This article was featured in our 2023 Construction Arbitration Report, which is part of a series of industry-focused arbitration reports edited by Jus Connect and Jus Mundi.
This issue explores the construction industry and presents a goldmine of information based on data available on Jus Mundi and Jus Connect as of May 2023. Discover updated insights into construction arbitration and exclusive statistics & rankings, as well as in-depth global and regional perspectives on construction projects, disputes, & arbitration from leading lawyers, arbitrators, experts, arbitral institutions, and in-house counsel.
THE AUTHOR:
Paul Starr, Joint Coordinator at King & Wood Mallesons
Donovan Ferguson, Partner at King & Wood Mallesons
Jesse Tizard, Associate (Foreign Registered Lawyer) at King & Wood Mallesons
Introduction
Recent years have seen big challenges for the construction industry globally. In the United Kingdom,the Insolvency Service reported in April 2023 that more UK companies in the construction industry succumbed to insolvency than in any other (19%), rising to 4,165 in the 12 months ending March 2023 (nearly 1,000 more than the previous year).
Figures from May this year tell a similar story for Australia: of the 7,991 companies that entered external administration from June 2022 to April 2023, over a quarter were in construction (2,143), more than twice the next highest industry.
The statistics for Hong Kong reveal an outlier: contrary to some predictions, there was not, in fact, an appreciable rise in winding-up orders in 2022 (just 303 across all industries, four more than 2021). While these numbers highlight the resilience of the region as a whole, the construction industry here is not immune to the same economic headwinds seen elsewhere: inflation, labour and material shortages, supply chain troubles and volatile material and energy costs. As such, now is no time to let the guard down on solvency issues. The nature of major construction projects (technically complex with a multitude of stakeholders) and the current economic climate call for continued vigilance.
In this article we:
- outline common issues to consider when negotiating and drafting your contract;
- identify options (and common pitfalls) when responding to solvency concerns in the supply chain; and
- highlight recent developments in Hong Kong in the solvency disputes space.
Pre-contract and Drafting Issues
Well before a project kicks off, the first line of defence against insolvency risk should always be thorough due diligence. That being said, even the most rigorous due diligence cannot exclude the possibility that solvency issues only come to light after the project has started. For this reason, negotiating and drafting the contract well is essential.
The contract should clearly spell the meaning and the consequences of “insolvency”. Will insolvency be grounds for termination of the contract? If so, will termination result by default, or will it be at the option of the solvent counterparty?
It is important to define “insolvency”. One party may wish to define it by reference to precise events, e.g., insolvency upon appointment of a receiver. Left undefined, its meaning will be determined in line with authorities, which generally say a company is insolvent if it is unable to pay debts as they become due. This will be a question of objective fact usually requiring a forensic insolvency expert to give evidence, if the matter is ever in dispute.
A challenge arises where signs of insolvency emerge in piecemeal fashion (as they often do). Early red flags might include staffing or turnover issues, repeated failures to achieve project milestones; failure to pay sub-contractors or even staff; performance issues or deficient workmanship; and requests for changes to the agreed payment mechanism or other arrangements to improve cash flow, to name a few.
In these situations, the ship may look to be sinking even as the source and extent of the leak are unknown. To protect your position, a key contractual safeguard is a clause setting out precisely what information must be made available on request and when it must be provided. For example, an employer may insist that the contract entitles it to certain financial information and accounts to provide a clearer picture of the true cash flow position, or details as to liabilities or the realisability of assets. Another option, which is often included in contracts, is security by way of performance bonds or retention, to provide some recourse if your counterparty becomes insolvent.
Insolvency in your Supply Chain – What are the Options (and Pitfalls)?
Termination on a construction project will normally be the last resort, because there is often an overriding desire to keep the project moving and the time and cost involved with securing a replacement contractor is unattractive. For employers faced with a potentially insolvent main contractor, one option may be to make direct payments to sub-contractors, to secure continued progress. Care should be taken here because there are distinct and hidden risks:
- First, making direct payments may not alleviate a contractor’s financial strife if the problem is more fundamental. An employer should monitor the situation closely and reconsider future payments if there is no improvement.
- Second, direct payments risk being treated as unfair preferences which, in Hong Kong, are voidable under Cap. 32 Companies (Winding Up and Miscellaneous Provisions) Ordinance, s. 266. In most instances, the issue in dispute is likely to be whether the employer was “influenced… by a desire to” prefer the sub-contractors, as required by s. 266(4). Provided the subjective desire of the employer is to maintain the project or respond to commercial or moral pressure from sub-contractors, direct payments are unlikely to be voidable. A prudent (but unpopular) option may be to require any sub-contractors to indemnify the employer in the event those payments were ever clawed back by liquidators.
- Third, before making any direct payments, it is essential to ensure that they are contractually operating as intended: i.e., that direct payments to sub-contractors defray any obligation to pay the employer by an equal amount. Again, one solution is to require the sub-contractors to provide an indemnity against any liability the employer may have to the contractor.
Depending on the outlook, other options might include advance payments or early release of retention money. However, one would expect these to be accompanied by appropriate security from the main contractor.
Termination may be preferred, especially if other options have been exhausted. If so, first check there is a right to terminate, either for insolvency, performance issues, or both. An invalid termination may lead to a counterclaim for repudiation. The terminating party should then be ready to immediately exercise its post-termination rights, e.g., taking possession of the site along with all equipment and temporary works (if entitled to do so).
It may be necessary for the employer to engage not just a replacement contractor but further sub-contractors, depending on what works remain to be completed. Detailed record keeping should be kept of all completion costs, plus any defects or unfilled “scope gaps” in the work.
Hong Kong as a Forum for Insolvency Related Disputes
Insolvency issues can flare into legal disputes in many ways. We highlight two key developments for insolvency disputes in Hong Kong below.
Interplay between the Hong Kong Courts’ Winding-up Jurisdiction and Arbitration
In Hong Kong, insolvency proceedings often begin with a statutory demand. If the debtor fails to pay the statutory demand within 21 days, the creditor can petition to have the debtor company wound up. However, the debtor may resist a statutory demand if the debt in question is subject to a dispute.
In Re Southwest Pacific Bauxite Ltd [2018] 2 HKLRD 449 (“Lasmos”), the Hong Kong Court of First Instance (“CFI”) had held that where three criteria are satisfied, a creditor’s winding-up petition should be dismissed (save in “exceptional” circumstances):
- the company disputes the debt;
- the contract under which the debt arises contains an arbitration clause covering the dispute; and
- the company take the steps required under the arbitration clause to commence the contractually mandated dispute resolution process.
The decision has been the subject of heated debate. A recent decision of the Court of Final (“CFA”) appeal, Re Guy Kwok-Hung Lam [2023] HKCFA 9, delivered on 4 May 2023, refers to but does not resolve the Lasmos controversy. The CFA upheld a decision of the Court of Appeal that, where a dispute over a petition debt was subject to an exclusive jurisdiction clause (“EJC”) in favour of a foreign court, the court in Hong Kong should decline to exercise jurisdiction in insolvency proceedings, save for “strong reasons” to the contrary.
While the parallel for insolvency proceedings where an arbitration agreement is at play is obvious, the CFA noted that, unlike EJC clauses (where the issue of whether to decline jurisdiction in favour of the agree forum is not “burdened by statutory constraint”), there was by statute a non-discretionary imperative to refer any disputes the subject of an arbitration agreement to arbitration. This points toward a potentially compelling policy argument in favour of the Lasmos approach insofar as arbitration agreements are concerned. However, the CFA said it was :
“not necessary for present purposes to explore the interaction of the non-discretionary provision applicable to arbitration clauses with the statutory jurisdiction of the CFI in bankruptcy and in company insolvency”.
Pilot Recognition and Cooperation Scheme
Insolvency proceedings in Hong Kong often involve a cross border element. The recent pilot mutual recognition and cooperation scheme for insolvency proceedings between Mainland China and Hong Kong, signed on 14 May 2021 (the “Pilot Scheme”), is a welcome development in this regard, for liquidators and investors alike.
Under the Pilot Scheme, liquidators form Hong Kong may seek recognition of insolvency proceedings in designated areas of the Mainland, and vice versa. The first application under the scheme was made on 20 July 2021, and decided in Re Samson paper Co Ltd [2021] HKCFI 2151. There, the CFI determined that it was :
“desirable that the Liquidators’ appointment [be] recognised and assistance provided in Shenzhen (…) in order that the Liquidators can collect in the assets within the jurisdiction of the Shenzhen Court.”
The assets concerned included wholly owned subsidiaries in Shenzhen, and receivables totalling HK$422 million.
In practice, the Hong Kong Court writes a letter to the relevant Mainland Court, and upon recognition by the Mainland Court, the liquidators then exercise the same functions and powers they would otherwise have in Hong Kong. The Pilot Scheme has seen significant uptake since it was implemented and marks a major enhancement to cross border insolvency administration between Hong Kong and the Mainland.
*References to “Hong Kong” shall be construed as references to “Hong Kong Special Administrative Region of the People’s Republic of China”.
ABOUT THE AUTHOR
Paul Starr is a Joint Coordinator of King & Wood Mallesons’ worldwide Arbitration Group. His work involves a range of commercial and construction disputes, including in litigation, arbitration and mediation. He has acted for PRC, Hong Kong and international clients on disputes involving the Hong Kong Airport; Disneyland; and the landmark M+ Museum development, to name a few. Beyond Hong Kong, his practice spans the Belt and Road: Greater China, Asia, Central America, the Middle East and Africa.
Donovan Ferguson is a Partner of King & Wood Mallesons in the Dispute Resolution team. He specialises in infrastructure, construction and commercial disputes. He works closely with clients in the building, energy and projects sectors, advising on the full life cycle of their projects in Asia. Donovan is praised for resolving major disputes quickly and cost effectively, avoiding litigation or arbitration where he can and using other methods to achieve his client’s commercial objectives.
Jesse Tizard is an Associate (Foreign Registered Lawyer) in King & Wood Mallesons’ Hong Kong Dispute Resolution team. His practice covers a wide range of construction and commercial disputes including in litigation and arbitration.
Find more data-backed insights in our 2023 Construction Arbitration Report
