The Effect of Arbitration Clauses on Winding Up Petitions: Arbitration Come What May?

As in many current and former Commonwealth jurisdictions, Hong Kong’s insolvency legislation empowers the courts to wind up or bankrupt debtors on grounds of insolvency. Traditionally, the courts have dismissed winding-up petitions where there is a bona fide defence on substantial grounds to the debt in question. With the growing policy emphasis on the use of arbitration, however, the courts in Hong Kong and elsewhere have been faced with the question of whether to dismiss winding up petitions where the parties’ underlying agreement contains an arbitration agreement. Does the pro-arbitration public policy require the courts to dismiss winding up petitions in favour of arbitration?

The Traditional Approach

Section 20 of the Hong Kong Arbitration Ordinance (the “AO”) requires the court to refer the parties to arbitration if a matter which is the subject of an arbitration agreement is brought before it, unless the agreement is null and void, inoperative or incapable of being performed. Established authorities, however, indicate that insolvency petitions do not fall within s. 20 of the AO because insolvency petitions are a class remedy available to all creditors and do not involve the enforcement of a creditor’s rights against the debtor (as there is no adjudication as between the creditor and the debtor even when the petition is granted). As a result, there is no automatic, mandatory or non-discretionary stay in favour of arbitration.

Instead, the courts in Hong Kong and in many other current and former Commonwealth jurisdictions (such as England and Wales, the British Virgin Islands and Singapore) have discretion in deciding whether to dismiss or stay an insolvency petition. The traditional approach is that the courts will only dismiss an insolvency petition in favour of arbitration if the opposing debtor is able to prove that it has a bona fide defence on substantial grounds to the underlying debt. In practice, this has meant that the courts will grant the creditor’s application to wind up the debtor if the debtor has failed to pay a debt without a credible defence, without requiring the parties to first arbitrate.

The Salford Estates Approach

The English courts, however, broke with the traditional approach in December 2014. In Salford Estates (No 2) Ltd v Altomart Ltd (No 2) [2015] Ch 589, the English Court of Appeal unanimously upheld a decision to stay a winding up petition in favour of arbitration. The Court held that in exercising their discretion whether or not to wind up a company on grounds of insolvency, the courts are required to exercise that discretion in a manner consistent with the legislative intent behind the Arbitration Act 1996. The Court stated that:

“[T]he intention of the legislature in enacting the 1996 Act was to exclude the court’s jurisdiction to give summary judgment… it would be anomalous, in the circumstances, for the Companies Court to conduct a summary judgment type analysis of liability for an unadmitted debt, on which a winding up petition is grounded, when the creditor has agreed to refer any dispute relating to the debt to arbitration. Exercise of the discretion otherwise than consistently with the policy underlying the 1996 Act would inevitably encourage parties to an arbitration agreement – as a standard tactic – to by-pass the arbitration agreement and the 1996 Act by presenting a winding up petition.”

The Court reasoned that the absence of an admission of the petitioning debt sufficed to constitute a “dispute” under the Arbitration Act 1996, which is defined to include “any difference”. The Court concluded that the arbitration agreement covered the dispute as to petitioning debt and thus stayed the petition so that the parties would be compelled to resolve their “dispute” by arbitration. The approach effectively places insolvent debtors who are party to an arbitration agreement in a favoured position as compared to other insolvent debtors, by enabling them to stave off insolvency proceedings simply by not admitting the underlying debt even though there is no “real” dispute about the debt.

The English courts followed the Salford Estates approach in subsequent cases. In 2015, the English High Court in Eco Measure Market Exchange Ltd [2015] BCC 877 summarised the ruling in Salford Estates as placing “a very heavy obstacle in the way of a party who presents a petition claiming sums due under an agreement that contains an arbitration clause.” As the Court explained, the new approach “entitled [the debtor] to have the petition dismissed without having to show, as would normally be the case, that the debt upon which the petition is based is, to use the time-hallowed expression, bona fide disputed on substantial grounds”.

Emergence of Divisions Over the Salford Estates Approach

However, a division soon emerged over the purportedly “pro-arbitration” approach in Salford Estates in the case law of certain current and former Commonwealth jurisdictions that consider English authorities to be highly persuasive. In late 2015, the Eastern Caribbean Court of Appeal declined to adopt the Salford Estates approach in Jinpeng Group Ltd v Peak Hotels and Resorts Ltd, BVI HCMAP 2014/0025 and 2015/0003, 8 December 2015. The Court concluded that the BVI courts’ statutory jurisdiction to wind up a company based on its inability to pay its debts as they fall due unless the debt is disputed on genuine and substantial grounds is “too firmly a part of BVI law” to impose new and additional requirements on creditors. Meanwhile, in Singapore, Aedit Abdullah JC (as he then was) in the High Court elected in September 2016 in BDG v BDH [2016] 5 SLR 977 to adopt the Salford Estates approach in light of Singapore’s pro-arbitration policy. The Court reasoned that the parties should be held to their contractual bargain to refer disputes to arbitration, and the courts should not concern themselves with the strength of the debtor’s defence, provided that there is a prima facie dispute covered by the arbitration agreement, and that the debtor has demonstrated “prima facie compliance” with the requirements of the dispute resolution clause.

Adoption of the Salford Estates Approach in Hong Kong

Meanwhile, Hong Kong had developed only first instance jurisprudence on point. The issue came before the Hong Kong courts for consideration again in early 2018. In a March 2018 decision in Re Southwest Pacific Bauxite (HK) Ltd [2018] 2 HKLRD 449 (“Lasmos”), Harris J in the Court of First Instance decided to depart from prior Hong Kong first instance authorities and broadly followed the English Court of Appeal’s approach in Salford Estates. Harris J considered that prior Hong Kong authorities had failed to attach sufficient weight to the policy underlying the AO, i.e., encouraging and supporting party autonomy in determining the means by which a dispute arising between them should be resolved. Citing Salford Estates and its related authorities and the Singaporean authority BDG v BDH, Harris J held that the courts should generally dismiss an insolvency petition in favour of arbitration when the following three requirements are met:

• The opposing debtor disputes the petitioning debt (it is sufficient for the debtor to show that the debt is not admitted);
• The contract under which the petitioning 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.

Like Salford Estates, the Lasmos approach establishes a substantial obstacle to winding up petitions in respect of debts arising under agreements containing an arbitration clause, with the additional requirement (derived from BDG v BDH) that the opposing debtor must have taken a step towards formal dispute resolution. If the creditor and the debtor have an arbitration agreement, the insolvent debtor is able to stave off insolvency proceedings simply by not admitting the underlying debt and is able to force the creditor to arbitrate, even though there is no “real” dispute about the debt.

The Hong Kong Court of Appeal’s Judgment in But Ka Chon

The issue came before the Hong Kong Court of Appeal in mid-2019 in But Ka Chon v Interactive Brokers LLC [2019] HKCA 873, an appeal concerning the Court of First Instance’s refusal to set aside a statutory demand, founded upon a debt arising out of a contract containing an arbitration agreement.

In the Court of First Instance, the opposing debtor had argued that (1) he had a defence and counterclaim based on misrepresentation, and (2) the court should follow the Salford Estates approach and set aside the statutory demand, without any need for him to show that the debt was bona fide disputed on substantial grounds. Deputy High Court Judge Yee (1) dismissed the claim on misrepresentations on the facts, and (2) decided to follow the pre-Lasmos approach, noting that the Lasmos decision “made a substantial departure from previous authorities at first instance in Hong Kong”. DHCJ Yee held that there was no genuine dispute to be arbitrated and dismissed the debtor’s application to set aside the statutory demand. The judge further noted that even if the Lasmos approach applied, he would not have set aside the statutory demand because the debtor had not commenced arbitration for over four years and had no genuine intention of doing so.

On appeal, the Court of Appeal upheld DPHC Yee’s findings on the facts, including that the debtor had no genuine intention of commencing arbitration. As such, regardless of the approach to be taken, there was no basis for the Court of Appeal to interfere with DPHC Yee’s exercise of discretion.

Although it was not necessary to rule on the applicable approach, the Court of Appeal went on to discuss the appropriateness of the Lasmos approach on an obiter basis, given “the importance of this issue to insolvency proceedings”. The Court noted that Hong Kong’s insolvency legislation confers a statutory right on creditors to petition for winding up or bankruptcy of an insolvent debtor. This right is firmly a part of Hong Kong law and no evidence was provided to the Court indicating that the intent of enacting the AO was to change the insolvency legislation. The Lasmos approach represents “a substantial curtailment” of creditors’ statutory right by requiring the courts to exercise the discretion in only one way if the three requirements are met: in favour of arbitration save in wholly exceptional circumstances. While noting that the courts should give considerable weight to the existence of an arbitration agreement, and recognising the possibility that exercise of the discretion in a manner inconsistent with pro-arbitration policy might encourage parties to bypass an arbitration agreement, the Court noted that the courts have powers to deal with such tactics. While it remains to be seen how the Court of Appeal will rule in the future, these obiter remarks indicate that it may not follow the Lasmos approach.

Growing Divisions Over the Salford Estates Approach

Meanwhile, divisions have continued to grow in other jurisdictions over the applicability of the Salford Estates approach. In Singapore, following the High Court’s September 2016 decision in BDG v BDH, a split has emerged in the first instance jurisprudence. In a November 2018 decision, the Singapore High Court rejected the Salford Estates approach in VTB Bank (Public Joint Stock Company) v Ana Group (Singapore) Pte Ltd [2018] SGHC 250. While recognising the force of the pro-arbitration policy underpinning the Salford Estates approach, the High Court considered that it was bound by the Singapore Court of Appeal decision in Metalform Asia Pte Ltd v Holland Leedon Pte Ltd [2007] 2 SLR(R) 268, which held that the debtor-company was required to show that the debt is bona fide disputed on substantial grounds before the court would stay winding up proceedings, regardless of whether that dispute is governed by an arbitration agreement. The division was further compounded in the High Court’s decision in March 2019 to follow Salford Estates in BWF v BWG [2019] SGHC 81, in which the Singapore High Court concluded that the relevant statements in Metalform were merely obiter dicta and hence it was not bound by the Court of Appeal decision. The appeals of both VTB Bank and BWF v BWG are currently pending before the Singapore Court of Appeal.

The Need for a Definitive Resolution

There is now a lack of clarity in both Hong Kong and Singapore as to whether winding up petitions are to be dismissed where the parties’ underlying agreement contains an arbitration clause. This is an important issue that is likely to substantially impact contracting parties’ choice of dispute resolution mechanism and litigation strategy. The irony of the English Court of Appeal’s “pro-arbitration” approach in Salford Estates is that it is likely to make arbitration less desirable as compared to litigation because it places creditors who are party to an arbitration agreement at a disadvantage as compared to other creditors. If the courts reach a definitive decision to follow Salford Estates, this may well cause likely creditors in contractual relationships giving rise to frequent and uncomplicated payments obligations (eg, distribution and licensing agreements and share purchase agreements) to favour litigation over arbitration.

The risk of giving absolute primacy to arbitration agreements come what may is obviously that insolvent companies and individuals who are party to an arbitration agreement will be able to avoid an order of winding up or bankruptcy by simply not admitting the debt (even in the absence of a credible defence or counter-claim), while incurring further debts, thereby prejudicing creditors as a whole. When this issue comes before the Hong Kong and Singapore Courts of Appeal for consideration – likely in short order in Singapore – the judges will be called upon to weigh pro-arbitration public policy against other important public policies.

Jurisdictions: 

Partner, Morrison & Foerster

Associate, Morrison & Foerster