In light of the judgment in Re Sweetmart Garment Works Limited (In Liquidation) (HCCW 755/2005), liquidators could make unfair preference claims more readily against non-associates.

What is Unfair Preference?

A business facing financial difficulties and on the verge of insolvency should treat its creditors fairly. An unfair preference may have occurred when an insolvent company shortly before going into liquidation makes a payment, or carries out any other act, which puts a creditor in a better position than other creditors. In the event of liquidation, if the Court is satisfied that the decision of the subject company to pay a creditor was influenced by a desire to prefer that creditor, the court may make such order as it thinks fit for restoring the position to what it would have been if the company had not given the unfair preference.

Associated Creditors and Non-Associated Creditors

The law on unfair preference differentiates between “associates” and “non-associates” of a company. By virtue of section 51B(6) of the Bankruptcy Ordinance (Cap. 6), a creditor is an associate of a company in liquidation if that company or its associates have control of that creditor. If the preferred creditor is an associate of the company, a desire to prefer that creditor over the others is presumed, except in the case where the associate is an employee. The creditor has the onus of proof to rebut the presumption. In contrast, in the case of an unfair preference which is given to a non-associate of the company, the onus of proof is on the liquidators to show that the company was influenced by a desire to prefer that creditor over the others.

In addition, section 51(1) provides that in the case of a non-associate, an unfair preference is only susceptible to challenge where it is given at a time in the period of 6 months ending with the date of the presentation of the bankruptcy petition against he debtor. The relevant time period is extended to two years in the case of an unfair preference which is given to an associate of the company.

It has been observed that unfair preference claim against non-associates has rarely been made by liquidators. This may be explained by the difficulties foreseen by them to prove to the satisfaction of the Court that the transaction was motivated by the debtor’s desire to prefer a creditor. There is a common misconception that financial institutions like banks, being independent entitles, do not have connection to or interest in their clients. In view of this, it would be difficult for the liquidators to establish the relevant desire to prefer. This is likely to change following the judgment in Re Sweetmart Garment Works Limited (HCCW 755/2005).

Re Sweetmart Garment Works Limited (In Liquidation) 

In this case, the company in liquidation, Sweetmart Garment Works Limited (the “Company”), went into compulsory liquidation on a creditor’s petition. A little over a month prior to the presentation of the petition, the Company granted a mortgage over a yacht in favour of HSG Nordbank AG (the “Bank”), which is a non-associate of the Company. The loan was drawn down three days later and used to repay an existing overdraft of the Company with the Bank.

Following the presentation of the petition, the bank exercised its right under the mortgage and took possession of the yacht. The vessel was sold and a sum was realized after the deduction of sale expenses. The Company’s liquidators (the “Liquidators”) then sought, inter alia, a declaration from the Court that the mortgage constituted an unfair preference in favour of the Bank and that it was accordingly void. The Bank disputed that the Company, in granting the mortgage to it, was influenced by the desire to put the Bank in a better position than it would have been in had the mortgage not been granted.

How to Determine if the Transaction was Influenced by a Desire to Prefer?

In determining whether the mortgage was influenced by such a desire, the judge reiterated the approaches adopted by Millett J (as he then was) in Re MC Bacon Limited [1990] BCLC 324, and by Kwan J in Re Phantom Records Limited (HCMP 2770/2003), which are summarized as below:

1.      In deciding whether a transaction would be set aside as an unfair preference, two elements have to be established:

(i)                 a desire of the company to produce the effect of improving the creditor’s position in liquidation, and

(ii)               that such desire had influenced the decision of the company to enter into the transaction.

2.      Desire is a subjective state of mind, whereas intention is objective in that a person is taken to intend the necessary consequences of his actions. It is no longer necessary to establish a dominant intention to prefer but a desire to better the creditor’s position.

3.      There is no need for there to be direct evidence of the requisite desire. Its existence may be inferred from the circumstances of the case.

4.      The requisite desire, if present, must be one of the factors which operated on the minds of those who made the decision. It needed not be the only factors or even the decisive one.

Counsel for the Bank also relied on an observation that a preference would normally escape censure if there was a good explanation for it having been made, which could consist of the fact that the preference was made in response to pressure being placed on the debtor by the creditor, which whether such pressure be commercial or moral.

Drawing Inference from the Steps Taken by the Bank and Other Creditors

The judge, having reviewed the contemporaneous correspondence between the Bank and the Company and the evidence of the steps being taken by other creditors of the Company, expressed that the steps taken by the Bank were too mild and unspecific, which could not sensibly be regarded as constituting pressure on the Company in any real form. In stark contrast, the steps taken by the other creditors were “more concrete, more serious, and instituted much more promptly” than those threatened by the Bank.

Besides, given it did not appear that there could have been any real prospect of the Company trading through its difficulties, it could not be said that the mortgage was granted to preserve the ongoing commercial relationship with the Bank. As the overall indebtedness of the Company to the Bank was not thereby reduced by the mortgage, the judge found no good reason for the grant.

Furthermore, even though personal bankruptcy proceedings were threatened against the Company's directors by other creditors consequent on the service of statutory demands against them, on the very day the vessel was offered to the Bank as security. The judge took this as strong evidence of a desire to prefer the Bank.

In view of the above, the judge found the indirect evidence comfortably discharged the burden on the Liquidators of proving the relevant desire and was, at least, one of the factors which influenced the Company in its decision to grant the mortgage. The declaration sought was therefore granted.