In particular, have you found that capital structures now increasingly comprise debt governed by different laws (such as New York law governed high yield bonds)? If so, how do you expect these changes to impact on restructurings in the future?
Banks having material lending operations in Hong Kong at the time of the GFC were well-regulated and well-capitalised, and few of them suffered financial difficulties as a result of the GFC. Although some of the Western banks have reduced their appetite for lending since the GFC, many Asian banks, particularly the state-owned PRC banks, have continued lending heavily. SMEs have found it more difficult to borrow, but the bigger corporates have had continued access to bank lending sources. However, that has not stopped many HK-listed companies, several having businesses in the PRC, from borrowing through bond issues, particularly NY law governed bonds. The existence of such bond obligations and, following the commodity price falls and the PRC economy slowdown, the inability of some HK-listed companies to service such bonds have not only precipitated financial difficulties for the issuers but also required the involvement of NY lawyers in the insolvent restructurings of the debt of HK-listed companies.
6. Is there significant activity on the part of distressed debt funds in your jurisdiction? How successful have they been in entering the market, and how much has market practice (or law) evolved in response? If funds have not successfully entered the market, can you identify reasons why?
Distressed debt funds have a presence in Hong Kong and are well established. However, their activities are mainly focused on distressed debts in other jurisdictions, such as mainland China and other countries in Asia. We think that this is so because Hong Kong does not have any primary and secondary industries.
7. Are there any unusual features of your insolvency or restructuring law that an external investor should be aware of (such as equitable subordination, or substantive consolidation)?
Hong Kong’s insolvency and winding up provisions currently in use are broadly based on the Companies Act 1929 and the Companies Act 1948 of the UK. The absence of some common provisions available in other jurisdictions has made Hong Kong’s insolvency laws somewhat unusual, these include:
Costs and expenses in the winding up can only be claimed out of the company’s free assets and are not payable out of assets subject to floating charge until the sum due to the charge holders and interest are fully paid. [Note: Re KCL Capital Limited.] This is at least different from the UK regime where the cost and expenses in the winding up have priority over the charge holders in assets subject to a floating charge. [Note: S176ZA to the Insolvency Act 1986.]
8. Are there any proposals for reform of the legal framework that governs insolvency and restructurings in your jurisdiction?
The last major review of Hong Kong’s corporate insolvency laws was conducted in 1984. A corporate insolvency amendment bill was recently gazetted in October 2015 and at the moment it is envisaged that the new legislation will be effective in autumn 2016. The policy objectives of the amendment bill are to increase the protection of creditors and enhance the integrity of the winding up process. The more important changes to the present insolvency law provisions include: (1) the addition of provisions for setting aside transaction at an undervalue within five years of the winding-up; (2) the rectification of the current anomalies on unfair preference provisions which arose as a result of certain concepts borrowed from personal insolvency legislations; (3) the addition of a provision for liabilities of directors and members to contribute to the assets of the company in connection with a redemption or buy-back of the company’s own shares out of capital where the company is wound up within one year of the relevant payment out of capital; and (4) improvements in the procedures for private and public examinations.
There is no proposal for reforming restructuring laws under the present corporate insolvency amendment bill, and the government is targeting to introduce an amendment bill on restructuring in 2017/18. It is worth mentioning that a mechanism known as “provisional supervision” was put forward by the government more than 15 years ago as a formal tool for corporate restructuring which contains a statutory moratorium. However, that proposal failed to gain acceptance primarily because the provisions in relation to employees’ compensation are extraordinarily onerous to creditors.
9. If it was up to you, what changes would you make?
Hong Kong does not adopt the UNCITRAL Model Law on cross-border insolvency, and insolvency laws on cross-border issues are mainly dealt with by case laws. This is so despite its status as a major international financial centre and the fact that many foreign companies (listed companies or otherwise) have registered in Hong Kong. In the past few years, an increasing number of cases that the Companies Court handled concern cross-border issues, such as recognition of foreign liquidators and foreign liquidations, as well as winding up foreign companies. In modern times, assets of a company or a company group located in various jurisdictions are the norm rather than the exception. It would appear that the adoption of the UNCITRAL Model law is patently beneficial to an international financial hub such as Hong Kong.
There have also been problems with the recognition of insolvency practitioners between Hong Kong and mainland China, even though most of Hong Kong’s businesses are now connected with assets and/or production lines in mainland China. The powers of Hong Kong insolvency practitioners being recognised in mainland China has improved, at least in large cities such as Shanghai. Will the Hong Kong Court recognise the powers of insolvency practitioners from mainland China? It appears that this is unlikely if the Hong Kong Court can only decide such issues based on case laws. Bilateral reciprocal arrangements between Hong Kong and China for recognising powers of insolvency practitioners similar to those in relation to mutual recognition for arbitral awards and judgments may seem to provide a solution to this issue. Given that the government has progressively put forward reforms in different parts of the corporate insolvency and restructuring laws, perhaps the next agenda of reform is the cross-border insolvency law.