Up Again Hong Kong: Governance

Corporate

1. What are the key topics that boards should focus on to ensure proper discharge of their duties as directors, as their businesses return to work following a lockdown?

All directors have a duty to act in the best interests of the company. Directors should examine the financial condition of the company and whether it can continue to trade as a going concern. See the section What are the repercussions for continuing to operate your company? below for more details on what directors should consider if the company is facing liquidity concerns.

If the company is listed on an exchange, it should consider whether there have been any significant developments during the lockdown period that have a material impact on its business (e.g. termination of key contracts). These may constitute inside information that has to be announced to the public, unless a safe harbour exception applies.

From an operational perspective, directors should also consider:

  • whether the lockdown has affected its ability to fulfil its contractual obligations to its customers and suppliers; and
  • whether any policies of the company have to be revised to reflect government regulations such as social distancing policies.

2. Should Boards adopt particular governance practices in this context?

In the present economic climate, where there are widespread liquidity concerns, directors should pay close attention to whether cost control measures are in place and whether the company’s liabilities are at sustainable levels. When a company is unable to pay its debts, the directors must focus on the best interests of creditors.

The board should also ensure that management frequently prepares cashflow projections and budget plans and carries out regular stress-testing on the same. The board should also be mindful that the company does not incur new credit unless there is a reasonable expectation that it will be repaid.

Restructuring

3. Your company is facing liquidity issues as a result of COVID-19:

a. What are the repercussions for continuing to operate your company?

All directors have a duty to act in the best interests of the company. When a company is unable to pay its debts as they fall due the directors must continue to act in the best interests of the company but the paramount consideration for the directors is the best interests of creditors taken as a whole.

The transition from solvent going concern to insolvent entity is called the twilight zone. Directors operating in the twilight zone must be prudent – it is important to appoint an experienced professional team and ensure all financial information about the business is current, accurate and reviewed frequently.

Hong Kong’s insolvency laws are outdated; there is no equivalent of the wrongful trading provisions found in Singapore or the UK, or of similar insolvent trading provisions in Australia. However, directors may be subject to both civil and criminal penalties, and possibly a disqualification order, if they engage in fraudulent trading. The civil and criminal penalties apply to any persons who were knowingly parties to the fraudulent trading, rather than being limited to directors.

Fraudulent trading arises where any business of the company has been carried on with the intent to defraud creditors of the company or creditors of any other person, or for any fraudulent purpose.

The civil penalty is that the court may declare that any persons who were knowingly parties to the fraudulent carrying on of the business to be personally liable, without limit, for all or any of the debts or other liabilities of the company. This civil penalty is only applicable if the fraudulent trading becomes apparent in the course of the winding-up/liquidation of the company.

The criminal penalty may consist of a fine and/or a jail sentence of up to five years. There is no limit on the fine. The criminal penalty may apply whether or not the company is being wound up.

Where the directors have failed to have regard to the company’s financial status and caused the company to enter into certain transactions in breach of their fiduciary duties and losses were incurred, the directors can be liable for such losses. See Moulin Global Eyecare Holdings Limited (In Liquidation) & Ors v Olivia Lee Sin Mei [2019] HKCU 2763.

b. Do you have to file for insolvency if your company cannot pay all its debts as they fall due?

Unlike certain civil jurisdictions, strictly, there is no obligation to commence a liquidation because of an illiquidity problem. However, given the critical absence of any formal rescue regime in Hong Kong, the underlying legal regime effectively causes companies to file unless the company:

  • extends the terms of their outstanding obligations by agreement;
  • seeks to effect a standstill or forbearance with creditors (may be, in due course, a Restructuring Support Agreement (RSA);
  • seeks to effect a Scheme of Arrangement;
  • seeks to appoint provisional liquidators in Hong Kong (or so called soft-touch provisional liquidators in offshore jurisdictions such as Cayman Islands or BVI); or
  • seeks to use “insolvency tourism” to obtain protection in another jurisdiction, for example under Chapter 11 of the US Bankruptcy Code.

In practical terms, fraudulent trading is likely to arise only where new liabilities have been assumed by the company and the directors then took (perhaps an improper) step that ensured those liabilities could not be repaid.

Directors must act prudently in conjunction with an experienced professional team. The reality is that outdated legalisation in Hong Kong makes it difficult for directors to navigate the way forward in these complex modern times on their own.

c. Are there any steps that should be taken to minimise the risk of your actions as director being challenged?

The Hong Kong regime revolves around directors acting “reasonably” in the prevailing circumstances, taking into account any special knowledge/skill set the individual director may have.

In the current climate, directors may ultimately be afforded more latitude. However, there are a number of steps directors may take in order to try and protect themselves from future challenge and personal liability (e.g. misfeasance claims). These are:

  • hold regular board meetings, especially given how fast matters are moving/developing, and ensure decisions are documented with reference to all factors considered and taken into account;
  • ensure that all directors have full information from the business (i.e. all accounts and financial statements, key contracts, pipeline);
  • monitor compliance with financial covenants in finance documentation and, if non-compliant, procure that the company informs the relevant lender;
  • consider whether there are any ways of delaying incurrence of new credit or minimising losses (e.g. temporarily closing down non-core operations); and
  • seek professional advice from financial advisors and lawyers.

d. Will your company be wound up if you fail to make payments when due?

As a matter of law, unpaid creditors are entitled to a winding-up order (unless the debt is disputed on bona fide substantial grounds) where a company is unable to pay its debts as they fall due taking into account all contingent and prospective liabilities.

However, when a winding-up petition is presented to the Court, no winding-up order will be made immediately. Unless there is a dispute or the Court exercises its discretion to adjourn, there is generally a period of six weeks between the presentation of the petition and the winding-up order being made