Insolvent Trading – The Last Piece of HK’s Corporate Rescue Puzzle

By Stephen Briscoe

In the eyes of many people in Hong Kong, the most important part of the new corporate rescue legislation is that relating to Insolvent Trading.

Very similar to Wrongful Trading in the UK, the purpose of this legislation is to encourage directors of distressed companies to act sooner rather than later, and by doing so to protect the interests of creditors. If they don’t, it gives the power to a liquidator to apply to the court for a declaration that the director can be personally liable for some or all of the company’s debts that have been incurred because the company continued to trade whilst it was insolvent.

What Is Insolvency

It seems that the proposed legislation will adopt the current insolvency test from the Companies (Winding-up and Miscellaneous Provisions) Ordinance, being a mixture of the cash flow test (the inability to pay its debts as and when they are due);  and the balance sheet test (not having sufficient assets to pay its debts in full). In other words, if a company fails either of the two tests, it can be deemed to be insolvent.

Who Could Be Liable

These new provisions would apply to both directors and “shadow directors” as currently defined by s.2 of the Companies Ordinance. A shadow director is generally viewed as being someone “upon whose instructions the company is accustomed to act.”

What Is Insolvent Trading

Insolvent trading takes place where:

  • a company is insolvent (using either of the two tests);
  • it continues to trade and incur further debts; and
  • the director knew or ought to have known that the company would not be able repay those debts.

In other words, if the director:

  • allows the company to continue trading;
  • it incurs further debts which it is unable to pay; and
  • it then goes into insolvent liquidation;

there is a possibility that the director(s), (or shadow director(s) as the case may be) could be made personal liable for some or all of the debts incurred.

In determining the knowledge of the director as to whether or not the company was insolvent at the time, the director will be judged on the basis of:

  • the general knowledge skill and experience that can reasonably be expected of a person carrying out the same functions as carried out by that director in relation to the company; and
  • the general knowledge skills and experience that the direct actually has.

If the legislation is enacted as envisaged it will inevitably put greater pressure on directors who “should know better” than to allow a distressed company to continue trading without considering the position very carefully. At the same time, given recent case law, particularly that in particular the disqualification of directors, it appears unlikely that a director will be able to hide behind the excuse that he did not have sufficient information to be aware of the company’s position; (he should have made himself aware of the Company’s financial position); nor will he be able to hide behind the excuse that he did not have the necessary skills and experience; (in that case, he should not have been acting as a director in the first place).

Possible Defences

As with the legislation in the UK, it seems that the key defence that a director will be able to put forward is that he took all reasonable steps to prevent the company from incurring the debts referred to. It is also envisaged that if the director has taken steps to seek to rescue the company, possibly through the new provisional supervision process, that this will similarly constitute a defence to an insolvent trading case.

It is also likely that a good defence to an insolvent trading claim would be that the director, whilst allowing the company to continue to trade, took all the necessary steps to improve the company’s position; to return it to profitability; to reduce costs and to take such steps as were appropriate to improve as far as possible the position of the unsecured creditors.

Compensation

It is important to appreciate that an insolvent trading application can only be made by the liquidator of the company. The legislation only “kicks in” once the company has gone into insolvent liquidation. Importantly, the proposed legislation specifies that any compensation would not be subject to any pre-exising legal charge over the assets of the company, whether that be either a fixed or a floating charge, and would thus be available for the benefit of the unsecured creditors of the company.

Conclusion

When these provisions were first suggested, it was envisaged that “senior management” would also be subject to possible insolvent trading claims. For a variety of reasons, which make sense, that provision has now been removed from the draft legislation.

However it is imperative that the current version of the legislation is not watered down when it comes before LegCo.

Provisional supervision and insolvent trading go hand-in-hand. They form a “carrot and stick” approach.

The carrot for directors is that if the company is in difficulties they now have a formal corporate rescue process, that is provisional supervision, which can be utilised to create a moratorium to give the company or part of its business an opportunity to be rescued in one form or another.

The stick is that if the directors do not act in a responsible manner, i.e. when faced with an insolvent company, among other things they:

  • allow it to continue to trade;
  • to incur further credit which they know or must reasonably believe is not going to be paid;
  • where they cannot reasonably believe that it can avoid insolvent liquidation;
  • where they themselves benefit from the continuation of trading, particularly through the continued payment of their remuneration when creditors remain unpaid;

then they face the prospect of having personal liability imposed on them by the courts in respect to the debts of the company.

The hope is that the enactment of a robust Insolvent Trading regime will contribute materially towards the improvement of corporate governance in Hong Kong.