Potentially Voidable Transactions in Hong Kong Liquidations

By Wong Teck Meng

In recent months we have come across several situations where directors of companies have got themselves into difficulties – simply because they were trying to help the company get out of its difficulties. In this post we will explain how those difficulties arose and offer some practical advice as to how directors and other potential lenders can avoid getting themselves into these situations.

It is not uncommon for directors of a company, when it is in financial difficulties, to advance funds to the company in the hope that it can avoid going into liquidation. This is all well and good and directors should be encouraged to support an ailing company in the hope that its fortunes can be turned around. The problem arises when directors fail to seek professional advice prior to advancing money to an insolvent company, but then at the first opportunity are repaid, often in priority to the general body of creditors.

Unfair Preference

There is no suggestion that it is the intention of the lender is to prefer themselves, but that is what they are doing. The lender’s argument is that had the money not been advanced to the company, it is possible that it would have failed with the result that all creditors would have been worse off. This is a logical argument, but unfortunately comes unstuck if the company does eventually go into liquidation. At this point the liquidator will investigate the transaction and is likely to conclude the following:

  • that the company was insolvent at the time when the repayment was made;
  • that the party which was repaid was a creditor of the company;
  • that when the repayment was made, the creditor was put in a better position than the other creditors; and
  • if the lender was a director, who was in control the company (in the parlance of the legislation he was an associate), that the company in making the repayment was influenced by a desire to prefer the director.

Once these four criteria are established, it is only a matter of time before the liquidator seeks repayment from the director. The liquidator can go back as far as two years to unwind such a transaction if it is in favour of a director.

The Practical Solution

The question that arises is what can a lender do in the circumstances.

In commercial terms it is difficult for a lender, particularly if he is a director, to justify lending money to the company but seeking its early repayment ahead of external creditors. What a lender can do, is at the time he advances the money, ask the company to give him security over its assets. The purpose of the security is to ensure that if, at some time in the future, the company does go into liquidation, the lender can look to the security for repayment of the advances.

What we sometimes see is that a lender asks the company to create a floating charge in return for advancing funds to enable the Company’s operations to continue. In broad terms, a floating charge gives the holder of the charge security over all of the company’s movable assets such as plant and equipment, inventory, accounts receivable and office equipment. In the event of a liquidation, the holder of a floating charge is entitled to look to the proceeds of realisation of these assets for payment of the outstanding advance. However, it is important to note that the claims of preferential creditors have to be paid first out of the proceeds of realisation of these assets before any payment can be made to the floating charge holder.

Effect of Floating Charges

It is also important to note that floating charges created within 12 months of the commencement of the winding-up are invalid unless the company was solvent immediately after the creation of the floating charge.  If the company was insolvent, the floating charge may be wholly or partially valid if the lender is able prove that:-

  • cash was advanced to the company;
  • the cash was paid at the time of or after the creation of the charge; and
  • the cash was paid in consideration of the charge being granted.

Conclusion

When deciding to take this course of action there are two issues which are of crucial importance. The first is to ensure that the floating charge and the associated loan agreements are properly drawn up and that the floating charge is registered with the Companies Registry within the prescribed time period. Failure to register the charge within 1 month of its creation can render it invalid in the event of the company going into liquidation. Secondly, the funds should not be advanced to the company until such time as the floating charge documentation has been drawn up. If the monies are advanced and then a floating charge is subsequently created, it is highly likely that its validity will be challenged by any liquidator who might be appointed in due course.

Needless to say, we would recommend that legal advice be sought regarding the loan agreement and  the floating charge to ensure that the interests of the lender are properly protected.