Liquidator’s Avoidance Powers: Unfair Preference and Fraudulent Conveyance

Background

In an insolvent winding up in Hong Kong, a liquidator’s primary duties are to realize the company’s assets and settle its liabilities. In doing so, the liquidator will review past conduct, decisions and actions in relation to the operation of a company and the management of its affairs. The scope of investigation work in a liquidation is wide, but the liquidator’s exercise of his or her avoidance powers is often fraught with difficulties. This update examines the extent to which a liquidator can overturn past transactions involving the debtor’s property, focusing on two recent cases in relation to unfair preference and fraudulent conveyance.

Unfair preference

Section 266B of the Companies Ordinance (Cap 32) provides for the avoidance of unfair preferences in corporate insolvencies and, in doing so, incorporates Section 50 of the Bankruptcy Ordinance (Cap 6).

An unfair preference arises where (i) a payment has been made to a creditor in the period leading up to the commencement of the winding up, and (ii) the effect of that payment is to put the recipient in a better position than other creditors when the liquidation starts.

Liquidators are empowered to review transactions which took place in the six months before the commencement of the winding up to see whether any of them constitute unfair preferences. However, if it appears that the unfair preference has taken place in favour of an associate of the company, the liquidator can go back up to two years to overturn transactions of this nature. In such cases there is a statutory presumption that the debtor was influenced by a desire to improve the creditor’s position.

Unfair preference claims against non-associates in relation to arm’s-length transactions have rarely been made out. This can be explained by the difficulties that liquidators face in proving to the court’s satisfaction that the transaction was motivated by the debtor’s desire to prefer a creditor. It has conventionally been accepted that financial institutions are independent entities that do not have connection to or interest in their clients. Moreover, it is unclear which corporate organ is the repository of a debtor company’s desires or how this subjective desire is to be constructed out of the states of mind of the various corporate officers and employees.1 Thus, it is very difficult for a liquidator to present evidence to establish the debtor’s subjective state of mind.

Another problem for liquidators in Hong Kong is that a defendant in a preference action is entitled to rely on the defence that genuine pressure was exerted on the debtor, even where the presumption of desire applies in transactions involving associates. In Trustees of the Property of Hau Po Man Stanley (in bankruptcy) v Hau Po Fun Ivy [2005] 2 HKC 227 it was held that moral pressure can be as real as commercial pressure and was sufficient to negate the suggestion that the debtor company was motivated by a desire to prefer. In effect, creditors are encouraged to apply pressure to extract payments or other advantages, since this immunizes their actions from challenge under preference law.

Fraudulent conveyance

A liquidator will also review dispositions of properties that have taken place before the commencement of liquidation. Section 60 of the Conveyancing and Property Ordinance (Cap 219) provides that every disposition of property made with intent to defraud creditors shall be voidable at the instance of the person prejudiced thereby. This provision does not extend to an estate or interest in property disposed of for valuable consideration and in good faith, or upon good consideration and in good faith to a person that, at the time of the disposition, has no notice of the intent to defraud creditors.

Recoveries by liquidators under this section are rare, despite the fact that no time limit is set for bringing applications to impeach a transaction. One reason may be that the critical element which the liquidator must prove is intent to defraud – proving that something was done with a particular purpose in mind is never easy.

A further problem for a liquidator is that there is no built-in presumption with regard to the debtor’s accompanying motive, even in cases where the transaction has been entered into with a closely connected person.2

Recent Developments

Unfair preference

In light of the successful unfair preference claim against a non-associate in Re Sweetmart Garment Works Ltd (in liquidation) [2008] 2 HKC 252, liquidators may now be in a better position to use Section 266B as a tool to recover assets.

The company in question went into compulsory liquidation on a creditor’s petition that was presented on September 28 2005. Around one month before the presentation of the petition, the company granted a mortgage over a yacht in favour of one of its bank creditors. The mortgage was granted to secure general credit facilities. The loan was drawn down three days later and used to repay an existing overdraft of the company with the same bank, payments to which had long been overdue.

Following the presentation of the petition, the bank exercised its right under the mortgage and took possession of the yacht. In May 2007 the liquidators applied for a declaration that the mortgage constituted an unfair preference.

In determining whether the company was influenced by a desire to prefer the bank over the other creditors in granting the mortgage, the court was willing to consider indirect and second-hand evidence in the absence of direct testimony from the company or the bank. The relevant evidence included the contemporaneous correspondence between the bank and the company and evidence of the steps that other creditors were taking in recovering the company’s debts.

On the basis of the indirect evidence, the court was able to infer that the company had been influenced by a desire to prefer the bank. It concluded that the nature of the bank’s complaints regarding non-payment had been mild and the bank had not placed real commercial pressure on the company, whereas the other creditors’ measures had been more concrete and serious and had been taken more promptly.

The court also held that there had been no real prospect of the company trading through its difficulties, given the critical steps taken by the creditors and the extent of the debts owing to them. It could not be said that the mortgage had been granted to preserve the ongoing commercial relationship with the bank or that the company had benefited tangibly, as the loan granted against the mortgage did not involve fresh credit being given to the company. The declaration of unfair preference was therefore granted.

This case is notable for the bullish approach taken by the court. It recognized that indirect evidence can be relied upon to infer the existence of the requisite desire. This approach is welcome and will alleviate the heavy demands placed on a liquidator in terms of proof.

Fraudulent conveyance

The liquidators in Tradepower Holdings Limited (in liquidation) v Tradepower (Hong Kong) Limited [2008] HKCU 1715 successfully set aside a transfer of property undertaken with an intent to defraud creditors.

The plaintiff was sued by a creditor for damages for breach of contract. The creditor obtained summary judgment with damages to be assessed and the plaintiff’s appeal against the summary judgment was dismissed.

Before the creditor’s damages could be assessed and enforced, the plaintiff’s directors implemented a deferred shares scheme whereby all of the plaintiff’s interests in a related company (company A) were transferred to another company controlled by the directors (company B) for no consideration. The plaintiff was subsequently wound up and the liquidators commenced proceedings to set aside the transfer.

The trial judge in the Court of First Instance dismissed the liquidators’ claim. It was held that since company B had been helping company A to finance its mortgage without security, the directors of the plaintiff who were also directors of company B had a legitimate reason to be concerned about the latter’s interests. The trial judge found no intent to defraud the creditors.

The Court of Appeal overturned the decision, adopting a much more robust approach and drawing inferences from company A’s audited accounts, which had been dismissed as irrelevant. The court considered that the subjective intent to defraud could be inferred from the objective facts that the transfer was for no consideration and that creditors had suffered as a consequence.

Comment

The two cases illustrate the court’s willingness to consider direct and indirect evidence and all other circumstances when inferring the requisite state of mind in unfair preference and fraudulent conveyance cases. It is hoped that they will boost a liquidator’s avoidance powers and pave the way for increased creditor protection.

1. For a discussion of this point, see R J Mokal, Corporate Insolvency Law: Theory and Application, Oxford University Press, 2005, page 366.
2. I F Fletcher, The Law of Insolvency, Sweet and Maxwell, 2009.