Does removing an insolvent party from a joint venture infringe the anti-deprivation rule?

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Introduction

The Court of First Instance analysed whether a clause within a joint venture agreement between a company in liquidation and an interested party should be void for being classified as “disposition” under section 182 of the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap 32).

Build King Construction Ltd (“BK”) formed a joint venture with Hsin Chong Construction Company Limited (in liquidation) (the “Company”) to prepare for a tender for executing a major government design and construction project in Kowloon (the “JV”). The case Re Hsin Chong Construction Co Ltd (unreported, HCCW 239/2018, 7 May 2019) is an application of BK against the Company for a declaration of the validity of a clause in a joint venture agreement (“JV Agreement”) signed between BK and the Company.

The clause provides a contractual right on the innocent party upon the occurrence of any one of five specified events on the defaulting party, including insolvency, to (1) exclude the defaulting party from the JV and carry on the JV on its own, in the absence of the defaulting party, and to operate all the accounts under the JV or (2) wind up the affairs of the JV (the “Clause”).

Upon the liquidation of the Company, BK exercised the Clause and excluded the Company from the share profits generated by the JV. The two parties then entered into a supplemental agreement allowing BK to acquire the Company’s residual rights in the JV. The provisional liquidators, on behalf of the Company, argued that the exercise of the rights under the Clause amounted to a “disposition” under section 182 and was void. BK therefore sought for, inter alia, an order from the Court to confirm that the Clause did not constitute a “disposition” within section 182 and that the supplemental agreement is valid.

Section 182 of Cap 32

Section 182 of Cap 32 provides that, “in a winding up by the court, any disposition of the property of the company, including things in action, and any transfer of shares, or alteration in the status of the members of the company, made after the commencement of the winding up, shall, unless the court otherwise orders, be void.

The purpose of Section 182 is to preserve the status quo and support the principle of pari passu distribution of assets. The leading English authority is the decision of the Supreme Court in Belmon Park Investments Pty Ltd v BNY Corproate Trustee Services Ltd & Anor [2012] 1 AC 383. The general principle is that parties cannot contract out of the insolvency legislation, and the two sub-rules are namely, (1) the anti-deprivation rule and (2) the pari passu rule that it is contrary to public policy to contract out of pro rata distribution on insolvency.

The current issues before the Court were:

  1. whether the exercise of the Clause was a disposition within section 182;
  2. whether the Clause breached the anti-deprivation rule, therefore rendering the Clause void;
  3. whether the Clause amounts to a penalty; and
  4. whether the supplementary agreement was valid.

Issue 1: Whether the exercise of exclusion rights is a “disposition”

The Court considered that since the Company was insolvent, it was in no position to continue to perform its own contractual obligation, and therefore the Company would not be entitled to any share in the future profits of the JV. A such, there could be no “asset” or “rights” that are currently subject to disposition, and the exercise of exclusion rights under the Clause could not be regarded as destroying or dealing with any “asset” of the Company or “rights” which cannot be accrued because of the Company’s insolvency. Therefore the exercise of exclusion rights does not constitute as a “disposition”.

 Issue 2: Whether the Clause contravenes the anti-deprivation rule

Under the Supreme Court decision, it is necessary to look at the substance of the agreement rather than its form and consider whether the provision in question amounted to an illegitimate attempt to evade the relevant bankruptcy law or had some legitimate commercial basis. The issue is “to consider each transaction on its merits to see whether the shift in interests complained of could be justified as a genuine and justifiable commercial response to the consequences of insolvency”.

In the present case upon the exercise of the exclusion rights under the Clause, the defaulting party was excluded from enjoying the profits of the JV accruing after the date of exclusion while having to bear the its share of losses until the completion or termination of the construction project.

By construing the JV agreement as a whole, the Court held that the Clause was clearly sensible and it was in the interest of the parties to provide for the contingency that one of the parties may become insolvent. Both parties are seasoned players in the construction industry and have similar bargaining strengths. It is therefore difficult to discern any scheme or plan to evade insolvency laws. The Court also accepted BK’s argument that given the context of construction project, it is appropriate for defaulting party to bear its share of loss in the project since claims for latent defects tend to emerge only upon the completion of the project.

Based on the above, the Court concluded that the Clause did not offend the anti-deprivation rule. Thus, it was held that BK had adequately exercised its rights pursuant to the Clause.

Issue 3: Whether the Clause is penal in nature

Furthermore, the provisional liquidators argued that the Clause serves no legitimate commercial purpose and only serve to punish the defaulting party. The question was whether the Clause imposes a detriment on the Company out of all proportion to any legitimate interest of BK in the enforcement of the primary obligation under the JV agreement.

The Court considered that upon the insolvency of one party, the risk profile under a JV would change significantly i.e. when the remaining JV partner would have to carry on the project on its own and bear an increased risk of loss. Additional protection was therefore reasonable. Therefore the Clause was not inherently penal and was conducive to the parties achieving the commercial objectives in completing the JV.

Issue 4: Validity of the supplemental agreement

The Court was unable to find evidence suggesting the price paid by BK in acquiring the residual rights of the Company was unfair or at an undervalue. The supplemental agreement was negotiated at arm’s length and the Court found no ulterior purpose in BK making the payments. It was thus held that the supplemental agreement entered into by the two parties was valid and effective.

Takeaway

Parties under joint ventures should bear in mind the above analysis of the court when drafting clauses in the joint venture agreements which provide that one party in essence would be “kicked out” of the joint venture upon its insolvency. Clauses should provide an adequate commercial rearrangement of rights to deal with the insolvency of either party and give effect to the commercial purpose of the joint venture to avoid infringing the anti-deprivation rule and related pitfalls.

 

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Important: The law and procedure on this subject are very specialised and complicated. This article is just a very general outline for reference and cannot be relied upon as legal advice in any individual case. If any advice or assistance is needed, please contact our solicitors.
Published by ONC Lawyers © 2019