Who owes what? Nature of compensation under insolvency rules

According to Hong Kong SAR Government Statistics, Hong Kong’s economy for 2020 contracted 6.1% overall, the largest annual decline on record. The COVID-19 pandemic continues to affect the city’s livelihoods and economic development. The Hong Kong General Chamber of Commerce described a “booming bankruptcy tsunami, with 7,381 bankruptcy orders and 254 liquidation orders issued between January 2020 and January 2021. These numbers are worse than for the SARS crisis of 2003 and the global financial crisis of 2008/9. This is quite a disturbing feat for a virus.

Like the rest of the planet, we remain hopeful that global and local economies will recover quickly and solidly in 2021. The recent global rollout of successful immunization options will hopefully mean what was once perhaps a vision. of hope based on a ‘wing and a prayer’ will now become a reality and a return to a new post COVID-19 normal. However, for now, the sad fact remains that COVID-19 has given many businesses a one-way ticket to bankruptcy / liquidation in the face of growing debts and drastically reduced revenues.

In this article, we look at the legal concept of ‘netting’ under Hong Kong law and in the context of bankruptcy and insolvency, as it is probably a well-used mechanism for adjusting liabilities. between the debtor companies and the creditors COVID-19 landscape that awaits us.

To release

In general, netting refers to a method of adjusting cross-currency claims between two parties to deduct liability from each other, so that only the remaining balance is due.

Under Hong Kong law, there are several forms of compensation:

  1. Legal compensation works as a defense to legal action. The relevant procedure for establishing a defense of set-off is provided in Section 16 (2) (a) of the High Court Order (Cap 4) as well as Order 18, Rule 17 of the High Court Rules ( Cap 4A) (and the equivalent rules of the district court): “When a claim by a defendant for a sum of money (of a fixed amount or not) is raised as a defense to all or part of a claim made by the plaintiff, it may be included in the defense and offset against the plaintiff’s claim, whether or not it is also added as a counterclaim. ‘ It is essential that there is “mutuality” and that the cross claims must be liquidated and be between the same parties who are held by the same title, right or interest. “Mutuality” is not concerned with the nature of the debts themselves, ie the two claims must not result from identical or closely related transactions. Under section 35 of the Limitation Ordinance (Chapter 347), a claim for set-off or a counterclaim is deemed to be a separate action and to have been brought on the same date as the original action.
  2. Fair netting requires that the cross-claims are sufficiently linked and be available even if the claims are not liquidated. Fair set-off would occur when there were cross-claims arising from a contract and it was unfair for the plaintiff to insist on its terms without crediting the balance owed to the defendant. (Rawson -v- Samuel (1841) 41 ER 451). It can also arise from an express or implied agreement in the context of a transaction. The differences between legal compensation and fair compensation are set out in Re Finbo Engineering Co. Ltd. [1998] 2 HKLRD 695.
  3. Contractual compensation arises by mutual agreement between the parties. When both parties to a transaction need to make payments, instead of arranging separate payments from each other, the parties can agree that the lower amount is cleared, and the party that needs to make the more payment. high would pay the difference between the two amounts owed. For example, say A owes B $ 600,000, but B also owes A $ 400,000; the parties can agree that the $ 400,000 can be set off by A and pay B only the balance of $ 200,000.
  4. Bank clearing is also known as the right to consolidate accounts. When a customer has two or more current accounts with the bank at the same capacity, of which at least one is a debtor and one is a credit, the bank may invoke the right to combine the accounts in order to give a balanced net result.
  5. Legal / insolvency netting refers to mandatory netting that applies to liquidations where there have been mutual transactions. It can also apply to contingent and unpaid debts. Insolvency netting should be distinguished from other types of netting which aim to prevent cross claims between two solvent parties. The rationale for offsetting in insolvency is to ensure substantial justice between the insolvent and the creditor (s) upon liquidation. Under the rules, it may be possible to set off an amount owed by the creditor to the business against a debt owed by the business to the creditor, in order to determine the amount for which the creditor can prove upon liquidation. Otherwise, without such set-off, the creditor would have to pay the liquidator’s full debt owed to the company, then compete with other creditors and attempt to collect all of the debt owed to it by the company.

For the purposes of this article, we discuss mandatory insolvency netting in more detail.

Insolvency compensation

The rule on compensation and mutual credits is enshrined in Article 35 of the Bankruptcy Ordinance (Cap 6) (BO), which is imported into the liquidation of companies under Article 264 of the Law on companies (liquidation and various provisions) Ordinance (CWUMPO) (chap. 32).

The legal compensation provided for in article 35 BO is compulsory and cannot be subcontracted (National Westminster Bank Ltd -v- Halesowen Presswork and Assemblies Ltd [1972] AC 785). Case law shows that the following conditions must be met for set-off to apply:

  1. There must be mutual credits, debts or other commitments that make it possible to find a financial balance.
  2. There has to be reciprocity.
  3. The claim must be provable at the time of liquidation.
  4. The benefit of compensation against an insolvent company cannot be claimed if the other party at the time of granting the credit to the company had been informed of the start of liquidation. The notice here covers not only the actual opinion, but also the constructive opinion.

The terms “mutual credits, mutual debts or other mutual transactions” are broad, covering current debts and liabilities, future and contingent debts, as well as other types of transactions, events and statutory obligations which may give rise to liability. monetary. As such, contingent debts can be offset against debts currently due, as long as the conditional obligation existed at the start of liquidation (Young Hong Yui, William -v- Hong Kong Commercial and Credit Bank Ltd [1994] 2 HKC 89). However, legal set-off will not be applicable if the debtor does not become a creditor until after the bankruptcy judgment or the date of the request for liquidation.

Examples of triggered insolvency

  1. In Tam Wing Chuen and Skai Import-Export Ltd -v- Bank of Credit and Commerce Hong Kong Ltd (in liquidation) [1996] 1 HKC 692, the cleared insolvency was not authorized due to the lack of reciprocity in charge of the document, with regard to the debt of a company to a bank under a loan facility and a deposit of money made to the same bank by the director and shareholder of said company.
  2. In contrast, “mutuality” was found in MS Fashions Ltd -v- Bank of Credit and Commerce International SA (n ° 2) [1993] Ch 425. Two brothers held directorships in three companies. They executed a mortgage to secure the bank’s advances to their businesses. In the mortgage document, the brothers guaranteed their company’s debt to the bank as a “principal debtor,” authorizing the bank to withdraw money from its personal deposit account with the bank in preparation for repayment of the loan. The “principal debtor” was defined as including brothers and corporations. When the bank was forced into liquidation, one of the brothers, Mr Sarwar, had around £ 300,000 in the deposit account with the bank and his companies owed the bank around £ 572,000. Mr Sarwar claimed to set off his deposit with what he owed the bank under the mortgage deed and bill of charge, and the set-off would also extinguish the companies’ liability. Hoffman LJ concluded that since Mr. Sarwar was responsible to the bank as principal, and the bank was also primarily responsible to Mr. Sarwar himself, there was reciprocity and therefore set-off was permitted.
  3. Sy Chin Mong, Stephen -v- Xian Karkiu Electric Power Limited Company [2009] 6 HKC 1 insolvency compensation in the context of a joint debt. Sy and BT China (in liquidation) were jointly and severally indebted to Karkiu for approximately 3.5 million RMB (the Sum) under an arbitration award. At the same time, Karkiu was indebted to BT China for ¥ 2.5 million RMB. The question was whether Sy was entitled to set off the 2.5 million RMB owed to Karkiu to BT China with the amount he and BT China owed Karkiu. Justice Pichon cited [12.21] of Derham’s Law of Compensation as the correct statement of the law in the context of a joint debt:“In the case of a joint and several debt, each of the debtors is jointly and severally liable. The creditor in such a case can sue all the debtors in a single action, or he can sue one or more of them separately. The debt of a genuinely joint and several debtor and a debt owed by the creditor to that debtor constitute mutual debts and can be set off. The occurrence of set-off would lead to a pro tanto reduction of the joint and several debt and would also release the other debtors. Le Pichon J. held that due to the automatic and self-executing nature of the set-off under the insolvency rules, set-off would have taken place between BT China and Karkiu, which also resulted in a pro tanto reduction of joint and several liability debt for all debtors. As Sy was willing to pay the balance after set-off, all debt owed to Karkiu was discharged.

Some limitations of legal / insolvency compensation

Compensation in the event of insolvency is subject to a few exceptions:

  1. Section 45 of the Securities and Futures Ordinance (Cap 571) provides that the proceedings of a recognized clearing house take precedence over insolvency law.
  2. It is legally permissible for a creditor to contractually modify its position to its detriment, placing itself in a worse position under the pari passu to reign. (Re Maxwell Communications Corp plc [1994] 1 All ER 737)
  3. When a creditor has both preferred and non-preferred / ordinary claims on the insolvent company, he must set off proportionally to the amount of the two claims (Re Unit 2 Windows Ltd [1985] 3 All ER 647). When a creditor has both secured claims and unsecured claims, the set-off can only apply to the unsecured claim, unless the creditor decides to waive its guarantee and prove upon liquidation (Re Norman Holding Co Ltd (in cash) [1990] 3 All ER 757).

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