Hong Kong’s corporate rescue marathon – Are we approaching the finishing line?
Credit crunches and sudden economic downturns can quickly undermine businesses in difficult times, but some businesses may be able to survive short-term financial difficulties if an effective corporate rescue process is available. This article will take you through the corporate rescue practices established over the years in Hong Kong and explains why the marathon to establish a statutory corporate rescue procedure has yet to cross the finishing line.
Before the onset of the Asian Financial Crisis in 1998, the average number of winding-up orders made by the High Court in Hong Kong for the decade before 1998 was about 400. In 2003/ 2004, company collapses stood at the peak of over 1,200 after the outbreak of the SARs epidemic. In 2008/ 2009, company failures fell to about 550 cases after the collapse of Lehman Brothers. Winding-up orders made in 2012 dropped to around 300 cases.
One key factor which contributed to the rising number of corporate collapses after the financial crisis was the lack of a corporate rescue regime in Hong Kong. The Companies Ordinance (Cap 32) and its subsidiary legislation provides comprehensive rules to deal with solvent and insolvent liquidations for both registered and unregistered companies. However, there is a lack of a modern legal framework designed to save troubled companies from the fate of liquidation and, at the same time, balance the interests of creditors.
Corporate rescue – the Hong Kong approach
Traditionally, any default of payments on loans or failure to serve interest on debts by companies has triggered lenders, in particular bank creditors, to protect their interests by imposing an immediate suspension or termination of all financial support. Since the debtor companies are already struggling on extremely tight cash flow positions, few businesses survive this termination of credit.
The high number of company failures resulting from these arrangements triggered concern among major bank creditors to find alternative solutions to prevent debt-ridden companies from sinking in this way – thereby preserving business value for a better return to creditors. Quite often, informal meetings among key creditors were called at short notice aiming to highlight key problems and bring in experienced restructuring and insolvency specialists for an urgent corporate health check and to recommend viable solutions to the debtor company.
In the absence of fraud or criminal allegations, this positive move in many instances safeguarded viable businesses as well as jobs for employees through a successful corporate rescue. This practice was widely adopted in many corporate work-outs and eventually resulted in the publication of a corporate rescue guideline, namely the Hong Kong Approach to Corporate Difficulties, jointly issued by the Hong Kong Monetary Authority and the Hong Kong Association of Bankers in late 1999 which standardised the best practices at that time.
Essentially, the Hong Kong Approach to Corporate Difficulties promoted a supportive initiative led by bank creditors to maintain liquidity support to the borrower until well-informed decisions could be made to determine its prospects collectively by the bank creditors involved. Key to the success of this approach was the allowance of some breathing space on a consensus basis at the early stage, which prevented a financial crisis or a complete meltdown of the debtor company.
However, the Hong Kong Approach to Corporate Difficulties was only a voluntary and non-binding process. Other creditors, having diverse rights and interests, sometimes felt that their concerns were not considered at the outset and sometimes they were not even notified of the initial meetings. At best, these creditors pushed for separate meetings with the company in distress, but at worst, they petitioned for a court winding-up procedure to protect their interests.
Employees, typically with a mixture of preferential and unsecured claims, often find it unattractive to prolong their suffering by allowing time to proceed with corporate restructuring. Employees can apply for ex-gratia payments from the Protection of Wages on Insolvency Fund, which quickly alleviates their immediate financial needs. These payments are triggered upon the filing of a winding-up petition, rather than the discretionary process assessed on merit for companies undergoing restructuring where no liquidation proceedings have commenced. the marathon to establish a statutory corporate rescue procedure in Hong Kong has already taken over 16 years
Appointment of provisional liquidators and schemes of arrangement
This ‘tug of war’ between creditors trying to protect their interests is certainly unhelpful where companies are fighting to stay afloat. Over the last decade or more, the appointment of provisional liquidators though a court application (Section 193 of the existing Companies Ordinance) by debtors or creditors was well regarded as a practical solution, pursuant to which a moratorium to stay legal proceedings was achieved automatically by operation of law unless with leave of the court (Section 186). This mechanism was complementary with the procedures set out in the Hong Kong Approach to Corporate Difficulties in most if not all restructuring attempts.
A typical Hong Kong corporate restructuring process therefore begins with the searching for a white knight investor and ends up with a rescue proposal through a scheme of arrangement (Section 166). Approval of a scheme of arrangement requires a majority in the number of creditors voting in favour of the proposal and they must represent at least three quarters of the value in question. A scheme of arrangement sanctioned by the court will bind other creditors holding opposite views to the scheme. Restructuring through a scheme of arrangement has become a practical tool for the corporate rescue of large-scale or listed companies but it is rarely used for an SME as it can be complex and costly. Contractual debt rescheduling or composition have also been used to rescue troubled businesses but the absence of a moratorium on debt demands remains a major obstacle.
Establishing a statutory corporate rescue procedure
‘Provisional supervision’ was first recommended as a corporate rescue procedure in the 1996 Law Reform Commission’s Corporate Rescue and Insolvent Trading report. Provisional supervision provides for a moratorium on debt demands for companies in corporate rescue. In 2000 and 2001, bills were proposed to the Legislative Council but the proposed law on provisional supervision was not enacted mainly due to the diversity of views regarding the treatment of employee entitlements.
The bills proposed either a full payment of all employee claims before the commencement of a provisional supervision, or a trust account to be set up in advance with money sufficient to fully pay all employee debts. It is not difficult to understand why this proposal did not appeal to investors. For companies which are either labour- intensive or employ high-ranking professionals selling financial products or services, employment debts could be significant. Investors are generally reluctant to provide funding solely for payment to employees and would rather ease the cash flow needs of the troubled organisation to maintain operations during the restructuring.
A further public consultation on a statutory corporate rescue procedure was launched in late 2009 and concluded in July 2010. The focus was on rescuing viable businesses in short-term financial difficulties and the proposed moratorium on debt demands was increased to 45 days from 30 days with a possible further extension of up to 12 months with court approval.
To further enhance employee payments, a new staged payment proposal with a minimum protection equivalent to the Protection of Wages on Insolvency Fund limits for ex-gratia payments was suggested. Outstanding wages would be paid within 30 days of the commencement of provisional supervision. A second-stage payment of wages in lieu of notice and severance would be made within 45 days of the approval of the restructuring arrangement, or within 45 days of the extension of the moratorium. These staged payments reduce the outflow of cash by investors before creditors agree on a rescue proposal and, at the same time, preserve the same employee entitlements in the Protection of Wages on Insolvency Fund so that employees are no worse off than in a liquidation.
New legislation on insolvent trading
Quite often corporate rescue attempts commence only after companies find themselves in serious financial difficulties. In order to encourage directors to address problems at an earlier stage, legislation on ‘insolvent trading’ was proposed alongside the government’s corporate rescue proposals. Under this proposed legislation directors could be personally liable for company losses where their company continues to trade when the directors know, or ought to know, that the company is insolvent.
Opponents of this proposed legislation have argued that this threat of personal liability will discourage directors from taking a proactive stand in restructuring attempts. In practice, directors in modern commercial companies should be both knowledgeable enough to read financial statements and aware of their obligation to pay close attention to the company’s financial position in tough times.
Moreover, thanks to technological advances, directors have better access to timely information for making informed decisions. The circumstances which may persuade directors to seek help during corporate financial problems go beyond the numbers. Directors need to consider the company’s future prospects, its profitability, its competitiveness, the industry climate, stakeholder expectations, corporate social responsibility, as well as their own remuneration packages and potential loss of personal reputation. All these factors could be as important as any concerns about personal liability.
The government’s latest proposals to reform Hong Kong’s corporate insolvency and winding-up regime (see the consultation document Improvement of Corporate Insolvency Law Legislative Proposals on the Financial Services and Treasury Bureau website: www.fstb.gov.hk) do not include proposals for a statutory corporate rescue procedure and insolvent trading provisions. The government hopes to issue a consultation on new detailed proposals in this area soon.
The marathon to establish a statutory corporate rescue procedure in Hong Kong has already taken over 16 years. This does not compare well with the situation in mainland China – the PRC Enterprise Bankruptcy Law became effective in June 2007. Time is always of the essence in corporate rescue attempts for listed companies and SMEs alike so perhaps this element should also be recognised in our law drafting process. We need to strike a balance between the interests of all creditors and stakeholders involved, but we also need to consider the reputation of our well-regarded market infrastructure in Hong Kong.
Terry Kan ACIS ACS
Partner, SHINEWING Specialist Advisory Services