On 23 April 2024, the Hong Kong Court of Appeal handed down two important decisions clarifying the applicability of the approach emerged from the Court of Final Appeal’s decision in Re Guy Kwok Hung Lam [2023] HKCFA 9 (“Re Guy Lam“) to disputed petition debts subject to an arbitration clause, and arbitrable cross-claims raised by a company in a winding up proceeding.

Re Simplicity – disputed debt subject to arbitration clause

In Re Simplicity & Vogue Retailing (HK) Co., Limited [2024] HKCA 299 (“Re Simplicity“), the Court of Appeal held that when the debt forming the petition debt is disputed and should be referred to arbitration pursuant to an arbitration agreement, the established approach, namely that a petitioner is ordinarily entitled to a winding order if the petition debt is not subject to a bona fide dispute does not apply. Rather, the approach in Re Guy Lam should apply, meaning the petitioner and the debtor company ought to be held to their contract to refer dispute to arbitration, 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 controversy is whether the debtor company should be required to demonstrate a bona fide dispute of the petition debt on substantial grounds notwithstanding the existence of an arbitration clause in order for a petition to be stayed or dismissed ([33]). In this regard, the Court of Appeal held that it is appropriate such controversy should be laid to rest in light of the reasoning in Re Guy Lam, as the effect of arbitration clauses on insolvency petitions is of central importance to the reasoning of the Court of Appeal and Court of Final Appeal’s judgments of Re Guy Lam ([34]).

Further, having regard to the statutory framework protective of arbitration (as evidenced by Section 20 of the Arbitration Ordinance (Cap 609) which provides for the Court to refer matter subject to an arbitration agreement to arbitration), there is 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 ([37]). Vice versa, it would be an anomaly that a party bound by an agreement for dispute resolution cannot expect to proceed with an ordinary action for his claim, but can resort to the more draconian measure of presenting a petition for winding up a company ([35(5)]).

Importantly, such public policy consideration of holding parties to their bargain is not the only consideration and the approach of the Court in exercising its discretion is “multi-factorial” – the “countervailing factors” mentioned in Re Guy Lam, namely (i) the risk of insolvency affecting third parties, and (ii) a dispute that borders on the frivolous or abuse of process, are simply instances the Court may exercise its discretion not to hold the parties to their agreed dispute resolution mechanism. In this way, the Court retains the flexibility to deal with cases as circumstances require ([39]).

The Third Requirement of Lasmos survives

Prior to Re Guy Lam and Re Simplicity, the approach to disputed petition debt subject to arbitration clause is set out in Re Southwest Pacific Bauxite (HK) Limited [2018] HKCFI 426 as the “Lasmos” approach: the petition should generally be dismissed where it is shown that (i) if the company disputes the debt relied on by the petitioner, (ii) the contract under which the debt is alleged to arise contains an arbitration clause that covers any dispute relating to the debt, and (iii) the company takes the steps required under the arbitration clause to commence the contractually mandated disputed resolution process ([23]). In responding to the company’s submission in this case that the petitioner took no steps to express their intention to arbitrate, the Court of Appeal held that a genuine intention to arbitrate on part of the petitioner remains to be relevant. Otherwise, petitioners could simply raise arbitration clauses as a tactical move with no genuine intention to arbitrate in stalling the winding up process ([42]). However, even if no steps at all were taken, the Court could still exercise its discretion in appropriate cases to grant a short adjournment for the debtor to commence arbitration and require an undertaking from him to proceed with arbitration with all due dispatch. If no progress is made during the adjournment, the Court could consider lifting the stay and proceed to exercise its jurisdiction on the petition debt ([42]).

Nevertheless, as the company in this case did not file any evidence in opposition to the petition and did not comply with the condition for an extension of time to do so, the Court of Appeal dismissed the company’s appeal and ruled that the petitioner is entitled to a winding up order ([43]).

Re Shandong Chenming – The treatment of cross-claims

Further to our previous articles[1], the petitioner in Re Shandong Chenming Papers Holdings Limited [2024] HKCA 352 (“Re Shandong Chenming“) appealed the Court of First Instance’s stay of the petition to wind up the company pending determination of an arbitration between the parties. Following Re Simplicity, the principal question here is whether the approach in Re Guy Lam should also be applied where a company has raised a cross-claim against the petitioner which is arbitrated pursuant to an arbitration agreement between the parties. The petitioner submitted that the Court should assess the cross-claim in the ordinary case without an arbitration clause, the test being whether there is a genuine cross-claim based on substantial grounds.

To begin with, the petitioner submitted that there are two questions arising in a petition, the first being the threshold question of whether the petitioner has standing to present his petition. If the petitioner has standing, the second question is whether the company is insolvent and should be wound up. Within this framework, the petitioner posited that Re Guy Lam only concerned with the prior question of standing and the question of cross-claims falls under the second question, which is to be considered with a range of other matters in determining the insolvency of the company. Further, the petitioner argued that since the reason underlying the principle in Re Guy Lam is that the petitioner should be held to his bargain, that principle does not apply to cross-claim which is instead asserted by the company ([24]).

Contrary to the petitioner’s submissions, the Court of Appeal held that while it is true that the dispute over the petition debt is described in Re Guy Lam as a “threshold” question, it is relevant to note that the reasoning in that case is grounded in the wider context of the Court’s discretion to decline jurisdiction and it will be too narrow to read Re Guy Lam to confine its rationale to the question of standing to petition ([37]-[38]). Rather, the Court considers the overall relationship between the parties to see whether the petitioner is a net creditor having an interest to wind up the debtor company ([40], [42])). In this process the Court does not ignore the company’s cross-claims against the petitioner, and indeed regard them as “practically equivalent to disputes of the debt” where reverse cross-claims by the petitioner against the company could also be relevant ([39]). Therefore, where the cross-claim is subject to an arbitration clause, the forum agreement between the parties is likely to be relevant to the exercise of the Court’s discretion – for the Court to enter into the merits of the cross-claim would be against the parties’ agreement ([42]-[43]).

Moreover, the Court of Appeal held that while it is true that it will be the debtor company who has drawn the cross-claim to the Court’s attention, it is not the company seeking the Court’s determination of his cross-claim but the petitioner who is asking the Court to reject the cross-claim as a ground of opposition to the petition. For these reasons the petitioner is making a distinction without a difference and thus the appeal was dismissed ([45]).

Takeaways

The two Court of Appeal decisions put the controversy and debates sparked from First Instance’s decisions to rest and confirmed that Re Guy Lam applies equally to disputed petition debt and cross-claim subject to an arbitration clause.

Further, as the Court of Appeal made clear in Re Shandong Chenming, extending the Re Guy Lam approach to cross-claims would not create a “debt dodger’s charter” as the debtor company would have to show a valid exclusive forum agreement between the parties that governed the cross-claim to rely on the approach. In this light parties who have agreed to refer their disputes to arbitration should proceed with arbitration to resolve any issues before commencing winding up proceedings, so as to avoid wasted time and costs as the Courts will probably hold parties to their contractual bargain and stay or dismiss petitions, save for exceptional circumstances

[1] Articles published on 28 June 2022, 25 August 2023, and 15 November 2023