The Hong Kong Court of Final Appeal considers principles of Quistclose trust

The recent Court of Final Appeal (the "CFA") case of China Life Trustees Limited v China Energy Reserve and Chemicals Group Overseas Company Limited [2024] HKCFA 15 provides an authoritative and thorough analysis of the principles governing whether a Quistclose trust arises in relation to intra-group transfer of funds, highlighting potential pitfalls faced by creditors. In particular, this case clarifies the legal position in Hong Kong, having regard to the English judgments on the topic of Quistclose trust.  

Background

This case concerns two series of bonds issued by two SPVs of the China Energy Group (the "Group"), being the 2018 Bonds and the 2022 Bonds. The Group lacked the funds to pay the principal and interest when the 2018 Bonds matured. In response, the Group attempted to procure funds, but was only able to raise US$120 million (the "Funds").

To that end, the Group's treasury company (the "Treasury") arranged for the Funds to be transferred into the US dollar sub-account (the "Account") of SPV1. However, the Group's failure in raising sufficient funds led to cross-defaults on its other bonds, including the 2022 Bonds. Ultimately, the Funds had remained in the Account.

The sole bondholder of the 2022 Bonds, China Life Trustees Limited ("China Life"), subsequently obtained (i) a judgment against SPV1 with regard to the 2022 Bonds; and (ii) a garnishee order nisi in respect of the Funds in the Account. China Life contended that the Funds belonged to SPV1, and China Life was therefore entitled to enforce against the Funds by virtue of the judgment and garnishee order obtained.

However, the bondholders of the 2018 Bonds (the "Appellants") sought to set aside the garnishee order on the basis that the Funds were subject to a Quistclose trust, i.e. the Funds did not belong to SPV1 and shall be used by the Group in its restructuring. While the Appellants' argument was dismissed at first instance by Au-Yeung J and was again rejected by the Court of Appeal, the Court of Final Appeal unanimously allowed the appeal and held that a Quistclose trust existed.

The relevant principles

After detailed consideration of the relevant case law on Quistclose trust, the CFA summarised the relevant principles as follows:

1. A Quistclose trust is established where the payer objectively intended that the money be used solely for a specific purpose and should not be at the recipient's free disposal. If that specific purpose fails, the money is returnable to the payer.
2. This mutual intention may be established either (i) by express stipulation; or (ii) impliedly, where the payment is made in circumstances which, on the evidence, objectively justify the inference that the payment was intended to be subject to the restrictive conditions.
3. Where the mutual intention, and accordingly, a Quistclose trust are found, these consequences would follow:
   1. Beneficial ownership of the money is not transferred to the recipient, and the recipient takes it in a fiduciary capacity to apply it only for the specific purpose. Thus, applying the funds for purposes outside of the specific purpose would constitute a breach of the recipient's fiduciary duty owed to the payer.
   2. If the specific purpose fails, the recipient holds the funds on a resulting trust to restore them to the payer. 
   3. In the context of an insolvency, as the money is not the recipient's property, it does not pass to the recipient's trustee in bankruptcy.
4. Having considered the English judgment of Prickly Bay Waterside v British American Insurance [2022] 1 WLR 2087, the CFA concluded that, contrary to the decision of the Court of Appeal, a payer need not intend to retain some beneficial interests in the funds to establish a Quistclose trust. The retention of beneficial interests is a consequence of, rather than a requirement for, finding a Quistclose trust.
5. The above principles apply equally to intra-group transfers, without any additional requirements.

Decision

Based on the above principles, the CFA found that on the facts, the Funds were held by SPV1 under a Quistclose trust for the Treasury. In particular:

1. The Funds were to be used solely for paying off the 2018 Bonds and was not intended to become part of SPV1's general assets or to be used freely at SPV1's disposal.  
2. The Funds were held by SPV1 on trust for the Treasury for the purposes of the Group, following the failure of the specific purpose.
3. Where intra-group transfers are made as "fire-fighting" measures pursuant to restructuring plans, it is assumed that the group companies are aware that the sole purpose for each transfer would be to "rescue" the group. In these circumstances, the group companies are not expected to expressly spell out the intended purpose of the transfer, or to stipulate that the payer reserves a beneficial interest in the money transferred. Thus, the absence of an express restrictive stipulation in intra-group transfers would not negate the finding of a Quistclose trust.  

Comments

This CFA case will likely be of interest to group companies which could take comfort in knowing that the Hong Kong courts recognise the nature and purpose of intra-group transfers, particularly in the context of a restructuring.

On the other hand, the key takeaway for lenders is that lenders should always consider including a well-drafted purpose clause in loan agreements. If the specific purpose of the amount advanced is clearly stipulated in the loan agreements, it would likely assist with recoverability of any outstanding sums due, in circumstances where the amount advanced is not applied for the specific purpose.

Lastly, judgment creditors should also be aware that the enforcement process for even the most straightforward debt claim may not come without risk. As demonstrated in this CFA case, assets seemingly available for enforcement may be subject to a Quistclose trust, which would defeat any enforcement action as the Court would not allow funds that do not belong to the judgment debtor to be applied to satisfy the judgment debt.

For further information, please contact Jojo Fan, Partner, Rachael Shek, Partner, Veronica So, Senior Associate, Timothy Shaw, Senior Associate, Cheryl Mok, Associate, or your usual Herbert Smith Freehills contact.