Court of Appeal confirms Guy Lam applies to an arbitrable petition debt, set-off or cross-claim

The Court of Appeal recently issued two judgments in Re Simplicity & Vogue Retailing (HK) Co. Limited [2024] HKCA 299 (the CFI decision previously discussed here) and Arjowiggins HKK2 Limited v. Shandong Chenming Paper Holdings Limited [2024] HKCA 352 (the CFI decision previously discussed here).

These two judgments were handed down on the same day, both of which addressed the application of the landmark Court of Final Appeal decision in Re Guy Kwok-Hung Lam v. Tor Asia Credit Master Fund LP [2023] HKCFA 9 (previously discussed here). The only difference is that the dispute sought to be referred to arbitration in Simplicity is the petition debt (a disputed debt petition) whereas the debtor company in Shandong Chenming does not dispute the petition debt but seeks to refer to arbitration its cross-claim which exceeds the amount of the petition debt (a cross-claim petition).

Background

Simplicity

The company guaranteed payment obligations in respect of certain convertible bond instruments, which the issuer failed to fulfil upon maturity. Since the company was not able to pay the redemption amount, a petition was filed for a winding-up order to be made against the company. However, the company failed to file an affidavit in opposition in time and the court granted leave for the affidavit to be filed, conditional upon the company's payment of the debt into court (the Condition). Ultimately, the payment did not occur and the company sought an extension of three months to comply with the Condition and an adjournment of the petition. The company relied on two grounds of opposition: (i) there is a bona fide dispute as to whether the guarantee has been discharged, given variations of the principal contract between the petitioner and the issuer (Discharge Ground); and (ii) the dispute should be referred to arbitration in light of the arbitration clauses present in the relevant agreements (Arbitration Ground).

Linda Chan J at first instance found that there was no credible evidence that the company would be able to comply with the Condition, even if time were granted, since it was clear that it lacked the financial means to pay the debt. Since there was no basis to extend time or adjourn the petition, the petitioner was entitled to a winding-up order as of right. The company subsequently appealed.

Shandong Chenming

A petitioner issued a petition seeking to wind up Shandong Chenming Paper Holdings Limited (Shandong Chenming) on the ground of insolvency arising from the non-payment of an arbitration award, which the petitioner had been given leave to enforce as a judgment in Hong Kong. Shandong Chenming subsequently issued a summons seeking to dismiss or adjourn the petition on the basis that it had a cross-claim which exceeded the judgment debt owed to the petitioner under the petition and that the cross-claim was subject to an arbitration agreement.

Harris J at first instance held that Guy Lam applies to not only an exclusive jurisdiction clause, but also an arbitration clause and stayed the petition in view of Shandong Chenming's arbitrable cross-claim against the petitioner. The petitioner appealed.

Ruling

Simplicity

In Simplicity, the company raised two grounds of appeal.

Ground 1 is premised on the Arbitration Ground, where the appellant contends that the judge erred in failing to recognise that the reasoning in Guy Lam is, in principle, broad and wide enough by analogy to the scenario of a petition presented in reliance on a debt where the petitioner had previously agreed to resolve disputes over the debt by arbitration. In a pro-arbitration jurisdiction such as Hong Kong, a contracting party should similarly be bound by the arbitration clause unless the ground of opposition "borders on the frivolous or abuse of process", and/or where there are other creditors supporting the winding-up petition. In proceeding to resolve the disputes between the petitioner and the company summarily, the judge's approach went against the principles in Guy Lam which stressed the importance of party autonomy and holding parties to their agreements.

Ground 2 sought to challenge the judge's refusal to adjourn the petition for three months to another call-over hearing and extend time for the company to comply with the Condition. The contention is that the judge's exercise of discretion is plainly wrong.

In considering whether the principles in Guy Lam should be applied by analogy, Kwan VP held that the controversy as to whether the debtor should be required to demonstrate a bona fide dispute of the petition debt on substantial grounds, notwithstanding the existence of an arbitration clause for a petition to be stayed or dismissed, should be laid to rest in light of the reasoning in Guy Lam. The Court of Appeal confirmed the following:

• the "established approach" that a petitioner is ordinarily entitled to a bankruptcy or winding-up order if the petition debt is not subject to a bona fide dispute would not be appropriate where the petition debt is covered by an arbitration clause. Having considered the pro-arbitration approach taken by Hong Kong courts, 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;
• the approach of the court in exercising its discretion is "multifactorial", whether it be the exercise of its jurisdiction to make a bankruptcy or winding-up order upon being satisfied with the proof of the petitioning debt, or in determining whether there is a bona fide dispute of the debt on substantial grounds, or in ordering the petition to be dismissed or stayed. Hence, the court may decline to hold the parties to the agreed dispute resolution mechanism where the defence is frivolous or an abuse of process; and
• the debtor needs to demonstrate a genuine intention to arbitrate. The steps required under the arbitration clause to commence the process may include preliminary stages such as mediation and, even if no steps were taken, the court could still exercise its discretion to grant a short adjournment for the debtor to commence arbitration and require an undertaking from them to proceed with the arbitration with all due dispatch.

The Court of Appeal dismissed the appeal. There is nothing to suggest that the trial judge had misunderstood the evidence or the relevant principles in exercising her discretion, given that the company had not provided sufficient and proper evidence to indicate that the petition debt was disputed and that the dispute would be referred to arbitration. The court held that, even if the Arbitration Ground is regarded as properly raised in opposition to the petition, the Discharge Ground (being the sole defence relied on by the company to dispute the petition debt) is one which "borders on the frivolous or abuse of process". This would be a sufficient countervailing factor against the exercise of discretion to decline the jurisdiction in the winding-up petition and hold the parties to their agreement to arbitrate.

Shandong Chenming

The appellant in Shandong Chenming also raised, as a ground of appeal, that Guy Lam does not apply by analogy to a disputed petition debt subject to an arbitration clause, but conceded the point subsequently, only seeking to argue that Guy Lam does not apply to disputed cross-claims subject to an arbitration clause. The Court of Appeal considered such concession to be correct, based on Simplicity.

The Court of Appeal held that the treatment of mere cross-claims was not directly dealt with in Guy Lam. In considering whether the approach in Guy Lam applies to cross-claims subject to arbitration, G Lam JA held that:

• where the company opposes the winding-up petition by relying on a claim that exceeds and constitutes a transaction set off against the petition debt, it is treated as a dispute of the petition debt itself;
• where the cross-claim is subject to an arbitration clause, for the court to enter into its merits and determine that there is no genuine and serious cross-claim, or one that is of substance, would be against the parties' agreement. Such a determination would be akin to giving a summary judgment in favour of the defendant and against the claimant in respect of the cross-claim; and
• applying the Guy Lam approach to cross-claims would not create a debt dodger's charter since the debtor needs to show a valid exclusive forum agreement between the parties that governed the cross-claim. In any event, the rule can be displaced where the dispute "borders on the frivolous or abuse of process", such as delay in putting forward a cross-claim, which acts as a safety valve.

The appeal was dismissed. The Court of Appeal held that the Guy Lam approach is applicable where the dispute that falls within the scope of an exclusive forum agreement has been raised by: (i) a dispute of the petition debt; (ii) a claim of set-off; or (iii) a cross-claim that does not give rise to set-off.

Commentary

The two Court of Appeal judgments have dispelled uncertainty surrounding the applicability of Guy Lam to cases involving arbitration clauses. The implications are significant - a debtor may now seek to dismiss or stay a bankruptcy or winding-up petition pending arbitration by relying on an arbitrable petition debt, set-off or cross-claim which exceeds the petition debt. This underscores the key considerations of whether the petitioner is a net creditor with an interest in having the debtor wound up, taking into account the entire relationship between the parties and whether the parties have agreed to resolve their disputes by arbitration.

It should be noted that an arbitration clause by itself will not automatically lead to a dismissal or stay of an insolvency petition. The court will adopt a multifactorial approach in exercising its discretion to hold the parties to their agreed dispute resolution mechanism as a matter of public policy and decline to exercise its insolvency jurisdiction only in the absence of countervailing factors such as a dispute that borders on the frivolous or abuse of process.

Therefore, in applying to stay an insolvency petition on the basis that there is an arbitrable petition debt or cross-claim, it is paramount for the debtor to produce sufficient and proper evidence to indicate that the petition debt/cross-claim is disputed and that the dispute would be referred to arbitration (which the company in Simplicity failed to do). Most importantly, the Hong Kong court requires a debtor to demonstrate a genuine intention to arbitrate to deter the debtor from merely raising an arbitration clause as a tactical move. Any cross-claim that exceeds the petition debt should be put forward promptly because any delay in doing so without justification may be regarded as an abuse of process.

Sunny Liu, trainee solicitor of Dentons Hong Kong, is one of the authors of this article.

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