Creditors' and security holders' rights in China companies subject to winding-up under Hong Kong law

This article provides an overview of the rights and positions of creditors and security holders under Hong Kong law in relation to an entity that has been wound-up (the Wound-up Entity) and its related China company(ies) or person(s) (each a Related Entity) following a Court winding-up order.

Are you a creditor or security holder? Or both?

Under Hong Kong law, a creditor may be a person or an entity to whom the Wound-up Entity owes a current debt (e.g., a primary liability) and/or a contingent debt (e.g., a secondary liability). Examples include:

• A lender when the Wound-Up Entity is a debtor under a loan facility.
• A note or bondholder when the Wound-Up Entity is an issuer of notes or bonds.
• An obligee of a guarantor when the Wound-Up Entity is a guarantor under a guarantee for a third party's borrowing by way of a standard guarantee or a Keepwell Deed (see our earlier blogpost regarding enforceability of Keepwell Deeds here). Depending on the guarantee's and/or Keepwell Deed's terms and the default status of the underlying obligation, the obligee may be a contingent creditor or a current creditor.

A security holder may be an individual or an entity that has been provided with security in relation to the aforementioned debts. This security can take various forms, such as shares, real estate, bank accounts, or other receivables.
 

Scenario one: Where the Wound-Up Entity may be liable to the creditor

In ascertaining the legal position of a creditor or security holder, it is essential to review the terms of the underlying contractual documentation that give rise to the Wound-Up Entity's liabilities. The following aspects should be considered:

a. Has there been an "Event of Default"?

In most situations, a Wound-up Entity that has been in prolonged financial difficulties would have triggered an "event of default" as defined under most standard finance documents. This could be due to failure to meet financial requirements, inability to repay debts, or the making of a winding-up order, etc. That said, creditors should still carefully consider whether any "event of default" has been triggered under the specific contractual document. Creditors should also consider declaring any "event(s) of default" in accordance with contractual stipulations at the earliest opportunity to preserve their positions, even if amicable negotiations remain possible – see point (b) below.

b. Can you enforce the debt?

A creditor may not be immediately entitled to enforce the whole of its debt, or its security, even after an "event of default" has occurred.

There may be contractually stipulated prerequisites to enforcement, such as any requirement to first declare an "event of default" to accelerate any loans or crystallise any security.

In most syndicated loans, only the syndicate agent can take enforcement actions (whereas bilateral loans can be directly enforced by the lender).

Similarly, for creditors that are holders of notes or bonds issued by the Wound-up Entity, where trustees and multiple layers of intermediary agents may be involved, there is often a question of whether any enforcement action must be pursued by the note / bond trustee. In these situations, the legal question to ask is whether, as a note or bondholder, you have standing to enforce? If not, creditors will need to consider whether under the terms of the contractual documents a requisite percentage of likeminded noteholders is required, and accordingly obtain proper proofs of one's note-holding from relevant custodians and work with the trustee in taking enforcement actions (see our earlier blogpost regarding rights of noteholders to wind-up issuer company here).

c. Have you got everything needed to file a Proof of Debt?

Following a winding-up order, creditors of the Wound-up Entity must complete a Proof of Debt Form and submit it to the liquidator(s) of the Wound-up Entity (the Liquidator) together with any documentary evidence, such as the underlying contractual documentations, the latest balance of any debts and communications declaring an "event of default" (if applicable).

d. Are you an unsecured or secured creditor?

Unsecured creditors: Where the creditor's debt is unsecured or only partially secured, the creditor will typically have to wait for the Liquidators to realise all the Wound-Up Entity's assets. After (i) deducting the expenses of the liquidation and (ii) paying off the preferential creditors, any remaining funds will be distributed to unsecured creditors whose claims have been admitted. For many grossly insolvent companies, it is most likely that the remaining funds will be insufficient to fully satisfy debts owed to unsecured creditors, who will be left without further recourse.

Secured creditors: On the other hand, where a creditor is a security holder, that creditor will be considered a secured creditor for the purposes of the winding-up process. Secured creditors are generally entitled to be repaid from the enforcement of their security, outside of the winding-up pool of assets, and do not need to wait for the conclusion of the winding-up process to take their own enforcement actions, e.g., appointing a receiver over their security.

However, there may be instances where the security is insufficient to fully cover the amount of debt owed to a security holder. If there remains any unpaid balance after realisation of the security, a secured creditor is entitled to claim for the amount as an unsecured creditor in the general pool of assets. The considerations outlined elsewhere in this article for "unsecured creditors" would equally apply to such residual debts.

e. For secured creditors: Is the security subject to challenge?

For secured creditors, the timing of the security granted by the Wound-Up Entity can affect its validity and susceptibility to challenge by the Liquidators.

If the Wound-Up Entity granted security (i) while insolvent and with the intention to prefer a specific creditor over the other creditors, and (ii) within six months (or two years if the security holder is an associate of the Wound-Up Entity) before the commencement of the winding-up petition (the Commencement Date), the Liquidators may seek a declaration from the Hong Kong Court that the grant of security constitutes an "unfair preference". If the Hong Kong Court rules that there was an "unfair preference", then the Hong Kong Court may make such order as it thinks fit to restore the position to what it would have been if that security was not granted.

Direct evidence of the Wound-Up Entity's requisite desire to prefer is not required. The Hong Kong Court will draw inferences of such intention based on the relevant surrounding circumstances. However, such inferred intention to prefer may be displaced if it can be demonstrated that the grant of security was (i) granted by the Wound-Up Entity as a sensible way of ensuring its survival amidst financial difficulty, or (ii) granted as a result of commercial (or even moral) pressure exerted by the preferred creditor on the Wound-Up Company. Therefore, whether a security will be rendered unenforceable is a highly fact-sensitive question.

Relatedly, a floating charge created within 12 months prior to the Commencement Date will be invalid unless it is validated by the Court upon the benefitting creditor's application.

f. For unsecured creditors: Are repayments received in the past subject to challenge

For the same reason as stated in Section (e) above, repayments that an unsecured creditor received from six months to two years before the Commencement Date may be challenged by the Liquidator as unfair preference and clawed back.

g. For unsecured creditors: who should be the Liquidator? How should the liquidation be run?

Once a Hong Kong Liquidator is appointed over the Wound-Up Entity, its Hong Kong assets will be controlled by the Liquidator. Specifically, the Liquidator will seek to gain control over the company’s assets and subsidiaries in Mainland China by exercising Wound-Up Entity's rights as shareholder, and/or through the use of the Mainland-Hong Kong mutual recognition mechanism for insolvencies (which we wrote about here and here) or the common law regime for recognising and assisting foreign insolvency proceedings (which we wrote about here).

Different approaches to conducting the liquidation are possible. Many property sector companies will have numerous operating subsidiaries in Mainland China and Hong Kong. Often, some of these subsidiaries will remain viable going concerns. In some cases, unsecured creditors may prefer an approach to the liquidation that is more collaborative, i.e., seeking to work with the existing management to maximise creditor returns. In other cases, especially where the existing management is uncooperative or cannot be reached, then obviously a more hardline approach may be preferred. The creditors' preferences will be reflected in their nominations of Liquidator candidates, and their votes for those candidates at the first creditors' meeting.
 

Scenario two: Where the Wound-Up Entity is not itself liable to the creditor, but another Related Entity is

General Position: Unless contractual documents explicitly state otherwise, the winding-up of the Wound-Up Entity should not directly impact a creditor's position in respect of a debt owed by a Related Entity. This is due to the doctrine of separate legal personality, whereby the insolvency or liquidation of one company within a group does not automatically affect the solvency or viability of other group companies.

Special Circumstances: However, certain contractual provisions may render the winding-up of the Wound-Up Entity relevant to the creditor's position with respect to Related Entities. Some potential scenarios include:

i. Liquidation of the Wound-up Entity is an "event of default"

There may be provisions in contractual documents which could make the winding-up of the Wound-up Entity relevant to the dealings between the creditor and a Related Entity. For example, there may be "cross-default" clauses in contractual documents whereby the winding-up of the Wound-Up Entity constitutes an "event of default" in the contract between the creditor and a Related Entity.

In such circumstances, the creditor may be entitled to declare an "event of default" or otherwise call on or accelerate the debt owed. However, the debt will still be owed by a Related Entity rather than by the Wound-up Entity. Therefore, the considerations set out in "Scenario One" above would not be relevant as the claim would be against the Related Entity (which may well be in financial difficulty itself, but not automatically wound-up because of its relationship with the Wound-up Entity).

ii. Competition for assets with other creditors of the Wound-Up Entity and/or the Liquidator

A Related Entity may have acted as security provider, guarantor or Keepwell Deed providers for the Wound-up Entity for loans and other contractual arrangements which have mostly likely defaulted by this point. Given the challenges, uncertainties, and time delay in enforcement in a winding-up context outlined above, such creditors may look to the Related Entity for enforcement instead. This is particularly so in light of the Hong Kong Courts' recent recognition of the enforceability of Keewell Deeds (although their enforcement may be subject to supervening events and to approval from relevant PRC authorities). This could in turn affect the solvency and ongoing viability of these Related Entities.

Furthermore, for many group companies, the Wound-up Entity may act as a holding company and therefore its key assets could be its indirect interests in a Related Entity rather than material assets (e.g., bank balances, goods and receivables). It is therefore not uncommon for the Liquidator to seek to take control of and thereafter realise valuable assets of a Related Entity to facilitate the liquidation of the Wound-up Entity, thereby significantly impacting the financial status and viability of such Related Entity.

Relatedly, the Hong Kong Courts have held that a freezing order (i.e., a Chabra injunction, which we wrote about here) could be granted against a Related Entity that is a solvent wholly-owned subsidiary of an insolvent holding Wound-Up Entity, if the assets of the Related Entity can be said to be susceptible to enforcement by creditors or by the winding-up of the Wound-Up Entity eventually.

Creditors of a Related Entity should revisit the relevant terms of the contractual documents to check whether they would have priority or preference over other creditors and/or the Liquidator, and whether there are any steps that should be taken to prevent losing out to other competing creditors and/or the Liquidator. Ultimately, time is of the essence.
 

Conclusion

For creditors and security holders, understanding the rights and positions of creditors and security holders under Hong Kong law is crucial for assessing potential remedies and recouping outstanding debts as illustrated by recent cases involving the Chinese real estate sector.