Arbitration v. Winding Up – To Stay or Not To Stay?

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18 March 2024

The interplay between insolvency proceedings and arbitration clauses has been a longstanding dilemma that has attracted much legal debate. Indeed, the question of whether a winding-up petition, or the arbitration clause that the parties have contracted into should take priority, is not an easy question to answer, given the conflicting policy considerations in the statutory insolvency regime and the privately negotiated arbitration process.

Insolvency proceedings is a collective statutory proceeding, involving the public centralisation of disputes so as to achieve economic efficiency and optimal returns for all creditors in an equitable, transparent and predictable manner. As such, the Court has the supervisory power to direct how the proceedings shall be conducted. In contrast, arbitration is a party autonomy-oriented, private and confidential process. The contracted parties are free to decide the procedures of the arbitration proceedings to their mutual benefit and the results would only be binding on them.

A. An Overview of the Approach Taken by the Court

The Traditional Approach – the Triable Issue Threshold

Traditionally, if a winding up petition has been presented against a debtor company, the debtor company must show a “bona fide dispute of the debt on substantial grounds” rather than mere assertions, for the Court to grant a stay of the winding up petition in favour of arbitration. The rationale is that it would be a futile requisite for the petitioning creditor to first obtain an arbitral award when there is in fact no genuine dispute on the petition debt. The existence of an arbitration clause or the commencement of arbitration does not by itself prevent the Court from considering whether there is a bona fide dispute of substance, hence there is no automatic stay in favour of arbitration. (See Re Sinom (Hong Kong) Ltd. [2009] HKCU 1203)

The Lasmos Approach – the Prima Facie Threshold

A new approach was introduced in the English case of Salford Estates (No 2) Ltd v Altomart Ltd. (No 2) [2014] EWCA CIV 1575, which was followed by Hon Harris J in Lasmos Ltd v Southwest Pacific Bauxite (HK) Ltd [2018] HKCFI 426; HCCW 277/2017 (“Lasmos): A winding up petition should “generally be dismissed” if:-

  • a debtor company disputes the debt relied on by the petitioning creditor;
  • the contract under which the debt is alleged to arise contains an arbitration clause that covers any dispute relating to the debt; and
  • the debtor company takes the steps required under the arbitration clause to commence the contractually mandated dispute resolution process.

The justification of this approach is to uphold the legislative intent to support party autonomy and to compel the parties to resolve their dispute in accordance with their chosen dispute resolution method. It also guards against the Court engaging in “summary judgment type” analysis. However, the Lasmos approach is not without criticism.

B. An Overview of the Recent Case Law

In But Ka Chon v Interactive Brokers LLC [2019] HKCA 873; CACV 611/2018 (“But Ka Chon), while it was unnecessary for the Court of Appeal (“CA”) to determine the appropriateness of the Lasmos approach, the CA, in obiter, noted its reservations about the Lasmos approach which substantially curtails the statutory right under the insolvency regime for the creditors to petition for winding up.

In the same year, though the CA in Sit Kwong Lam v Petrolimex Singapore Pte Ltd [2019] HKCA 1220; CACV 215/2019 (“Sit Kwong Lam”) did not make further remarks on the obiter observations in But Ka Chon, they made a number of clarifications to discourage debtor companies from “making opportunistic attempts to invoke the Lasmos approach in future”.

Last year, the Court of Final Appeal (“CFA”) in Re Guy Kwok-Hung Lam [2023] HKCFA 9; FACV 13/2022 (“Re Guy Lam”) unanimously upheld the majority decision of the CA that, in an ordinary case where the dispute of the petition debt is subject to a foreign exclusive jurisdiction clause (“EJC”), the Court should give effect to the EJC and decline insolvency jurisdiction unless there are countervailing factors, such as the risk of insolvency affecting third parties and a dispute that borders on the frivolous or there is an abuse of process. However, the CFA expressly left open the issue of whether the same approach would have applied to an arbitration clause.

The opportunity shortly came in the case of Re Simplicity & Vogue Retailing (HK) Co., Limited [2023] HKCFI 1443; HCCW 457/2022 (“Re Simplicity”) before Hon Linda Chan J. She took the view that Re Guy Lam is only applicable to EJC but not an arbitration clause. The requirements in the Lasmos approach, and the principles in But Ka Chon and Sit Kwong Lam should be considered. However, she cautioned against the mechanistic application and emphasised that the mere existence of an arbitration clause does not fetter the Court’s discretion to consider the merits of the defence raised by the debtor company. After considering the debtor company’s grounds of opposition, the Court exercised its discretion and made the usual winding up order against the debtor company. This decision is currently pending appeal.

Soon afterwards, Hon Harris J had another opportunity to consider the approach in Re Shandong Chenming Paper Holdings Limited [2023] HKCFI 2065; HCCW 175/2017 (“Re Shandong). In this case, the debtor company advanced a cross-claim of value greater than the petition debt in an arbitration against the petitioner. Hon Harris J did not follow Re Simplicity. He took the view that both the judgments of the majority of the CA and the CFA in Re Guy Lam are that the Lasmos approach applies to arbitrations just as it has been expressly found to apply to EJCs, and that there is no difference in the applicable principles whether the disputed petition debt or the cross-claim was the subject of an EJC or arbitration clause. Hon Harris J considered that the petition in question should be stayed pending arbitration, and his decision is currently also pending appeal.

Thereafter, the same issue arose in Sun Entertainment Culture Limited v Inversion Productions Limited [2023] HKCFI 2400; HCCW 444/2022. While the Court recognised the distinction in the approach adopted by Re Simplicity and Re Shandong on the application of Re Guy Lam respectively, it was not necessary for the Court to resolve the inconsistency in this case, as the defence raised by the debtor company was considered to be frivolous and an abuse of process. Even if Re Shandong is followed and Re Guy Lam is applied to an arbitration provision, the frivolous nature of the defence would be a recognised “countervailing factor” against staying or dismissing the petition. As such, the Court made a winding up order against the debtor company.

C. Clarification from the Appellate Court

As one can tell from the recent cases, the existing state of the law in this area is still uncertain and in flux. This is the reason why Hon Harris J recently granted the petitioner in Re Shandong leave to appeal, and considered there to be merit in hearing this appeal at the same time as the appeal of Re Simplicity in February 2024. Hon Harris J opined that “it is highly undesirable that there are conflicting first instance decisions”, and that “it is also desirable that the Court of Appeal has the opportunity to clarify the application in Hong Kong of the Lasmos approach”, which has recently been approved by the UK Supreme Court and Privy Council. (See Re Shandong Chenming Paper Holdings Limited [2023] HKCFI 2731; HCCW 175/2017)

Hopefully, upon judgment being delivered, the Appellate Court will soon be settling the prevailing uncertainty on the applicable approach in dealing with arbitration clauses in winding up proceedings. Stay tuned for further updates.

 

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The information contained herein is for general guidance only and should not be relied upon as, or treated as a substitute for, specific advice. We accept no responsibility for any loss which may arise from reliance on any of the information contained in these materials. No representation or warranty, express or implied, is given as to the accuracy, validity, timeliness or completeness of any such information. All proprietary rights in relation to the contents herein are hereby fully reserved.

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