Transactions at undervalue and unfair preferences - how will the Court interpret s49 and s50 of the Bankruptcy Ordinance?

In Wong Tak Man, Stephen & Another v Cheung Siu Fai & Ors [2015] HMP 1431/2012, the Court held that transfers of funds made by a bankrupt were not transactions at undervalue or unfair preferences pursuant to s49 and s50 of the Bankruptcy Ordinance (the "BO"). This case serves as a useful reminder on how the Court will interpret s49 and s50 BO, as deemed to be applied in a corporate context by s.266B(1)(a) of the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap 32).

Facts 

The bankrupt began trading securities in the late 1990s and had a number of accounts with brokerage houses in Hong Kong, particularly Quam Securities Company Limited ("Quam"). His elder brother was the 1^st Respondent. In July 2007 the bankrupt suffered substantial losses through securities and futures trading and in August 2008 owed Quam $17 million. On 25 August 2008 Quam petitioned for the bankrupt's bankruptcy.  

The trustee in bankruptcy ("Trustee") identified a number of mutual payments between the bankrupt and the 1^st and 2^nd Respondents (and other third parties) between 2003 and 2008. The Trustee was particularly interested in forty-six payments made by the bankrupt to the 1^st and 2^nd Respondents between 2003 and 2008 in the sum of c. $39 million ("Payments"). Payments were made in both directions during this period.

The Trustee sought a declaration that i) the Payments should be set aside as transactions at undervalue pursuant to s49 BO or, alternatively, ii) the Payments should be set aside as unfair preferences pursuant to s50 BO.

The Court's jurisdiction

S49 and s50 BO govern transactions at undervalue and unfair preferences respectively. Where a debtor is adjudged bankrupt and has at the relevant time entered into a transaction with any person at undervalue or given an unfair preference, the Court may make an order to restore the position as if he had not entered into that transaction or preference.

The relevant time is five years prior to the date of the bankruptcy petition for transactions at undervalue. This is shortened to 2 years (if the preference is given to an associate) or 6 months for unfair preferences. Further, a transaction or preference will only be within the relevant time where the debtor is insolvent at the time of the transaction or becomes insolvent as a result of the transaction or preference.

A transaction will only be an unfair preference where the bankrupt was motivated by a desire to prefer.  

Arguments of the Trustee and the 1^st and 2^nd Respondents

The Trustee advanced two arguments; i) the Payments were gifts and were therefore transactions at undervalue pursuant to s49 BO or, alternatively, ii) the Payments were loan repayments which were caught by s50 BO as unfair preferences.

The 1^st and 2^nd Respondents denied that the Payments were gifts or loan repayments. They argued that the bankrupt was running a private investment firm and the Payments were returns on their investments. As such, the money belonged to the Respondents beneficially and did not fall within the scope of the bankruptcy regime.

Issues before the Court

The Court considered the following questions in reaching its decision:

Transactions at undervalue

1. Were the Payments gifts which would come within the scope of s49 BO?
2. If the Payments were gifts, did the Trustee show that the bankrupt was insolvent at the time of the Payments or became insolvent as a result of the Payments?

Unfair preferences

3. Were the Payments loan repayments which would come within the scope of s50 BO? Or did the 1^st and 2^nd Respondents have a proprietary interest in the money, thereby bringing the payments outside the scope of the BO?
4. If the Payments were loan repayments, did the Trustee show that the bankrupt was insolvent at the time of the Payments or became insolvent as a result of the Payments?
5. Did the bankrupt have a desire to prefer the Respondents?

Judgment

The Court reached the following conclusions on the issues:

Transactions at undervalue

1. The Court heard evidence from both parties as to whether the Payments were gifts. The 1^st and 2^nd Respondents argued that the Payments were not gifts but rather a return on their investment in the bankrupt's investment fund. They argued that whilst they had been generous with their money, they had always expected to be repaid. The Court held that the bankrupt was running an informal investment fund and that the Payments were investments in the fund or payments to assist the bankrupt. The Payments were not gifts for the purposes of s49 BO.
2. The Payments were not transactions at undervalue for the purposes of s49 BO and therefore the Court did not consider this question. 

Unfair preferences

3. The Court held that if the Payments were loan repayments pursuant to a proprietary interest, the Respondents would have a beneficial interest in the funds and therefore they would not be caught as unfair preferences under section 50 BO. However, the Court held that there was limited evidence to suggest that the Payments were made as a result of the Respondents' proprietary interest in the money. A proprietary interest can only arise where the assets are identifiable but, given the structure of the bankrupt's fund, no particular client could claim ownership to specific funds. The bankrupt's obligation to repay was therefore personal rather than proprietary and was caught by section 50 BO. 
4. By virtue of section 51(2) BO a transaction cannot be impugned as an unfair preference unless the debtor was insolvent or became insolvent as a consequence of the preference. The burden of proving insolvency lies with the person who seeks to invalidate the preference. Both parties appointed experts who could not reach a definitive conclusion as to when the bankrupt became insolvent. However, after weighing up both expert reports, the Court held that it was likely the bankrupt was insolvent from August 2006 onwards. Section 51(2) BO was therefore satisfied for payments made between August 2006 and August 2008. 
5. By virtue of section 50(5) BO there is a rebuttable presumption that a debtor who has given an unfair preference has been influenced by a desire to prefer. The Court held that there was no evidence that the bankrupt exercised a desire to prefer the Respondents because a) the payments to the Respondents were nothing out of the ordinary, b) the payments were made in both directions (i.e. it would be odd for the bankrupt to ask the Respondent to lend him money when he knew he was bankrupt) and c) the bankrupt made payments to other third parties as well as the Respondents. There was thus no desire to prefer and the Payments were not unfair preferences for the purposes of section 50 BO.

Conclusion

This case is an interesting example of how the Court will interpret s49 and s50 BO. The Court will follow the matrix of the statute to apply each criteria to the facts systematically.

Practitioners should also note the requirement to prove that the bankrupt was insolvent or became insolvent as a result of the transaction or preference. This case demonstrates that this can be difficult to prove and may require expert evidence, adding to the costs of the litigation.

If you wish to discuss this case or any other matter, please contact Gareth Thomas, Damien Whitehead or your usual Herbert Smith Freehills contact.