In Hong Kong, the majority of companies in the construction industry which fail tend to be contractors. It is extremely rare for a developer to fail and indeed it is infrequent that a main contractor will fail. However, the nature of the construction industry is such that the failure of companies further down the “food chain” is an all too common occurrence. Moreover, in these extremely competitive times, when profit margins are being squeezed ever thinner, the line between success and failure continues to become narrower.
However, the story is not all bad. The legislative environment in Hong Kong and the nature of the construction industry is such that although a company may become insolvent, there is often an opportunity, provided action is taken at an early enough stage, for the business of the company, if not the company itself, to be rescued; for its creditors to make some recovery; for its employees and sub-contractors to retain their jobs; and for developers and main contractors to ensure that the insolvency of a sub-contractor does not have a significant negative impact on any ongoing contracts.
Here, we look at some of the issues which frequently arise in construction related insolvencies. Although all the problems we look at are unlikely to arise in any one particular case, they are examples of those which commonly arise in the construction industry in Hong Kong.
To start with we will look at the options which are available for the purposes of trying to rescue an insolvent company in the construction industry.We will then look at some of the issues which arise when formal insolvency, usually liquidation occurs and how best these problems can be dealt with for the benefit all the stakeholders.
Rescue And Recovery Opportunities
Before looking in detail at the available options it’s important to understand what is not available. Hong Kong, unlike many other common law jurisdictions, does not have any formal corporate rescue procedure. The USA has Chapter 11, the UK has Administration. Even Indonesia, Thailand and PRC have formal procedures which create a moratorium on creditors claims. This in turn gives a distressed company a breathing space during which it and its advisors can formulate a rescue plan. Hong Kong has no such legislation and is unlikely to have any within the foreseeable future.
In its absence, professional advisors and their clients are often forced to rely on outdated procedures not necessarily suited to the present economic and commercial environment. Principle among these is the scheme of arrangement procedure.
Schemes Of Arrangement For Construction Companies
In essence, a scheme of arrangement is a Court supervised agreement between a company and its creditors whereby the creditors will generally agree to accept less than they are entitled to in full and final settlement of their claims against the company. In Hong Kong, in recent years, it has become common practice for schemes to be undertaken in conjunction with the appointment by the Court of a provisional liquidator pursuant to the provisions of s193 of the Companies (Winding-up and Miscellaneous Provisions) Ordinance.
The principle reason for the appointment of a provisional liquidator is that the Court order creates a moratorium which prevents creditors pursuing claims against the company. Whilst the moratorium is in place it gives the company’s professional advisors the opportunity to review its affairs and, if possible, come up with a rescue proposal which will provide creditors with a greater benefit than would be the case if the company went into liquidation.
Construction companies, provided their problems are identified at a sufficiently early date, are prime candidates for rescue using the scheme of arrangement procedure. However, before considering how a scheme can be used to rescue an insolvent construction company it is worth reviewing the circumstances under which the Court will appoint a provisional liquidator.
To persuade the Court to appoint a provisional liquidator it is necessary to show that the assets of the company are in jeopardy. In the case of a construction company, it is perhaps easier to persuade the Court of the danger to the assets than in other trading operations. It should, in most circumstances, be possible to establish that in the event of a provisional liquidator not being appointed, contracts may be terminated; sites may be re-entered; employers will withhold stage payments; and, at a more unofficial level, assets are likely to be illegally removed from the company’s construction sites by unhappy creditors. All of these events have negative consequences for the value of the company’s assets and ultimately the recovery for creditors.
Needless to say, each individual case will need to be treated on its merits. However, it is likely that following a review of the contracts being undertaken by the company and the extent of the difficulties faced by the company, it should be possible to show that the assets of the company are in jeopardy and thus persuade the Court that a provisional liquidator should be appointed.
Providing this can be shown to the satisfaction of the Court, there is every reason to expect that the Court will appoint a provisional liquidator. This creates the moratorium which prevents creditors pursuing any further legal action except with the leave of the Court. Leave is granted only in exceptional circumstances. The provisional liquidator, under the powers granted to him by the Court, is then in a position to review the various contracts (if he has not already done so) to assess whether or not they should be continued, discontinued, assigned, novated or otherwise dealt with.
At the same time, he is in a position to formulate a strategy for rescuing the company, if that is possible.
Exit Routes
In most cases, there are two possible exit routes, once a provisional liquidator has been appointed to a construction company. In most cases, a scheme of arrangement is dependent upon a third party investor injecting funds into the company to enable it to exit from its difficulties. With that in mind, the investor will need to be satisfied that going forward the company can trade profitably. The immediate question is “why should the company be able to trade profitably in the future, when it has clearly experienced difficulties in the past”. There are a number of potential answers to that question, although as with all things construction related, the real answer if probably an amalgam of various factors. One reason could be that new, more experienced management is brought in; greater economies of scale may be generated by being part of a larger group, the new owners may provide the company with access to markets from which previously it had been excluded either by virtue of its size or its lack of connections.
As part of the scheme of arrangement, the liabilities of the company are effectively erased. In return, the creditors receive a dividend in full and final settlement of all their claims. For its part, the investor acquires control of the company and is then free to utilise the company and its assets to generate future profits.
Among these assets are often government construction licenses. It is often for this reason that an investor will be prepared to inject funds into an otherwise insolvent company. This paper does not set out to explain the system of construction licences in respect of government contracts. However, in the context of an insolvent company the important aspect of a government licence is that it is not transferable. Indeed, it is not strictly an ‘asset” in the accepted sense of the word. It is not shown on the company’s balance sheet and it cannot be sold. However, it does have an intrinsic value which lies in the ability, by virtue of holding the licence, to allow the company to tender for government contracts. Companies which do not have any licences or which only have licences in specific areas are often prepared to acquire an insolvent construction company, through a scheme of arrangement, in order to in effect, acquire additional government licences.
However, it is not always possible to rescue a company in this way. All too often the directors of insolvent companies (and this comment does not apply solely to the directors of construction companies) fail to act on a timely basis. As a consequence the financial position of a company often deteriorates to such a parlous state that the prospects of rescuing the company are non-existent. However, there is still an opportunity to create value for the creditors by novating ongoing contracts.
Novation Of Construction Contracts
In broad terms, the novation of a contract is a tripartite agreement usually between the employer, the insolvent sub-contractor and the third party who wishes to take on the contract. As a consequence of the novation, the insolvent sub-contractor is relieved of any further responsibility or liability in respect of the contract, the employer agrees to this and passes over the contractual liability to the third party who assumes the benefits and liabilities associated with the contract.
In practical terms, if a company successfully proposes a scheme of arrangement, it is unlikely to want, or indeed be able to novate any of its contracts. To do so would in many ways defeat the object of a third party acquiring the company through a scheme, as it would not have any ongoing business. Moreover, if it is decided to novate the contracts, because on balance that is the best course of action which will create the greater benefit for creditors, then it is unlikely that a scheme of arrangement will be practical.
This is because, if the contacts are novated, it is probable that the company’s licences will be suspended and eventually terminated. Among the criteria for retaining government licences is that the company has a business of a particular size, has a minimum level of financial resources and has the necessary plant and equipment to undertake certain jobs together with the relevant technical expertise. If the contracts have already been novated to a third party, it is probable that the plant and equipment, expertise and financial resources will have been lost and the company’s licences are likely to be suspended permanently.
Liquidation Issues
What Happens In A Liquidation
Unfortunately, often due to directors not taking action on a timely basis, companies do fail. It is when this happens that the liquidator’s difficulties start. He is often faced with conflicting claims to assets which he has to resolve to his satisfaction. Moreover, he has to report eventually to the Court and the company’s creditors. As a result the liquidator must fully pursue all the possible claims.
Direct Payment Provisions
Direct payment provisions are essentially put in place in construction contracts in order to cut out the “middleman” and to help ensure that in the appropriate circumstances a project progresses on a timely basis if one of the parties gets into financial difficulties. However, when insolvency arises, the timing and circumstances surrounding any direct payments must be carefully scrutinised to see whether or not they contravene the provisions of the Companies (Winding-up and Miscellaneous Provisions) Ordinance which seek to ensure that once a liquidation starts, all creditors are treated equally.
In Hong Kong, two cases stand out which establish certain ground rules as regards direct payment provisions and their interaction with the insolvency process. These are Right Time Construction Company Limited and Golden Sand Marble Factory v Easy Success Limited
Right Time Construction Company Limited (“Right Time”) went into liquidation. It was the main contractor on a development for which Reality Enterprises (Hong Kong) Limited (“Reality”) was the employer. Before the presentation of the petition, the architects on the project certified a payment due from the employer to Right Time. However, rather than make the whole of the payment to the contractor, the employer paid certain amounts direct to the nominated sub-contractors. The important factor here was that these payments were made after the presentation of the winding-up petition.
It is at this point that s.182 of the Companies (Winding-up and Miscellaneous Provisions) Ordinance comes into play.
On these facts, the Court took the view that the company in liquidation, was, as a result of the previous agreement to allow direct payment to the nominated sub-contractor, not entitled to receive the money from the employer. Consequently despite the fact that these payments had been made direct, and in some cases after the presentation of the petition, it was concluded that this did not breach the provisions of s.182 and as a result the liquidator was unable to recover any of the payments.
The rationale was that in effect through the course of events, the direct payment provisions had been invoked with the consent of the company which was being missed out. In these circumstances, it is likely that such payments would not be subject to claw back under the provisions of s.182. If however the payments are made independently and in particular if they are made after the presentation of the petition there would appear to be every chance that they can be recovered by the liquidator for the benefit of the creditors generally.
Plant And Materials On Site
In both practical and legal terms, and this is particularly the case with government contracts, then once plant and materials have gone onto the site, they cannot be removed except with the consent of the employer’s representative, usually the site engineer or the architect.
In the event of a company going into liquidation or even if a provisional liquidator has been appointed, it is almost certain that the employer’s representative will refuse to allow anything to be removed from the site. From the perspective of an insolvency practitioner it is important that he gets his professional advisors on site as soon as possible to at least take an inventory of and possibly make a valuation of the assets on site. At a later date, once the contract has been completed and the site has been cleared, the employer and the contractor who completes the contract will need to account to the liquidator for what has happened to the materials and plant and equipment. The principle case law on this issue is the English case of Cosslett (Contractors) Limited vs Bridgend County Borough Council.
S43C Employment Ordinance
This provision allows unpaid employees of a sub-contractor to claim wages, up to a maximum of two months, from the main contactor or another superior sub-contractor in the event that the sub-contractor by whom they are employed does not pay them.
It is important to note that this extends to employees only and does not extend to sub-contractors.
To the extent that a third party (i.e. in this case the employer or other sub-contractor) makes payment to the employees under this provision, then the employee’s rights to claim against the company will be subrogated to the third party who can then lodge their own claim in the liquidation for the same amount.
Retention Monies
In the liquidation of any insolvent construction company, the collection of retention monies is invariably an issue. It is also often an extremely difficult and time-consuming aspect of any insolvency administration. This arises as a result of the fact that some retention monies may have been long outstanding, the records of the company in liquidation may not have been kept as fully up to date as they might have been and key employees may no longer available to address any outstanding issues which may have arisen in the meantime. In addition there are likely to be competing claims to retention moneys, thus complicating further the liquidators’ collection efforts.
In general terms, if there are any nominated sub-contactors, they should be able to be paid their share of any retention monies direct by the employer. The balance of the retention monies should then be made available to the liquidator of the company.
However, the Hong Kong case of Hsin Chong Construction Co Ltd vs Yaton Realty Co Ltd suggests that if the employer is holding any retention monies, he can use those to settle any claims he may have against the company in liquidation, in priority to payments to nominated sub-contractor.
Whilst it is often the case the amount involved in respect of retention monies is not significant, it can still come as a blow to the nominated sub-contractor to find that, despite his status, he is still unable to collect as the employer sets off his portion of the retention monies against “claims” which have arisen.
Liquidators’ Investigations And S.221 Examinations
One of the principle roles of a liquidator, as well as realising the assets of the company and distributing them to the creditors, is to investigate the reasons why the company has failed. Indeed, these investigations can often give rise to additional recoveries for the benefit of the company’s creditors.
However, it is frequently the case that when a liquidator is appointed, the accounting records of the company are either inadequate or indeed in some cases non-existent. Moreover, it often happens that the directors of the company are either unavailable or unwilling to assist the liquidator in complying with his obligations.
S.221 of the Companies (Winding-up and Miscellaneous Provisions) Ordinance provides the liquidator with the power to apply to the Court for an order that anyone who has information relating to the company can be compelled to disclose that information, or can be forced to appear in Court and answer questions on oath relating to the affairs of the company.
In recent years, Hong Kong liquidators have used this provision more and more extensively. Indeed, the Court have tended to favour such applications by liquidators, particularly where it can be shown that their investigations are being hindered by the lack of cooperation.
One of the most important aspects of the examination process is that if someone is required to answer questions on oath he cannot refuse to answer any questions simply on the grounds that it may result in self-incrimination. In other words, he has to give a full and complete account of all issues on which he is questioned. He cannot refuse to answer any questions.
Because of the draconian nature of this provision, there are necessarily limits placed on the liquidator as to how he can use the information disclosed in the examination. However, the Courts have agreed that the liquidator can use any of the information which he obtains as a result of an examination in pursuit of realising assets of the company or furthering his investigations into the affairs of the company.
The importance of this section cannot be underestimated. Its purpose is to ensure that the liquidator, on behalf of the creditors, is able to fully investigate the affairs of the company so that he is able to maximise the realisation of the assets for the benefits of the creditors.