How Does Good Faith Prevent Clawbacks of Payments Made to Creditors in Validation Orders?

Overview

A Hong Kong company in financial distress may be the subject of a petition by a creditor to wind-up the company. During the intervening time after the petition has been presented and the time when a court grants a winding-up order (if the court grants the petition), the company may continue to carry on its business and in this regard, may continue to pay its creditors. However, if a winding-up order is made, under the Companies (Winding Up and Miscellaneous Provisions) Ordinance (“CWUMPO”), the winding-up is deemed to have commenced not from the date of the order but from the date when the petition was granted. The retrospective effect of the winding-up order is known as the relation back doctrine. It is intended to protect creditors as a whole by, in effect, invoking the protections afforded to creditors by insolvency laws from the moment the petition was made. However, it places individual creditors at risk in that during the intervening time, they may be unaware that they are dealing with an insolvent company and hence, unaware their dealings are subject to insolvency law restrictions.

Disposition of Property Void After Winding Up

Under CWUMPO, s.182, every disposition of the insolvent company’s property, including choses in action, and any transfer of shares, or alteration in the status of the members of the company, made after the commencement of the winding-up is void unless the court otherwise orders. An order of the court otherwise is known as a “validation order”. A validation order may validate a disposition of property both after the winding-up order has been made and before a winding-up order is made while the petition is still pending.

Validation orders may be sought by companies who are subject to a winding-up petition, by creditors who received a payment from a company at a time when they were unaware that a winding-up petition had been presented against the company with whom they were dealing where the liquidator following the granting of the winding-up order seeks to clawback the payment, or by creditors who despite knowing that the company is the subject of a winding up petition nevertheless wish to proceed to continue to conduct transaction with the company.

General Basis for Validation Orders

In determining whether to grant a validation order, the court will seek to ensure that the interests of the unsecured creditors as a whole will not be prejudiced.

In this regard subject to the provisions of CWUMPO as to preferential payments, the court seeks to ensure that the property of an insolvent company as at the commencement of the winding-up is, on the winding-up of company, applied in satisfaction of the company’s liabilities pari passu, meaning that all unsecured creditors in the insolvency process as at the commencement of the winding-up will share equally in the available assets of the company (or the proceeds from the sale of any of those assets) as at the commencement of the winding-up in proportion to the debts due to each creditor. The court guards against the possibility that the insolvent company prefers one unsecured creditor over others by paying this unsecured creditor’s claim first in full whilst other unsecured creditors receive less than the full amount of their claims as a result of the company’s asset pool having been depleted.

Good Faith

Traditionally, the courts have presumed that payments made by a company in the ordinary course of business in good faith in circumstances where the creditor was unaware of the winding-up petition against the company would be validated. The presumption originated in the English Court of Appeal case, Re Gray’s Inn Construction Co Ltd [1980] 1 All ER 814 (“Re Gray’s Inn”), where Buckley LJ suggested that:

“a disposition carried out in good faith in the ordinary course of business at a time when the parties are unaware that a petition has been presented may, it seems, normally be validated by the court unless there is any ground for thinking that the transaction may involve an attempt to prefer the disponee, in which case the transaction would probably not be validated.”

Criticism of Presumption of Good Faith

Over 30 years later, the same court backed away from the presumption. In Express Electrical Distributors Ltd v Beavis and others [2016] 1 WLR 4783 (CA) (“Express Electrical”) Sales LJ stated:

First, I do not see why Buckley LJ appears to accept the bald proposition that a disposition carried out in good faith in the ordinary course of business at a time when the parties are unaware that a petition has been presented should normally be validated by the court (p 718F—G).

In view of the muted language used by Buckley LJ at p 718G (may, it seems . . .) and the qualifications he enters, I do not think that Buckley LJ intended to lay down any binding rule at p 718F—G. Such a rule would not be consistent with the emphasis he gave elsewhere in his judgment to the importance of the pari passu principle in the exercise of discretion under section 127 of the 1986 Act and with his statement of the basic principle governing such exercise.

In Hong Kong, the Court of Final Appeal in Hong Kong echoed these sentiments. Though it was unnecessary to decide the point, in Hsin Chong Construction Company Limited (in Liquidation) v. Build King Construction Limited [2021] HKCFA 14 (“Hsin Cheong”), Justice Ribeiro PJ and Mr Justice Fok PJ took the opportunity to endorse the comments of Sales LJ in Express Electrical:

While the point does not arise in the present case, we note and respectfully agree with the comments of Sales LJ in Express Electrical Distributors Ltd v Beavis [2016] 1 WLR 4783 at §§33-40 qualifying an aspect of Buckley LJ’s judgment in In re Gray’s Inn Construction Co Ltd [1980] 1 WLR 711 at 718F-G involving the “bald proposition” that “a disposition carried out in good faith in the ordinary course of business at a time when the parties are unaware that a petition has been presented may, it seems, normally be validated by the court”.

Good Faith Remains a Powerful Factor

Though both Express Electrical and Hsin Chong overturned long standing understanding of the effect good faith in an application for a validation order, curiously, it appears that neither case in fact dealt with a creditor acting in good faith in the ordinary course of business without knowledge of the winding-up petition. In Express Electrical, the court specifically noted a payment was being made to the creditor in advance of the due date and in Hsin Chong, the court highlighted the fact that the creditor’s knowledge of a preference “certainly does not militate in favour of a validation order”.

Thus, while the retreat from the presumption that good faith will normally result in validation places unsecured creditors dealing in good faith with an insolvent company at greater risk, given these limitations in the facts of these seminal cases, it appears that good faith remains a relevant, if not powerful, factor to be considered by the court. However, because good faith cannot speak to the conduct of the insolvent company, a creditor seeking validation must be aware that such conduct may prove fatal to its application for validation. As Lord Neuberger stated in Akers v. Samba Financial Group [2017] 2 WLR 713, [2017] AC 424 (UKSC):

Section 127 [the UK equivalent of CWUMPO, s. 182] can operate harshly so far as people dealing in good faith the company are concerned. In many cases, a person dealing with a company will be unaware that a petition has been presented (particularly if the presentation occurred very recently), and the section contains no exception for transactions in the ordinary course of business or for transactions for which the company receives full value. The fact that the court will often sanction transactions in the ordinary course of business under its statutory dispensing power is by no means a wholly satisfactory answer to this.

Similarly, commenting on the Express Electrical decision, Mr. Justice Cooke stated in MKG Convenience v. NISA Retail [2019] EWHC 1383 (Ch):

This judgement therefore makes clear that the starting point for the court is the strong legislative policy of ensuring that the assets of the company at the commencement of the winding-up (ie, normally as in this case the time of presentation of the petition) should be made available for distribution among its creditors at that time. It is not sufficient for an application for a validation order to show (a) that a disposition to him was in the ordinary course of business and/or (b) that he was unaware of the presentation of a petition and/or (c) that he acted in good faith, though no doubt all of these will be relevant matters to consider in the exercise of the court’s discretion.