Bankruptcy applications in Hong Kong hit a five-year high in February, marking the highest level of petitions seen since the Severe Acute Respiratory Syndrome crisis. Filings were made by 1,500 individual and non-limited firms during the month, compared to 1,266 filings made in January, according to data from the Official Receiver’s Office. And lawyers believe that there is far more to come. “There is no real glut yet, we haven’t reached the peak,” says David Kidd, head of Allen & Overy’s financial restructuring group in Hong Kong.
The panic that spread through financial institutions from October has meant many banks have pulled credit lines as soon as a company is in trouble. In the last crisis, companies often had several months to restructure. Now, banks are pulling out within weeks.
“Everyone’s extremely nervous,” says Ian Chapman, senior consultant at Mayer Brown JSM in Hong Kong. “It’s hard to get financial institutions to restructure during the early part of the cycle, because things are dead in the water,” he says.
And the emergence of debt trades and funds means that more parties are involved during creditors meetings. As soon as a company is in trouble banks are contacted by third parties asking to buy their debt immediately. “You can see changes in the composition of the creditor group from one creditors meeting to the next,” says Stephen Eno, a restructuring partner at Baker & McKenzie in Hong Kong.
Many creditors have not had to deal with a financial crisis for some time. “Banks simply haven’t had to get together to organise restructurings in so long. It’s now completely changed,” says John Marsden, partner at Mayer Brown JSM in Hong Kong.
These problems are exacerbated by the absence of bankruptcy legislation. At a time when trust between banks and companies is at a historic low, the territory desperately needs clear legislation to outline debtor and creditor rights, and crucially, to provide provisional supervision, a statutory rescue mechanism similar to the Chapter 11 provision in the US.
“Trying to run a market without an effective insolvency regime is like Christianity without hell,” says Kidd.
The kindly liquidator
At the moment, the only way a company can restructure is by appointing a provisional liquidator (PL). According to law, these should only be appointed when a company is being wound up and they exist to safeguard its assets before being sold.
However, the example set by Legend’s case, where the court ruled that only liquidating companies could appoint a provisional liquidator, has not been followed, and companies that need time to restructure often do so.
In one case this year, a Hong Kong company with a provisional liquidator had two winding up petitions which were both postponed due to the possibility of the company being able to sell parts of its business. “The rationale is to stop creditors giving up on companies and allowing the provisional liquidators to find a better price for some of the assets, and ideally, be able to restructure not in fact liquidate,” says one Hong Kong-based partner.
All banks must agree to appoint a provisional liquidator. This happened quite frequently in previous downturns and they never went to court. But consensus is harder to find in this recession. In the 1997 financial crisis, companies were stripping their non-core businesses and concentrating on their traditional specialism, knowing that banks would support them again.
“But in this economic climate there are companies whose core business is no longer profitable as demand for their products has dropped dramatically. So the initial view from some banks is that there is little point in going through a restructuring and it might be better to appoint PLs straightaway to wind down the business.” says Eno. With this downturn and liquidity squeeze, any questionable dealings by management have quickly been exposed. “In these situations banks are more likely to petition the court to appoint PLs as soon as possible because they have lost faith in existing management,” Eno adds.
Companies bring in a provisional liquidator because that does provide a moratorium on debt. Although the process works, the original idea behind the role was to safeguard the assets but under the Hong Kong system they have come in to basically safeguard them in order to sell them. This is using legislation not intended for provisional liquidators.
“Our liquidation process is geared towards killing companies not restructuring them,” said one Hong Kong-based partner.
Previous failures
This is not the first time the territory has faced calls for a restructuring regime. A bill was proposed in 2000 called the Companies (Corporate Rescue) Bill. The proposed legislation failed though because it required the debtor to set aside in a trust fund enough money to pay all of the liabilities owed to its employees. “While the driver of this was admirable, we thought that it missed the point of such legislation,” says Kidd.
Many lawyers pointed out that unions failed to appreciate that the legislation was trying to save jobs. But ultimately, it ran the risk of preventing companies restructuring altogether because of an inability to fill this fund.
“It’s not a reasonable starting point, if a company is in trouble, to make them put their hand in their pocket,” says Chapman.
So, by 2004, the Bill had failed. But with the previous recession forgotten about, the urgency was lost and the plan was shelved.
A new law
Hong Kong needs bankruptcy legislation. Without it many companies that could be restructured will automatically liquidate. The government announced plans in January to re-visit the legislation, but at the time of going to press there had been no further developments. But it would certainly be welcome: “There is no other developed jurisdiction that creates such a barrier to entry,” says one Hong Kong-based lawyer.
Lawyers agree that the biggest need is for a moratorium without having to appoint a provisional liquidator. “Companies in financial difficulties need a breathing space to allow a professional to go in, take a good look at its business and try to formulate a restructuring plan,” says Eno. Once companies in the US enter into Chapter 11 they have months or even years to formulate a plan, depending on the size of the company. But in Hong Kong they receive only 30 days.
There is also a stigma attached to the notion of a provisional liquidator. Its title suggests liquidation, not restructuring. As such Hong Kong’s corporate rescue bill, which is now being revisited, introduces the concept of a provisional supervisor. “However, it is not clear when corporate rescue legislation will be enacted, there are still a number of issues on the table, in particular whether provisional supervisors would be personally liable for employees once the provisional supervisors have accepted their contracts,” says Eno.
There is no disagreement on the need for change though, and most believe that it does not need to be wholesale. Many lawyers believe that the 2000 Companies (Corporate Rescue) Bill could have succeeded and was largely undone by the employee liability fund. The government may also cherry pick facets of other laws, with the Chapter 11 process being taken from the US and the role of administrators adopted from China’s Enterprise Bankruptcy Law. Regardless, the government must act soon, to prevent more sound companies failing.