The interplay between insolvency and arbitration proceedings in Hong Kong

Pre-Lasmos approach

The Court may exercise its discretion under the insolvency legislation to dismiss or stay a winding up or bankruptcy petition where the alleged debt arises out of a transaction containing an arbitration agreement. Prior to the Lasmos case, in order to successfully challenge the winding up or bankruptcy proceedings, the debtor must establish that there is a bona fide dispute of the debt on substantial grounds¹. The test is the same as all other types of winding up or bankruptcy cases when the court is faced with the question of whether a debt is owed.

The Lasmos approach

In light of the development in this area of law in England² and Singapore³, the Companies Court departed from the earlier approach and held in the Lasmos case that save for exceptional circumstances, a creditor’s petition should generally be dismissed if:

1. A company disputes the debt relied on by the petition;
2. The contract under which the debt is alleged to arise contains an arbitration clause that covers any dispute relating to the debt; and
3. The company takes the steps required under the arbitration clause to commence the contractually mandated dispute resolution process (which might include preliminary stages such as mediation) and files an affirmation in accordance with r 32 of the Companies (Winding-Up) Rules (Cap 32H).

The Court explained that the new approach may be departed in exceptional circumstances such as:

1. Where a creditor can demonstrate a prima facie case for a winding up and a risk of misappropriation of assets or some other matter which would normally justify the Court appointing provisional liquidators, a petition could be issued and stayed (other than for applications relevant to the provisional liquidation) pending determination of the arbitration.
2. Where there are circumstances in which the early presentation of a petition is justified in order to engage the referral back provisions in s184(2) of Cap 32 because of substantiated concerns that there had been fraudulent preferences or to engage the avoidance provisions on void disposition in s182.

The two Court of Appeal cases

Kwan JA was the appeal judge giving the reasons for the Court of Appeal’s judgment in both cases.

But Ka Chon case

Upon failing to resolve the deficit in his margin account maintained with the petitioner in January 2015, the debtor was served with a statutory demand in December 2016. The debtor sought to set aside the statutory demand under the Bankruptcy Ordinance (Cap 6) on the grounds that (i) there is a counterclaim for misrepresentation and (ii) the dispute should be arbitrated as the customer agreement contains a mandatory arbitration clause. The Court of Appeal agreed with the first instance judge that the misrepresentation claim has no merit. The Court of Appeal further held that even if the Lasmos case was applicable, the third requirement was not complied with because the debtor took no steps to commence arbitration for more than four years apart from issuing a letter in December 2016 asking if the petitioner’s solicitors had instructions to accept service of a Notice of Arbitration.

The Court of Appeal had reservations on the Lasmos approach and gave the following obiter comments:

1. A winding up/bankruptcy petition is not covered by article 8(1) of the UNCITRAL Model Law on International Commercial Arbitration⁴. There is no automatic, mandatory or non-discretionary stay of winding up or bankruptcy proceedings where the underlying contract or transaction is the subject of an arbitration agreement.
2. The Court has a discretionary power to exercise under the insolvency legislation whether to dismiss or stay a petition where the alleged debt arises out of a transaction containing an arbitration agreement.
3. The Lasmos approach decided that the discretion under the insolvency legislation should be exercised only one way – the petition should generally be dismissed upon satisfying the three requirements save in exceptional or wholly exceptional circumstances.
4. A creditor has a statutory right to petition for bankruptcy or winding up on the grounds of insolvency. Although not an outright preclusion from invoking the insolvency jurisdiction of the court, the Lasmos approach is a substantial curtailment of a creditor’s statutory right.
5. The East Carribbean Court of Appeal declined to adopt the Salford approach, as the BVI court’s statutory jurisdiction to wind up a company based on its inability to pay its debt as they fall due unless the debt is disputed on genuine and substantial grounds is too firmly a part of BVI law to now require a creditor exercising the statutory right to prove exceptional circumstances to establish his status to apply to wind up a company. The statutory jurisdiction is satisfied once the creditor is applying on the basis of a debt that is not disputed on genuine and substantial grounds. The position is the same as regards the legislation in Hong Kong.
6. Considerable weight should be given to the arbitration factor in the exercise of the discretion, which was not the case pre-Lasmos. The exercise of the discretion should not encourage parties to an arbitration agreement to present winding up petitions as a tactic to bypass the arbitration agreement and the arbitration legislation. Also, even where the Court is satisfied that there is no bona fide dispute on substantial grounds, the discretion should not be invariably exercised in favour of granting winding up order or bankruptcy order thereby putting an end to any arbitration proceedings.

Sit Kwong Lam case

The debtor is the indirect controlling shareholder and chairman of a listed company in Hong Kong which has a Singapore subsidiary. A personal guarantee (PG) was executed by the debtor to guarantee outstanding trade debts owed by the Singapore subsidiary to a supplier. The Singapore subsidiary failed to pay trade debts by July 2018 and entered into a settlement agreement with the supplier. Pursuant to the terms of the settlement agreement, the debtor executed an addendum to the personal guarantee (PG Addendum) to extend the coverage of the guarantee to the settlement agreement. Upon the Singapore subsidiary failing to discharge the payment obligations under the settlement agreement, the supplier served a statutory demand on the appellant on 12 September 2018 and presented a bankruptcy petition on 23 October 2018.

The debtor opposed the petition on the grounds that the arbitration clause in the settlement agreement was incorporated by reference to the PG Addendum and therefore the court’s discretion should be exercised to stay or dismiss the petition. Two important facts are that:

1. Clause 4 of the PG Addendum provides that “All other terms and conditions of the PG, including the arbitration clause shall remain unchanged and this Addendum shall constitute an integral part of the PG”. (emphasis added)
2. There is no arbitration clause in the PG and the only arbitration clause is found in the settlement agreement.

The Court of Appeal agreed with the first instance judge that the mistake in Clause 4 of the PG Addendum should be cured by deleting the words “including the arbitration clause”.  The Court of Appeal also decided that even if the Lasmos approach is applicable, the third requirement was not satisfied. On the facts, the debtor was aware of the requirements in Lasmos but did not take steps to commence the arbitration process nor did he suggest there was any obstacle in taking those steps.

To discourage debtors from making opportunistic attempts to invoke the Lasmos approach, the Court of Appeal made the following obiter comments:

1. In order to show that the debtor has a genuine intention to arbitrate, all that is required under the Lasmos approach is that he has taken the steps under the arbitration clause to commence the arbitration process, which may include preliminary stages such as mediation and file an affirmation in accordance with rule 32 of Cap 32H. Citing the But Ka Chon decision⁵, the Court of Appeal emphasised that “it would make no sense to dismiss or stay an insolvency petition on the mere existence of an arbitration agreement when the debtor has no genuine intention to arbitrate”; and
2. The fact that the debtor has no substantive claim against the creditor is immaterial because the debtor can refer the dispute to arbitration and seek a declaration of non-liability in respect of the alleged debt.

Take away points

• The correctness of the Lasmos approach remains to be determined in a future Court of Appeal decision.
• The Court of Appeal has reservations about the Lasmos approach in which the Court’s discretion is to be exercised only one way to stay or to dismiss the winding up or bankruptcy petition.
• Before the Lasmos approach is determined in a future Court of Appeal case, debtors resisting statutory demands and insolvency proceedings on the basis of an arbitration agreement should:

1. Check whether there is a valid arbitration agreement in place to cover the disputed debt;
2. Commence arbitration or other processes set out in the arbitration agreement or dispute resolution clause to show that there is a genuine intention to arbitrate.  This should be done even where the debtor has only a defence of the disputed debt with no counterclaim.

¹  See for example Hollmet AG v Meridian Success Metal Supplies Ltd [1997] 4 HKC 343 ²  Salford Estate (No 2) Ltd v Altomart Ltd (No 2) [2015] Ch 589 (decision of the English Court of Appeal) followed by Eco Measure Market Exchange Ltd v Quantum Climate Services Ltd [2015] BCC 877 
³  BDG v BDH [2016] 5 SLR 977
⁴  Adopted in Hong Kong as section 20 of the Arbitration Ordinance (Cap 609)
⁵  At paragraph 53 of But Ka Chon v Interactive Brokers LLC [2019] 5 HKC 238 and Re Golden Oasis Health Limited [2019] HKCFI 2173 at paragraph 40