"Outmoded" parallel schemes of arrangement and a red flag on restructuring costs in Hong Kong

The Court of First Instance has recently helpfully summarised the legal position on schemes of arrangement under both Hong Kong law and English law. Notably, it has called for further development in cross-border coordination in order to avoid the trouble of parallel insolvency proceedings and it has raised a red flag in relation to detailed disclosure of restructuring costs: Da Yu Financial Holdings Limited [2019] HKCFI 2531.

Background:

Da Yu Financial Holdings Limited (the “Company”) is a company incorporated in the Cayman Islands, registered in Hong Kong as an overseas company and listed on the Hong Kong Stock Exchange.

The Company was liquidated with its only remaining substantial asset being its Hong Kong listing status. With a view to realising the value of the listing status for the benefit of creditors, the liquidators found an investor to pursue a restructuring and resume trading of the Company’s shares. As part of the proposed restructuring, the Company would acquire another business, Yu Ming Investment Management Limited, reduce its capital and issue new shares to investors. The proceeds of the shae issue would be used to pay for the business acquisition, the restructuring and liquidation expenses, and the Company's existing indebtedness. Proceedings for parallel schemes of arrangement were on foot in Hong Kong and the Cayman Islands, both of which were sanctioned.  The Hong Kong petition was sanctioned on the condition that the Company's restructuring and liquidation expenses would be subject to taxation and the cost savings resulting from the taxation process would be distributed to the scheme creditors. The Court granted a permanent stay for the winding-up of the Company.

Decision:

Legal position in Hong Kong

The Hong Kong Court has an unfettered discretion to sanction a scheme, but the following factors should be taken into account:

1. whether the scheme is for permissible purpose;
2. whether the creditors called onto vote as a single class had sufficient similar legal rights that they could consult together with a view to their common interest at a single meeting;
   • the test focuses on "rights" – whether there are material dissimilarities in these rights; and if so, whether these dissimilarities are so great that it makes it impossible for the holders of these differing rights to confer together because there is no community of interest;
3. whether the meeting was duly convened in accordance with the Court's directions;
4. whether the creditors have been given sufficient information about the scheme to enable them to make an informed decision;
5. whether the necessary statutory majority was obtained;
6. whether the Court is satisfied in the exercise of its discretion that an intelligent and honest man acting in accordance with his interests as a member of the class within which he voted might reasonably approve the scheme; and
7. in an international case, whether there is sufficient connection between the scheme and Hong Kong, and whether the scheme is effective in other relevant jurisdictions (as it would not be a proper exercise of discretion to sanction a scheme that serves no purpose).

Legal position in England & Wales

The English position consists of 5 stages, as follows:

1. Stage 1: compliance with statute, including issues on class composition, statutory majorities, adequate explanatory statement to creditors, etc.;
2. Stage 2: proper class representation, including questions of whether the class is fairly represented, whether there was any coercion on the minority;
3. Stage 3: fairness, whether the scheme is an arrangement that an intelligent and honest man, a member of the class concerned and acting in respect of his interest, might reasonably approve;
4. Stage 4: blot on the scheme, whether there are any technical or legal defects; and
5. Stage 5: international effectiveness, whether there is sufficient connection between the scheme and England, and the prospect of the scheme having real effectiveness.

Adopted approach in Hong Kong

The Court of First Instance considered the 7 factors under Hong Kong law mentioned above and added a factor from the English approach i.e., whether there were any "blots" on the Scheme. The Court was satisfied that all 8 requirements were met in this case.

The Court discussed, in particular, the issue on the apportionment between the rate of return to scheme creditors and the expenses for restructuring and liquidation. In considering this issue, the Court looked at two specific aspects: "permissible purpose" and "sufficient information".

On "permissible purpose"

The Court considered that if the amount recovered was contributed mostly towards the expenses of the restructuring and liquidation, instead of going to the scheme creditors, it might not be sensibly submitted that the purpose of the scheme was for the benefit of the scheme creditors. However, the Court did not consider it appropriate to lay down a hard and fast rule / precise percentage of the apportionment. The Court instead considered that it is an issue to be decided on a case-by-case basis, depending on the complexity of the scheme.

On "sufficient information"

In the explanatory statement given to the scheme creditors, there was only a one line statement listing out the costs of restructuring with no breakdown. The Court held that there should be a detailed breakdown of all costs incurred in the restructuring for the Court meaningfully to assess the reasonableness of such costs. The Court, however, stated that in spite of the lack of disclosure of information in the current case, it would not be right to withhold its sanction and leave the scheme creditors with nothing. The Court accordingly sanctioned the scheme on the condition that the expenses be subject to taxation and the cost savings resulting from the taxation process be distributed to the scheme creditors.

Future improvement of the law on cross border coordination

The current legal framework makes parallel schemes of arrangement necessary in both the place of incorporation of a company and the place where it operates its business. This is to ensure that the scheme creditors do not disrupt the smooth operation of the scheme by taking hostile action against the company in other jurisdictions. Deputy High Court Judge William Wong SC calls for a substantive recognition internationally of foreign schemes of arrangement in offshore jurisdictions in order to phase out parallel proceedings which he opines is an outmoded way of conducting cross-border restructuring and an antithesis of cross-border insolvency cooperation.

Key messages:

More attention should be paid to the apportionment of proceeds from a restructuring in a scheme of arrangement. If most of the proceeds go to cover the costs of the restructuring resulting in a low rate of return to scheme creditors, it might be difficult to argue that the restructuring is for the benefit of those creditors. The breakdown of such costs and the proceeds of the restructuring should be set out in the explanatory statement in detail for the scheme creditors to assess the reasonableness of such costs.

The current law on schemes of arrangement is not satisfactory. It still necessitates parallel schemes in both the main jurisdiction and the offshore jurisdiction, which is an outdated practice in conducting cross-border restructuring. A development in this area of law is necessary and a substantive recognition in the offshore jurisdictions of foreign schemes of arrangement could be the way forward.