Directors who oppose the winding-up of an insolvent company in the hope that a restructuring proposal would come to fruition should tread carefully and consider seriously whether to put the company into liquidation.

In the recent case of Re Carnival Group International Holdings Limited [2022] HKCFI 2668 (reasons for judgment) and [2022] HKCFI 3097 (decision on costs), Linda Chan J criticised the directors of a Bermuda company for opposing a winding-up petition on the basis of restructuring proposals which were determined to be wholly unrealistic in circumstances where liquidation was inevitable. The company was ordered to be wound up and the directors were ordered to personally pay the costs of and occasioned by the company’s opposition to the winding-up petition.

Background

The company was an investment holding company listed on the Stock Exchange of Hong Kong. From 2018, the company had been in financial distress and became unable to meet its debts as they fell due, including servicing unsecured bonds with outstanding principal in excess of HK$30 million. This culminated in a winding-up petition presented by the bondholder (the Petition). The Petition was supported by 99 other creditors including bondholders and unsecured creditors to whom HK$878 million was owed. The company’s total assets were HK$4.6 billion while its total liabilities were HK$5.6 billion and hence its net liabilities were HK$1 billion. The company was hopelessly insolvent.

The company did not contest the debt, but opposed the Petition citing ongoing restructuring efforts which the directors argued would yield a higher return for the company’s unsecured creditors. It came to light that no real efforts had been made by the directors in pursuing the restructuring proposals. The history of the matter indicated that the directors had used the restructuring proposals to obtain multiple adjournments of the Petition to delay the winding-up proceedings for some 2.5 years.

Directors’ duty to wind up insolvent companies

The court approached the company’s opposition to the winding-up petition by considering two questions: (1) what was the directors’ duty in the circumstances and (2) when did such duty arise?

In answer to question (1), the court held that the directors had an overriding obligation to protect creditors’ interests. The reason is that the interests of an insolvent company were effectively the interests of the creditors and directors must treat the interests of creditors as paramount. Such an obligation in turn required directors to consider whether there was any reasonable prospect of the company avoiding going into insolvent liquidation. In the absence of any viable restructuring proposal supported by a majority of creditors, insolvent liquidation was unavoidable. Directors would be obliged to take steps to trigger the statutory scheme of winding-up to protect the interests of creditors in such circumstances.

In answer to question (2), the court held that the duty to wind up a company would arise where a company was “insolvent or of doubtful solvency”, though the judgment was silent as to the precise timing or trigger point of the “doubtful insolvency”. This may be contrasted with the UK approach in the recent case of BTI 2014 v. Sequana SA and others [2022] UKSC 25, where the UK Supreme Court agreed that the interests of creditors were paramount but held that a mere real risk of insolvency which was not imminent was not sufficient to trigger a duty to wind up the company. Instead, the directors’ duty to creditors was triggered only where a company was actually insolvent or on the brink of insolvency, but not at some earlier time when there were merely signs of insolvency.

It was determined in Sequana that, although there was no strict duty on directors in the case of an insolvent company or one bordering on insolvency but not faced with an inevitable insolvent liquidation, the directors were nonetheless under a fiduciary duty to balance the interests of both shareholders and creditors. In such circumstances, both shareholders and creditors had an interest in the company’s affairs and, in case of a conflict between the two, a balancing exercise would be necessary to determine the correct course of action – liquidation or otherwise.

On the facts of Re Carnival, the court noted that it must have been clear to the directors that there was no reasonable prospect of the company being able to implement the proposals to compromise its debts and avoid liquidation. Nevertheless, instead of allowing the distressed company to be wound up, the directors continued to oppose the Petition. There was simply no basis on which the directors could come to the view that it would be in the interests of the company and the creditors to continue resisting the Petition.

Costs sanction for unreasonably opposing the winding-up

The usual costs order following an order for a winding-up is for the costs of the petitioner and supporting creditors to be paid out of the assets of the company. However, the court saw fit in the circumstances to depart from the usual costs order in finding that the directors failed to cause the company to be wound up upon becoming aware that liquidation was unavoidable. It was therefore ordered that the costs of and occasioned by the company’s opposition to the Petition be borne by the directors personally from the time they became aware the restructuring proposals would not come to fruition. 

Commentary

This decision serves as a useful reminder of directors’ duty to safeguard creditors’ interests when a company is insolvent or of doubtful solvency. While directors can consider a restructuring to avoid liquidation, if the circumstances are such that it is clear no restructuring proposal will have any reasonable prospect of coming to fruition, the directors are duty-bound to wind up the company. If directors nevertheless oppose or delay a winding-up petition, they will risk being sanctioned by the court with an adverse costs order and may have to bear the costs of the winding-up petition personally.

This decision is welcomed by creditors, particularly unsecured creditors, whose interests are put at risk when the company is in financial distress. In the absence of an insolvent trading regime in Hong Kong, such common law principles ensure that directors will not cause their company to continue operating despite its insolvency. With this more robust approach by the courts in Hong Kong, the winding-up regime in Hong Kong will be able to better protect the interests of creditors.

It will be of interest to both directors and creditors to see whether the courts in Hong Kong will adopt the principles in Sequana where a company is of doubtful solvency to impose a balancing act between the interests of shareholders and creditors, or whether the courts will continue to impose a wider and more stringent obligation on directors to hold creditors’ interests as paramount, as in Re Carnival. Watch this space.

Ronald Wan, a litigation team trainee, is one of the authors.