In recent years, the Hong Kong courts repeatedly considered the approach the court should adopt in proceedings where a creditor petitions to wind up a debtor and the parties have agreed to refer disputes over or related to the petition debt to arbitration. Should the court stay or dismiss the petition pending arbitration of the dispute where the debtor disputes the debt, or raises a set-off defence, a counterclaim or crossclaim, which if successful would extinguish the debt and therefore defeat the petition?
The Hong Kong courts’ answers to this fundamental question diverged.
In May 2023, the Court of Final Appeal in Re Guy Kwok-Hung Lam[1] clarified the position in relation to exclusive jurisdiction clauses (EJCs). The CFA upheld the decision of the Court of Appeal and found that absent countervailing factors (such as a dispute that borders on the frivolous or abuse of process), an EJC should be upheld, and the court should not proceed with an insolvency petition. While the CA (per Lam JA) made obiter comments specifically relevant to arbitration agreements, the CFA did not address or comment thereon.[2] It therefore remained unclear whether the principle in Guy Lam also applies to arbitration agreements.
On 23 April 2024, the CA handed down two important judgments in Re Simplicity & Vogue Retailing (HK) Co Ltd [3] and Arjowiggins HKK 2 Limited v Shandong Chenming Paper Holdings Limited.[4] The CA held that the principle in Guy Lam also applies to arbitration agreements: unless there are strong reasons, the court will leave the dispute to be resolved by arbitration as agreed.
The previous position and the Guy Lam decision
Prior to Guy Lam, two diverging approaches developed in the Court of First Instance where the disputed petition debt (or a dispute related to the debt) is subject to an arbitration clause. [5]
Under the “established approach”, a petitioner would ordinarily be entitled to a bankruptcy or winding-up order unless the petition debt is subject to a bona fide dispute on substantial grounds.[6]
In 2018, a different approach emerged known as the “Lasmos approach”,[7] which followed the English Court of Appeal’s decision in Salford Estates.[8] It required the court to dismiss a petition in favour of arbitration when three conditions are met:
- The opposing debtor disputes the petition debt;
- The contract under which the petition debt is alleged to arise contains an arbitration clause that covers any dispute relating to the debt; and
- The opposing debtor takes steps required under the arbitration clause to commence the contractually mandated dispute resolution process (which might include precursors to arbitration such as mediation) and files an affirmation demonstrating this.
Even where all three conditions have been met, the Lasmos approach recognised that there may be exceptional cases where it will nevertheless be appropriate to stay the petition.
In Guy Lam, the debt was subject to an EJC in favour of the New York courts. The CFA unanimously rejected the “established approach” as not appropriate where an EJC was involved. The CFA held that in the ordinary course of an EJC, absent “countervailing factors”, such as the risk of insolvency affecting third parties and a dispute that borders on the frivolous or abuse of process, the petitioner and the debtor ought to be held to their bargain.[9]
Shortly after Guy Lam, the cases in Simplicity and Shandongcame before the CFI which had to consider whether the principle in Guy Lam also applied where a petition debt (Simplicity) or a crossclaim exceeding the debt (Shandong) is subject to an arbitration clause.
The CFI’s decision in Simplicity
The petitioner served a statutory demand on a company for an outstanding debt due and payable under a guarantee. The company failed to satisfy the demand and the petitioner presented a winding-up petition.
The company sought to adjourn the petition and an extension of time to pay the petition debt into court, which was a necessary pre-condition for the company to file out-of-time evidence in opposition. The company’s out-of-time evidence raised two grounds. First, that there was a bona fide dispute as to whether the guarantee had been discharged (discharge ground). Second, the company relied on the Lasmos approach, arguing that the dispute over the debt should be referred to arbitration, as there were arbitration clauses in the relevant contracts (arbitration ground). However, at the hearing, counsel for the company contended that the court should not follow the Lasmos approach but the approach in Guy Lam.
The CFI refused to grant the adjournment and the extension of time as the company had failed to demonstrate any good reasons to justify the adjournment or extension sought. As a result, there was no evidence in opposition and the petitioner was entitled to a winding-up order.
For completeness, the CFI also considered the two grounds of opposition raised by the company, assuming there was a proper basis for the court to consider them. The court found on the discharge ground that the company’s defence was “wholly without merit”. On the arbitration ground, the court considered that the ratio in Guy Lam only applied to an EJC, not an arbitration clause and that where an arbitration clause was concerned, in exercising its discretion to dismiss or stay the petition, it also had to consider whether the Lasmos requirements were satisfied. The court took the view that where the company raised a substantive defence, the court should consider whether it was one which could readily be shown to be “wholly without merit”. If the court could come to that view without considering any detailed arguments or disputed evidence, it would have no difficulty in concluding that the defence bordered on the frivolous or abuse of process even if the Guy Lam approach applied. The court therefore concluded that in the absence of any genuine dispute in respect of the debt, there was no proper basis to require the parties to refer their “dispute” to arbitration.
The CFI’s decision in Shandong
The petitioner issued a statutory demand for a debt that arose under an HKIAC award rendered against a company incorporated in Mainland China and registered as a non-Hong Kong company under Part 16 of the Companies Ordinance (Cap 622). The company failed to satisfy the demand but applied to the CFI for an injunction preventing the petitioner from presenting a winding-up petition. It also sought a declaration that the petitioner could not satisfy the requirements for a Hong Kong court to exercise its jurisdiction to wind up an “unregistered company” under the Companies Ordinance.
On 14 June 2017, the CFI dismissed the company’s application. The next day, the petitioner presented a winding-up petition against the company. As the company appealed against the CFI’s decision dismissing its application and agreed to procure payment of approximately HKD 389 million into court, the CFI adjourned the hearing of the petition sine die with liberty to restore.
The company’s appeal to the CA was dismissed on 5 August 2020 and its further appeal to the CFA was dismissed on 14 June 2022, with an order for the funds in court to be paid out to the petitioner with interest (totalling over HKD 400 million). The funds were paid out on 30 June 2022, but over HKD 53 million with daily interest accruing remained outstanding on the debt. The petitioner then applied to the CFI on 18 July 2022 to restore the petition for hearing.
Meanwhile, the company commenced two further arbitrations against the petitioner:
- In the second arbitration, the company sought recovery of books and records of the parties’ joint venture company that were allegedly withheld from the company. On 5 August 2020, the tribunal rendered a final award ordering the petitioner to deliver these documents to the company’s “compulsory liquidation group”. However, the award was set aside by the CFI on 12 January 2022 because in ordering delivery to the liquidation group, the tribunal exceeded its jurisdiction, as the reference to arbitration concerned the company’s own right to recover the documents.[10]
- In the third arbitration, the company sought to rely on the findings made in the second arbitration to obtain the relief in the final award that was set aside and recover damages of approximately HKD 97 million from the petitioner.
On 25 October 2022, the debtor applied to the CFI seeking a dismissal of the petition or an adjournment pending the third arbitration, on the ground that its damages claim in the third arbitration constituted a crossclaim that exceeded the petition debt. Having heard the parties after the CFA handed down its judgmentin Guy Lam, the CFI decided to stay the petition pending determination of the third arbitration.
The petitioner appealed to the CA. The petitioner accepted that the Guy Lam approach also applies where the disputed debt falls within an arbitration clause but argued that the approach does not apply to a crossclaim.
The CA’s decisionsin Simplicity and Shandong
The key difference between the two cases is that the disputeto be referred to arbitration in Simplicity concerned the debt, whereas the dispute in Shandong concerned a crossclaim while the debt itself was not disputed.
Given the material question of law in both cases is closely related, the CA handed down its judgments on the same day. In dismissing the appeal in each case, the CA held:
- The effect of arbitration clauses on insolvency petitions is of central importance to the reasoning of the majority in the CA and of the CFA in Guy Lam. The reasoning relating to the appropriate exercise of the court’s discretion to decline the exercise of jurisdiction applies equally to arbitration clauses (Simplicity at ¶¶34, 36).
- On the CFA’s analysis in Guy Lam, the CA found that it was clear that the “established approach” would not be appropriate where the petition debt is covered by an arbitration clause. Having regard to the statutory framework protective of arbitration, there was apparently an even stronger case for upholding the parties’ contractual bargain that disputes falling within the scope of an arbitration clause should be resolved by arbitration (Simplicity at ¶37).
- Following the approach in Guy Lam, the threshold character of a dispute about indebtedness leaves room for the exercise of a discretion by the court to decline to exercise the jurisdiction to determine that question, leaving the dispute to be resolved by arbitration as agreed and with regard to the public policy in holding the parties to their agreement (Simplicity at ¶38).
- The exercise of discretion is a “multi-factorial” approach. The “countervailing factors” of the insolvency risk affecting third parties and a dispute that borders on the frivolous or abuse of process mentioned by the CFA in Guy Lam are just instances where the court may exercise its discretion not to hold the parties to the agreed dispute resolution mechanism. By this approach, the court retains flexibility to deal with the case as the circumstances require (Simplicity at ¶39).
- As the treatment of a crossclaim was not directly dealt with in Guy Lam, the CA had to determine this issue in Shandong as a matter of principle. The CA held that where the crossclaim is subject to an arbitration clause, it would be against the parties’ agreement if the court entered into the merits of the claim and determined that there was no genuine and serious crossclaim, or that it was of no substance. Such a determination would be akin to giving summary judgment in respect of the crossclaim (Shandong at ¶¶34, 43).
- The CA considered that the Guy Lam approach applies whether the relevant dispute had been raised by a dispute of the petition debt, a set-off claim, or a crossclaim that does not give rise to set-off. As to concerns that a debtor may search for a crossclaim subject to an arbitration clause merely to delay the process, the CA noted that the CFA had built in a “safety valve” that allows the rule to be displaced where the dispute borders on the frivolous or abuse of process. In Shandong, the company explained that its crossclaims were raised several years after the first arbitration because it was unable to bring them earlier as the petitioner had failed to make the documents available (Shandong at ¶¶45, 49-51).
The CA in Simplicity agreed with the ground of appeal raised by the company (i.e., the Guy Lam approach applies to an arbitration clause) but it dismissed the appeal. The CA agreed with the CFI’s exercise of discretion in refusing an adjournment or extension. Consequently, there was no evidence to show that the debt was disputed. The CA noted that even if the company had shown that it had taken steps to commence arbitration, the CFI had found that the defence was one which could readily be shown to be “wholly without merit”. It could therefore be shown without detailed argument that the defence was one which bordered on the frivolous or abuse of process which, applying Guy Lam, would be a sufficient countervailing factor.
Takeaways
- It remains to be seen whether any of the two judgments will be appealed to the CFA. For now, the CA has clarified the proper approach to be adopted in light of the reasoning in Guy Lam where a disputed petition debt or a crossclaim exceeding that debt is subject to an arbitration clause. The CA’s judgments reinforce the strong pro-arbitration attitude and pro-party autonomy stance of the Hong Kong courts.
- Based on the CA’s judgments, where a creditor presents a winding-up or bankruptcy petition where the debt or a crossclaim exceeding that debt is subject to an arbitration clause (or an EJC), the burden is on the creditor to demonstrate countervailing factors which justify the court’s exercise of its discretion to make a winding-up or bankruptcy order. Otherwise, the court will hold the parties to resolve the dispute pursuant to their agreed dispute resolution mechanism.
- Absent such countervailing factors, creditors need to first establish their claim or defeat a crossclaim by way an arbitration before invoking the court’s winding-up or bankruptcy jurisdiction. Whether creditors can avail themselves of mechanisms to expedite the arbitration process (such as expedited and early determination procedures) will depend on the arbitration agreement and in particular the chosen arbitration rules.
[1] Re Guy Kwok-Hung Lam, ex parte Tor Asia Credit Master Fund LP (2023) 26 HKCFAR 119. Our colleagues’ analysis of the CFA’s decision is here.
[2] For an analysis of the CA’s decision in this case, which was upheld by the CFA, see the Hong Kong Chapter of our International Arbitration Yearbook 2022-2023.
[3] Re Simplicity & Vogue Retailing (HK) Co., Limited [2024] HKCA 299.
[4] Arjowiggins HKK 2 Limited v Shandong Chenming Paper Holdings Limited [2024] HKCA 352.
[5] For an overview of these developments up to August 2020, see our previous blog post.
[6] The CFI adopted this approach in Dayang (HK) Marine Shipping Co Ltd v Asia Master Logistics Ltd [2020] HKCFI 311, Re Simplicity & Vogue Retailing (HK) Co., Limited [2023] HKCFI 1443 and Re NT Pharma International Co Ltd [2023] HKCFI 1623.
[7] Named after the CFI’s decision in Lasmos Limited v Southwest Pacific Bauxite (HK) Limited [2018] 2 HKLRD 449. The CFI adopted this approach in Re Shandong Chenming Paper Holdings Ltd [2023] HKCFI 2065.
[8] Salford Estates (No. 2) Limited v Altomart Limited [2014] EWCA 575 Civ.
[9] At ¶105.
[10] Arjowiggins HKK2 Ltd v. X Co [2022] HKCFI 128.
