A dollar for a dollar? The value of third party security in the bankruptcy context.

14 July 2020

In X v Y [2019] HKCFI 2880, Deputy High Court Judge Jose Maurellet SC considered (albeit on an obiter basis*) whether third party security can be taken into account as part of the Court’s discretionary exercise in deciding whether to set aside a statutory demand.**

The debtor applicant (“Debtor”) relied on certain shares charged by the Debtor’s company (“Company”) in favour of the creditor respondent (“Creditor”) (“Charged Shares”) in respect of the same underlying indebtedness. The Debtor complained about the fact that the Charged Shares held by the Company were not taken into account in the present Statutory Demand (“SD”).  

Simply put, it was thus contended on behalf of the Debtor that every dollar realised on the Charged Shares would result in an extra dollar available to the estate of the Debtor.

Hence, the Charged Shares should be taken into account in deciding whether the Debtor should be made bankrupt. The Court was thereby invited to set aside the SD having regard to the value of the Charged Shares. 

The Debtor’s application proceeded on the basis of Rule 48(5)(c) (“the 5(c) Limb”) and Rule 48(5)(d) (“the 5(d) Limb”) of the Bankruptcy Rules (Cap. 6A), which provide as follows:-

“(5) The court may grant the application if—

(c) it appears that the creditor holds some security in respect of the debt claimed by the demand, and either rule 44(5) is not complied with in respect of it, or the court is satisfied that the value of the security equals or exceeds the full amount of the debt; or

(d) the court is satisfied, on other grounds, that the demand ought to be set aside.”

Rule 5(c) Limb

It is well-established that “a petitioner is not to be regarded as a “secured creditor”, and the petitioning debt is not to be regarded as a “secured debt”, where the petitioner holds securities, whatever their form, furnished by third parties rather than the debtor himself”: Re Mann, Kevin Patrick (Unrep., HCB 8023/2013, 24 March 2015) at §16 per Ng J, citing inter alia Re Kwok Chok Yee [2000] 2 HKC 543 and Cheng Wai Kei v Commerzbank Aktiengesellschaft [2002] 2 HKC 340.

As seen in Kwok Chok Yee at §4, the above position is based on a construction of “secured creditor” under section 2 of the Bankruptcy Ordinance

This is also consistent with the clear pronouncement of the law by Chu J (as her Ladyship then was) in Cheng Wai Kei at §§16-17 and the detailed analysis by Deputy High Court Judge S Kwan (as the learned Vice President then was) in Lai Yuk Shau v Dao Heng Bank Ltd [2001] 4 HKC 299 at §§3-6.

It is therefore clear that “the Debtor's liability as guarantor is not affected by any third party security that the [Creditor] might have”: Re Kwok Chok Yee at §10 per Le Pichon J (as her Ladyship then was).  

The above propositions were accepted by the learned Deputy Judge at §§8-9 of his judgment. 

Rule 5(d) Limb – The Orthodox View

However, the learned Deputy Judge left open a further question viz. whether “the Debtor would [not] be able to avail himself of rule 48(5)(d)” (§10)?

As a matter of principle, the answer would seem to be ‘no’. 

First, there must be some degree of similarity between the circumstances constituting those “other grounds” and the situations already contemplated under the other limbs of Rule 48(5).

In Re Wah Tat Foundation (Unrep., HCSD 5/2003, 7 May 2003) at §11, Deputy High Court Judge Poon (as the learned Chief Judge then was) cited the following remarks of Nicholls LJ (as he then was) in Re a Debtor [1999] 1 WLR 271:

"When therefore the rules provide for the court to have a residual discretion to set aside a statutory demand, the circumstances which normally will be required before a court can be satisfied the statutory demand ought to be set aside are circumstances which would make it unjust for the statutory demand to give rise to those consequences in the particular case. The court's intervention is called for to prevent that injustice."

At first instance, Warner J had held at 421F that:-

It seems to me, reading that provision as a whole, that the “other grounds” which can be invoked under sub-paragraph (d) must be of the same degree of substance as the grounds specified in sub-paragraphs (a), (b) and (c) and that it is not enough for a debtor, under this provision, merely to show that a statutory demand served on him is perplexing.” (emphasis added)

Second, in White v Davenham Trust [2011] Bus LR 1443 at §§40-41, Lloyd LJ (as he then was) explained why there is nothing unjust to allow a creditor to proceed against a debtor who has given no security of his own in respect of the debt.  The rationale lies in the fact that the creditor (holding security belonging to a third party) is entitled to prove 100% of its debt in the debtor’s estate:-

“…As against a given debtor, if a creditor has security over that debtor’s assets which is more than sufficient, there is no reason to allow the creditor to pursue bankruptcy proceedings because the existence of the security means that the creditor has no interest in that debtor’s estate. He would not be able to prove his debt, and there is no reason for him to be able to invoke the collective realisation of assets which is the point of insolvency proceedings, unless he is willing to give up his security. By virtue of section 267 of the 1986 Act he is not even entitled to present a bankruptcy petition. It follows that there is every reason why he should not be entitled to take the preliminary step of serving a statutory demand. If, however, the security given to the creditor is over the assets of a different person, then the existence of that security does not constitute any reason why the particular creditor should not proceed against this other debtor, who has given no security over his assets, for an undoubted debt by way of a personal claim or by way of insolvency proceedings. There is no bar to the creditor presenting a bankruptcy petition in relation to such a debtor and there is therefore no reason why the creditor should not serve a statutory demand as a preliminary to the presentation of a petition if the demand is not satisfied.

…Since the fully secured creditor is not entitled to present a bankruptcy petition against a debtor over whose assets he has his full security, it is not merely because of injustice that he should not be able to serve a statutory demand, but because there is no justification at all for allowing such a creditor to take a preliminary step towards insolvency proceedings which the creditor would not be allowed to invoke. If it is to be seen as an example of injustice, the creditors’ lack of any right to present a bankruptcy petition if the statutory demand is not complied with is what makes it unjust.” (emphasis added)

It thus follows that one should construe a creditor's right to serve a statutory demand in a way which is consistent with the same creditor's right to present a bankruptcy petition.  At §64, it was concluded that “[F]or those reasons in my judgment the existence of third party security, which on a statutory demand against the debtor who gave the security would bring into application rule 6.5(4)(c)***, is by itself entirely irrelevant under rule 6.5(4)(d)**** to a statutory demand served on a separate debtor even if liable as guarantor for the same debt but who has given no security himself…”. 

In the premises, the orthodox view would seem to be that third party security should not at least in the ordinary course of things make any difference to the creditor’s entitlement to bring bankruptcy proceedings against the debtor.

Indeed, the learned Deputy Judge also pertinently observed at §45 of his Judgment that “the court should be careful in not effectively permitting an intrusion on other rules; for example, rule 5(c), whereby a Debtor would be able to rely on third party security as if he had provided it himself or herself. That of course would be incorrect”. 

Rule 5(d) Limb – The Extreme Case

Having said the above, one is mindful that, as reiterated in the citation by his Lordship in Re Wah Tat Foundation, the residual discretion under the Rule 5(d) Limb enables the Court to set aside a statutory demand where there are “circumstances which would make it unjust for the statutory demand to give rise to those consequences in the particular case” and the “court's intervention is called for to prevent that injustice”.

Bearing the above in mind, as well as having regard to the harsh consequences of a bankruptcy order, it is not surprising for DHCJ Maurellet SC to hold at §46 of his judgment that “in an extreme case where the security, albeit one provided by a third party, would be of such an amount and of such liquidity (say cash or cash equivalent) that it could be said that no reasonable creditor would have proceeded to bankrupt the Debtor rather than realise the security, then perhaps the residual discretion could be relied upon” (§46).

The learned Deputy Judge went on to explain (at §47) that “this should not be considered as an intrusion in the rule in China and South Sea Bank v Tan which provides that the lender clearly has the legal right to sue the guarantor or the borrower as he sees fit. But rather this would be recognising that as the bankruptcy regime engages class remedies, as well as the more draconian consequences which flow from the bankruptcy, the court is entitled to consider the practical realities in any given case.”

Postscript

What is an “extreme case” potentially leads to further debate. However, the Court is of course not unfamiliar with the proper exercise of its discretion where it is so warranted by exceptional circumstances present in any given case. The formulation by the learned Deputy Judge therefore should not pose any real difficulty in its application. In the meantime, such an approach reflects the practical reality of the matter, which is perhaps of particular significance where one is dealing with the potential bankruptcy of a debtor.  

Michael Lok appeared for the Creditor in X v Y and authored this article.

* By the time of the substantive hearing, however, the Charged Shares (as defined below) had been sold, therefore this point no longer strictly speaking arose for determination. 

** The hearing took place on 31 October 2019, with the judgment delivered on the same day. However, the uploading and publication of the judgment was embargoed until further order.  An anonymized version of the Judgment was published and uploaded on 14 July 2020. 

*** English equivalent of the 5(c) Limb.

**** English equivalent of the 5(d) Limb.

 

 

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