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In Hong Kong, families often hold properties and businesses through corporate vehicles, with family members also being shareholders and directors of the company. This creates a particular set of problems when those members take an informal approach to the management of company affairs….read more
The Hong Kong Competition Ordinance, Cap. 619 came into effect just over seven years ago. Designed to promote and protect competition in the market and prohibit anti-competitive conduct…read more
In Hong Kong, families often hold properties and businesses through corporate vehicles, with family members also being shareholders and directors of the company. This creates a particular set of problems when those members take an informal approach to the management of company affairs. If family relationships take a turn for the worst, such informality may be exploited as a means to seek intended derivative action by the minority, alleging a breach of fiduciary duty, which occurred in Re: Woncorn Investment Limited  HKCFI 1680. The question thus arises: how relevant is the familial context when a family feud coincides with company derivative actions?
In this case, a mother and her five children held shares in a company. The company held a property which the mother paid for, that she and the unmarried children lived in since 1986. The flat had been used as the company business address, for holding board and general meetings, booked as non-current assets, with the company paying the relevant utilities, repairs, rent and rates.
When the mother died, her shares in the company were split equally amongst the five siblings. One of the sisters emigrated and transferred all her shares to another sister, so the remaining brothers and sisters held shares in a 2:3 proportion. The elder brother and two sisters were directors of the company, whilst the younger brother and one of the sisters continued to occupy the property, rent-free. But disagreements started to arise shortly after the mother’s passing. The brothers (in the 40% minority) wished for the flat to be sold and proceeds distributed as dividends. The sisters (in the 60% majority) wished to allow the unmarried siblings to continue living in the flat. At both the board and general meeting levels, the proposal by the brothers for the flat to be sold was voted down. Litigation ensued, with the brothers seeking leave for statutory derivative action by the company against the sisters under s.733 of the Companies Ordinance (Cap. 622). The allegation was that the sisters, by refusing to vacate, rent out or sell the flat, and occupying it rent-free, were in breach of their fiduciary duties, acting in conflict of interest with the company.
There was apparent attraction for the brothers to apply for leave for derivative action. The bar is low: it only requires a serious issue to be tried and that the company has not itself brought the proceedings; and that the application appears to be in the interest of the company (which is usually prima facie satisfied where a serious question to be tried is demonstrated). Plus, under s. 738(2),(3) of the Companies Ordinance, the court may order indemnification by the company of the member’s costs in applying for leave and/or bringing the derivative action, provided such member was acting in good faith and had reasonable grounds for bringing the proceedings/application. In essence, the brothers could be able to use the company’s assets to fund their attack, whilst the sisters fund their own defence. This causes a great disadvantage and pressure to the majority in terms of litigation and negotiation.
In this case, the court carefully considered the familial context of the case and dismissed the brothers’ application for leave. Whilst it is true that fiduciaries are not allowed to put themselves in a position where their interest conflict with their duties, it was clarified that directors of a company do not necessarily have a duty to procure sale of a company property. The flat was classified in the financial statements as “non-current assets”. The brothers admitted that the company was an asset-holding family company vehicle without any business for profit. There were no inherent duties on the sisters to procure sale of properties, so it cannot be said that they conflicted with such duty.
Crucially, there was incontrovertible evidence (drawing from the background and history of the flat, pictures of its interior use and various company documents) that the company consented to the siblings living in the flat prior to the mother’s death. The principle from In re Duomatic  2 Ch 365 comes into play: a director’s act otherwise in breach of their fiduciary duty to the company is not such a breach if the shareholders, with full knowledge, have agreed to it, either expressly or tacitly. This is particularly relevant in a family company context. Whilst family members may not have formally or clearly resolved how to deal with company, given the relationship, it would be difficult for a disgruntled member to deny knowledge of what has occurred within the family over a long period of time (in this case, 34 years). As in Sharma v Sharma  B.C.C. 73, that meetings amongst family members (who were also shareholders) were relatively informal did not stop the application of In re Duomatic. The Court can and did find agreement by shareholders via their knowledge of the directors’ act and acquiescence thereof.
The brothers also invoked the wrong procedure in seeking leave for derivative action. Their complaint was not so much an issue of director misconduct as a mismanagement complaint amongst shareholders. The sisters, as majority shareholders, voted against the selling of the flat whilst the brothers sought distribution of dividends amongst shareholders after the sale. As such, derivative action against the sisters in their capacity as directors simply would not redress the complaint.
This case demonstrates why starting a derivative action against family company directors warrants additional scrutiny. Whilst the bar for leave is low, and having the company indemnify one’s legal costs is enticing, the family context will become relevant both in terms of the nature of the company, the duty of the directors and the ways in which the court may find consent by members to the complained act. Nonetheless, amicable relationships can change quickly in the absence of parents. As such, it is always prudent to keep proper company records and minutes to safeguard a position.
Adrian CK Wong acted for the company in this action. The CFI’s judgement can be accessed here.
The Hong Kong Competition Ordinance, Cap. 619 came into effect just over seven years ago. Designed to promote and protect competition in the market and prohibit anti-competitive conduct, it applies to all business sectors in Hong Kong, including local and international companies that operate there. The Competition Ordinance aims to create a level playing field for business, encouraging innovation and efficiency, and enhancing Hong Kong’s competitive reputation as a business hub. However, the longer-term impact of the Ordinance is probably yet to be seen. Its influence has steadily evolved over time, a slow burn rather than a swift remedy. So why is this the case? As with all things, it’s important to look at the past in order to understand the influence on tomorrow.
When the original bill for the Ordinance was published for consultation, critics were decidedly underwhelmed, directing their reproval mostly against a statutory cap on the penalty being 10% of the domestic, rather than international, turnover. There would be no blockbuster fines like those heavy sanctions we saw in other jurisdictions. As such, anti-competitive businesses, especially those international conglomerates, probably felt like they had dodged a bullet and would simply absorb fines as a cost-to-compete. But the devil is always in the details.
Back in 2015, much less attention was paid to some of the special features in the bill, features that were not present in the EU regime (the backbone of the HK regime) but have the potential to make the latter much more effective than it looked at first glance. One such feature was the extension of the subject of punishments from the infringing undertakings to a widely defined category of secondary parties under Sections 91 and 107. The recent judgment of the Competition Tribunal in Competition Commission v Kam Kwong & Ors has brought this to light. So, to fully understand the impact of the Competition Tribunal’s decision, as well as the relevant features in the Hong Kong regime in general, the most appropriate starting point of analysis is the prototype of the regime, namely the EU regime. And it all begins with the most well-known feature of EU competition law: the concept of undertaking.
The commercial world controls risk via the use of corporate vehicles, and it is not unusual for subsidiaries to be deployed by the parent company in the operation of a normal business. It was the original intent behind the creation of a fictitious legal person known as an incorporated company, after all. But it does pose challenges to effective regulation of anti-competitive conduct. So, the EU regulations were designed to regulate undertakings, the economic units to be defined by business or economic interests, rather than the legal personalities under the corporate laws of the relevant jurisdictions. As such, the conventional legal problems with regards to circumvention of responsibility posed by corporate veils are side-stepped. All corporate entities within the same undertaking would be jointly and severally liable for each other’s anti-competitive conduct.
The invention of the concept of an undertaking is a step towards removing the technicalities that hamper effective regulation of anti-competition. However, the European regulations still seem to be lenient on the management teams who control the undertakings and direct anti-competitive conduct. The EU regulations do not provide for sanctions against management teams for infringing undertakings merely in their capacity as such, but rather leave such issues to individual member states.
The concept of an undertaking is intended to be flexible, and therefore one may argue that management teams who are also substantial shareholders or directly benefit from anti-competitive conduct, could be regarded as part of the infringing undertaking, as their personal economic interests converge with their professional duties. Such argument, however, remains a theory as the European Commission, which is the enforcement agency of the EU regime, has not taken any enforcement actions on such a basis.
Individual member states of the EU have taken different efforts to hold the management teams responsible. In the Netherlands, the Dutch Courts recently allowed the liquidators of Heiploeg, a North Sea shrimp supplier, to recover part of the €27m cartel fine paid to the European Commission from a former director on the basis that his personal involvement in the relevant cartel arrangements amounted to serious mismanagement of the company. However, the UK Courts refused to take a similar line. In Safeway Stores Limited & Ors v Twigger & Ors, the EWCA held that the fine imposed by the Office of Fair Trading was intended to be a “personal” liability of the undertaking under the Competition Act 1998, therefore, the undertaking in question cannot recover the fine from former employees.
It seems that the UK regime turned to the tools of criminalising cartel agreements and director disqualification, instead of seeking to impose financial penalties on management teams. Section 188 of the Enterprise Act provides for an offence against an individual who agreed with others that undertakings will engage in direct or indirect price fixing, limitation of supply or production, market sharing and/or bid rigging. Instead of establishing a comprehensive criminal jurisdiction in respect of all kinds of anticompetitive conduct, the act only provides for a narrow criminal offence. Such cartel offence applies only in respect of reciprocal horizontal agreements. Vertical agreements are completely left out. Also, there is no attempt to criminalise the management teams for causing the undertakings to abuse the market dominance under Article 102 of the TFEU, the other major form of anti-competitive conduct regulated by the EU regime.
The Company Directors Disqualification Act 1986, as amended by Enterprise Act 2002, empowered the Competition and Markets Authority to seek an order from the court to disqualify an individual from being a company director for a period of up to 15 years. The court must make a disqualification order if it considers that a company of which that person is a director commits a breach of competition law and the court considers that person’s conduct as a director makes them unfit to be concerned in the management of a company.
Finally, in the UK, parties that have suffered damages as a result of the anti-competitive conduct may seek redress in the follow-on actions before the civil courts. However, instead of being able to invoke straightforward statutory causes of action, the victims would have to rely on the traditional common law causes of action in tort, namely a director’s tortuous liability for the company’s breach of statutory duty and/or conspiracy to injure. However, such causes of action are difficult to establish and are often exceptions to the general rule that a director of a limited company cannot be held liable for the torts of the employees unless they ordered and procured the acts to be done. Therefore, establishing the claim requires a high degree of participation of a director in the infringing conduct, placing a high evidential burden on the claimants.
If the efforts of the EU and the UK in holding management teams responsible have faced difficulties and setbacks through the lack of a unified approach, how has the HK regime evolved? Perhaps the individuals responsible for drafting the Competition Ordinance were fully apprised of the shortcomings of the EU regime and decided to take a much more robust approach. As Harris J commented in Competition Commission v Kam Kwong & Ors: “Hong Kong has decided to take a different approach at the penalties stage to the European Union. This is clear from sections 91 to 93.”
Sections 91 to 93 are the major provisions for the Competition Tribunal’s power to impose penalties and other sanctions. Instead of referring to undertakings, those provisions refer to persons as the subject of sanctions. More significantly, the persons that are caught by the regime are not confined to those constituent entities within the infringing undertaking and include those who have been involved in a contravention of a competition rule, as opposed to directly contravening it.
The definition of persons involved in a contravention under section 91 includes the well-known concepts of accessories under the criminal law, namely attempting to, or aiding/abetting/counselling/procuring/inducing or attempting to induce/conspiring with any other person to contravene a competition rule. Empowering the Competition Tribunal to sanction the accessories is a major expansion of the scope of the regulations compared to the EU regime. It has significantly enhanced the effectiveness in deterring all kinds of contravention of the competition rules. What is arguably the most noteworthy category of persons under section 91 are those who are “in any way, directly or indirectly, knowingly concerned in or a party to the contravention of the rule” under section 91(d). In the securities regulations, a “person knowingly concerned in or a party to contravention” has been held to include executive directors of a listed company: Securities and Futures Commission v Qunxing Paper Holdings Co Ltd (No. 2). Section 91(d) should have the same application in the competition context, which would send a chill in the spine of the management teams of the infringing undertakings.
There are no official explanations for the policy reason behind the Ordinance’s significant departure from the EU regime. However, it is apparent that Section 91 was inspired by section 75B of the Competition and Consumer Act 2010 in Australia (“CCA”). Plus, certain features of the CCA may allow us to predict the future trend of enforcement. Australian competition law does not adopt the concept of undertaking, it directly targets a corporation. Rather than being guided by policy considerations, the drafters of the TPA/CCA were probably more constrained by the peculiarity of the Australian constitutional law.
The TPA/CCA was also a Commonwealth legislation. Under the constitutional arrangement of Australia, the Commonwealth Parliament’s legislative powers are confined to specific subject matters, including “foreign, trading and financial corporations” under section 51 of the Australian Constitution, which was chosen to be the basis of the TPA/CCA. Owing to such constraint in the legislative power, the Commonwealth Parliament could only regulate individuals by providing for accessory liability. In fact, as a result of a major reform of the relevant law at the State level in Australia in 1995 and 1996, all individuals are now directly subject to the relevant provisions under TPA/CCA. In practice, the Australian Competition and Consumer Commission (“ACCC”) and its predecessor have been robust in enforcing the TPA/CCA against the directors and senior employees of an infringing corporation by way of secondary liability under section 75B (for example, ACCC v Giraffe World Australia and Rural Press Ltd. v ACCC)
It is undeniable that section 91 has cast the net of anti-competition as wide as possible. Whilst critics may have been underwhelmed by the statutory cap for the pecuniary penalty, the fact that senior management teams could be held directly liable for the conduct of the undertakings they manage is arguably no less effective or deterring than a blockbuster fine to be imposed on the undertakings. Not only will they face the risk of public enforcement, but they are also exposed to follow-on actions. The definition of the scope of the persons subject to public enforcement actions under section 91 is replicated in section 107 which defines the scope of the potential defendants in the follow-on actions under section 110(1)(b). On the face of such a definition, it is arguably much more straightforward to bring about statutory follow-on actions than the traditional common law claims based on breach of statutory duty or conspiracy to injure, as still practiced in the UK.
So, what does the future hold for the regime in Hong Kong? The drafters of the Competition Ordinance in Hong Kong do not explain the degree to which the EU and the Australian models are intended to be amalgamated. Nor does the concept of secondary liability exist in the EU regulations. Therefore, the Competition Commission and the Tribunal are facing a challenge, with very limited materials made available during the legislative process to assist the statutory interpretation. This may well have influenced the Competition Commission’s notably cautious manner in enforcing the Competition Ordinance.
Whilst section 91 catches senior management teams conceptually, the Competition Commission has just started invoking it in the more recently commenced proceedings which are yet to be decided by the Competition Tribunal. In Competition Commission v Kam Kwong & Ors, section 91 was invoked against a sole proprietor (R5) who “borrowed” the license from another contractor (R3) under the relevant scheme run by the Housing Authority. R5 ran the contravening business in the name of R3, which effectively rendered the relationship as one of agent and principal. On the other hand, section 91 was not invoked against R4, which was the sole shareholder and director of R1. Only a disqualification order under section 101 was sought and granted against R4. Such prudent enforcement is certainly welcome by practitioners as it is conducive to a solid development of competition jurisprudence.
Given the unprecedented amalgamation of the EU and Australian regimes, it is foreseeable that certain interesting legal issues will arise for arguments in the future. For example, how should the pecuniary penalty be calculated for persons who are found liable based on section 91? Conceptually, it is difficult to apply the same EU formula against the principal contraveners as there is no “value of sales” (i.e. step 1) that can be attributed to the accessories. The relevant Australian jurisprudence fails to provide a solution here. The calculation of the penalty against R5 in Competition Commission v Kam Kwong & Ors was not detailed, so the issue is certainly subject to future developments when suitable cases arise. Plus, will a separate fine against, for example, a substantial stakeholder of various companies constituting the infringing undertaking on top of a fine against those companies give rise to the issue of double jeopardy? And to what extent the principle of totality will feature in the calculation of the penalty?
What clues have all of these events and the examination of the underlying legal frameworks can we discern, as to how the enforcement of the competition law will evolve in Hong Kong? It is undeniable that since the inception of the Hong Kong regime seven years ago, the business world has experienced an unprecedented level of disruption and change. As corporations have struggled to navigate the very real prospect of insolvency through reigniting supply chains, refreshing capital stacks and building up stronger balance sheets, management teams have never faced so much pressure to perform. And that, of course, is why we face record levels of fraud, corruption, and business crime. The temptation to survive through anti-competitive conduct would be more real than ever. In such a tough economic climate, the daring experiment in implanting the Australian ideas under sections 91 and 107 into the otherwise EU-modelled Ordinance may pay off. For the Competition Commission, section 91 could be a formidable means to effectively police anti-competitive practices. For practitioners, both sections 91 and 107 may become fertile ground for litigation in the years to come.
Article written and compiled by Isaac Chan and Brian Chok
Whilst a company and its directors remain separate legal entities, the winding-up of the business does not always result in a risk-free outcome for its board members. In fact, it can often signal the beginning of far more turbulent times for the directors and their professional futures. So, with global insolvencies on a sharp rise, it’s more important than ever for directors to grasp the legal issues they could face, personally and professionally.
Directors can face legal action by way of Disqualification of Directors orders under sections 168D and 168H of the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap. 32), or CWUMPO. If granted, they would be barred from acting as a director of any company, or be concerned with (or take part in) the promotion, formation or management of a company for up to 15 years.
Is the failure by directors to ensure payment of wages to employees sufficient to attract a disqualification order? This was the question in the decision of the Official Receiver v Samuel Ajmal Victor , where the official receiver applied for a disqualification order against one of the directors. The company in question developed an electronic transaction processing platform and its operating expenses were sustained by shareholders’ fund injections and allotment of shares, including HK$5M by shareholder allotment injection in October 2012. Although the platform had been developed and looked promising, it proved to be too advanced for the market at the time and, by early 2013, the company was unable to generate any revenues.
The director made efforts to seek outside investments and, in May that year, an interested outside investor proposed to acquire the platform for US$500,000. The company had immediate liabilities, including employee wages, which it was unable to meet and, as such, negotiations continued regarding the method of payment and how much of those liabilities would be. Meetings were held with employees to explain the deal which could save the company and ensure payments of salary. The director asked if employees would agree to continue working with delayed payment of wages and, whilst some disagreed and left with their full wages paid, others agreed and stayed, expressing their faith in the platform and the deal, defined with a deferral agreement.
The outsider paid the consideration US$500,000 as an upfront loan, secured by the director’s personal guarantee and charged against the platform, for paying some creditors, employees and operational costs. A term sheet was signed in September 2013, with the outsider acknowledging the creditors with whom to negotiate the repayment schemes with.
However, further negotiations on the deal failed. Staff who agreed to stay, having not been paid between May to September, left upon being informed of the failure. Staff (including the director) applied to the Labour Tribunal claiming outstanding wages, which were granted in terms in default of the company’s appearance. By November 2013, the company went into voluntary liquidation.
The test for disqualification of directors, as stated in CWUMPO, is coined in broad terms: “the Court shall disqualify a person where it is satisfied that (i) he is/has been a director of a company which has become insolvent during/after his directorship, and (ii) his conduct as director of that company makes him “unfit to be concerned in the management of a company”. The CWUMPO, however, does not go on to define unfitness and must be deduced from case law.
The official receiver based its application for disqualification of the director on the failure to ensure due payment of employee wages. It alleged inter alia that the director should have used the HK$5M funds from October 2012 and US$500,000 from the deal to pay wages as a top priority. The official receiver alleged it was no defence that the director was seeking outside investments, and denied the existence and validity of the deferral agreement. Employees’ wages are preferential debts enjoying priority in distribution in liquidation, and non-payment of wages without reasonable excuse is a criminal offence under the Employment Ordinance (Cap. 57), therefore, the official receiver claimed, a breach of such duty itself satisfies “unfitness” and the deferral agreement and deal provide no defence.
After the trial, the court was in favour of the director and found that there was no unfitness. Failure to pay wages by a company does not justify or mandate granting a disqualification against a company director and is only a relevant conduction for consideration. Ordinary commercial misjudgment is not enough. In situations where the director in question had to decide whether to continue operating the company’s business at a loss (or with wages unpaid), the test for unfitness is “whether the director knew, or ought to have concluded, that there was no reasonable prospect that the company would avoid going into insolvent liquidation”.
The court must consider all circumstances of the case to decide whether such failure to pay was caused by the director’s lack of commercial probity, gross negligence or total incompetence in managing the affairs of the company. The basis and reasonableness for believing in the prospect of paying debts concerned in the future, including the likelihood of finding “white knight” investments and the efforts made by the relevant director, is important. Equally, the nature of the business and the circumstances leading to its demise, and whether relevant creditors (in this case, the employees) were voluntary creditors (i.e. they made an informed decision to agree to deferral of payment) are key considerations. Relevant also is whether the decision to continue operating would have benefited the director to the detriment of general creditors, putting personal interest first.
The court’s nuanced approach to the decision makes one thing very clear: directors of businesses facing financial difficulties must not assume that they can wind up their business with impunity. Instead, they would be well-advised to seek legal advice on the steps ahead, gathering evidence on the circumstances leading to insolvency along the way.
Risk is integral to running a business. The recent decision in Sunbroad Holdings Ltd v A80 Paris HK Ltd and Another reaffirms the significance of risk allocation under a commercial lease, in the context of the unprecedented outbreak of COVID-19 in Hong Kong since 2020.
The dispute arose out of the early termination of the lease of a ground floor store situated in Causeway Bay, in the vicinity of one of the busiest shopping districts in Hong Kong. The landlord of the store commenced two actions to recover rent in arrears over different but consecutive periods from the first defendant, the tenant, and the second, a guarantor of the tenant. The tenant belongs to an established group in the business of retail of beauty and hair products, possessing over 80 physical stores covering key locations in Hong Kong, Singapore and Macau, renting the retail store for selling beauty and hair products.
The landlord and the tenant entered into the lease in August 2019, where the store was let for a fixed term of three years. The lease contained no break clause for the tenant to terminate it. There was also an express term in the lease that the landlord was entitled to elect not to terminate the lease in the event of the tenant’s default.
The outbreak of COVID-19 resulted in the implementation of social distancing measures and, from February 2020, the tenant defaulted on the rent, ceased to operate the store and communicated to the landlord that it could not perform its obligations under the lease in the prevailing circumstances. After rounds of failed negotiations, the landlord commenced HCA 735/2020 on 21 May 2020 for inter alia arrears of rent from 1 February 2020 until 20 May 2020 in a total sum of around HK$1 million. The landlord then applied for summary judgment or alternatively interim payment of 50% of the amount claimed. The master granted the defendants an unconditional leave to defend and ordered the defendants to make an interim payment, though both parties appealed.
In July 2021, the tenant returned the keys to the store, but the landlord stated that it did not accept the tenant’s repudiation and that the lease was still valid and binding. The following month, the landlord commenced HCA 1174/2021, claiming inter alia further arrears of rent from 21 May 2020 until 31 July 2021 in a total sum of around HK$4.5 million, and applied once more for summary judgement in HCA 1174/2021.
In November 2021, some 20 months after the tenant’s exit from the store, the landlord informed the defendants that the lease was terminated as a result of the latter’s ongoing repudiation and abandonment of the store which the landlord accepted.
The appeals in HCA 735/2020 and the summary judgment application in HCA 1174/2021 were heard together, where the court allowed the appeal by the landlord in HCA 735/2020 and granted summary judgment in favour of the landlord in both actions. The central issue is whether the impact of the pandemic constitutes frustration of the lease (the frustration ground) and, as an alternative defence, whether it is reasonable for the landlord to refuse to accept the tenant’s early termination of the lease such that the landlord was not obliged to mitigate its loss upon the tenant’s repudiation (the mitigation ground).
For the frustration ground, the court, applying National Carriers v Panalpina (Northern) Limited, endorsed the trite common law principles on frustration of contracts. It held that frustration takes place only when there supervenes an event which so significantly changes the nature of the outstanding contractual rights or obligations from what the parties could reasonably have contemplated at the time of its execution so that it would be unjust to hold them to the literal sense of the stipulations in the new circumstances. Frustration cannot be lightly invoked to relieve the contracting parties of normal consequences of (imprudent) commercial bargain or commercial risk unless a common purpose could be said to have been frustrated by the most extraordinary circumstances which render the performance of a contract impossible.
The court went on to rule that COVID-19 has not fundamentally or radically changed the nature of the lease (i.e. letting and possession of the store) that exceeded the parties’ reasonable contemplation at the time of entering into it. Putting the tenant’s case to the highest, the impact of the pandemic would at most lead to a reduction of the profitability of the business of the tenant, which does not suffice in frustrating the lease.
In addition, it has been within the tenant’s knowledge at the time of signing the lease that there was no escape clause. The court pointed out that the tenant’s commercial standing should allow the making of a considered decision to choose the store suitable for its purpose and also to commit itself to a fixed-term lease without a break clause.
In the same vein, the court disagreed that force majeure would assist the tenant’s case. The crux of force majeure is whether the premises is unfit for use as a result of destruction or damage for causes beyond the control of the landlord and not attributable to the act or default of the tenant. In other words, unless a certain event renders the performance of the contractual obligations of the parties impossible, a mere lack of commercial viability or profitability is plainly distinguished from force majeure.
Turning to the mitigation ground, the court upheld the position that an action for rent in arrears is one for an agreed sum as a debt, and that the landlord does not have a duty of mitigation. This is subject to the restrictions where the innocent party requires the defaulting party’s cooperation to perform, or the innocent party has no legitimate interest in performing the contract, rather than claiming damages in which the court would decline to grant the remedy of an agreed sum (White & Carter v McGregor).
The court, applying Reichman v Beveridge, observed that instances of a court denying an innocent party’s entitlement to maintain the contract in force and to sue for the contract price are limited. They would be where an election to keep the contract alive would be wholly unreasonable and where damages would be an adequate remedy. The burden of proving that it was wholly unreasonable for a landlord to hold onto the lease is on the defaulting tenant. This heavy burden is not discharged merely by showing that the benefit to the innocent landlord is small compared to the loss to the defaulting tenant.
The court would readily find the commercial parties to have made an informed commercial decision in entering into the lease, and emphasised the cardinal principle that the innocent party is not bound to accept repudiation of a contract, especially when such right is clearly spelt out in the contract itself. On the evidence, it is not wholly unreasonable for the landlord not to terminate the lease given the lukewarm retail market brought about by the pandemic. Should the landlord elect to terminate the lease, there is a likelihood that it has to commit to a potentially lower rent than that under the lease for a substantial term with any replacement tenant. If the court were to accept that the landlord had the duty to accept early termination of the lease, this would have unjustifiably reversed the allocation of the risk in the commercial decision in committing to the lease term and the terms of the lease from the tenant to the landlord.
What can we learn from the circumstances and potential outcomes of these examples? That contracts are all about risk allocation. Hong Kong courts have consistently held parties liable for what had been agreed at the contract stage. So, commercial parties, in the course of contractual negotiation, should make it clear as to who bears the risk in times of unforeseen situations.
In the absence of a break clause for a tenant in a lease, a landlord is generally entitled to affirm the contract and to sue for an agreed sum of arrears of rent in the event of the tenant’s default of rent. Practically, unless the tenant can show that the landlord engaged in conduct such as deliberately turning down an existing replacement tenant who was ready and willing to enter into a lease for at least the remainder of the term of the lease at a comparable level of rent, it appears that argument on the “unreasonableness” on the part of the landlord in affirming the lease in the event of the tenant’s default is rather insurmountable.
Francis Chung acted for the defendants in this case. The CFI’s judgement can be accessed here.
Escalation clauses (also known as multi-tiered arbitration clauses) are an increasingly common feature across a multitude of commercial agreements. These well-intentioned clauses often require parties to a contract with a dispute to attempt other methods of resolving their dispute as a condition precedent before resorting to arbitration, such as negotiations, mediations or adjudication. After all, arbitrations are often seen as (and can indeed be) both costly and time-consuming.
However, these clauses have also been a source of problems for parties to a dispute, not only because of issues of enforceability of the clause itself but also because either or both of the parties had neglected to comply with the requirements or conditions set out in the escalation clause before proceeding to arbitration with their dispute. This may lead to challenges to the reference to the arbitral tribunal or even the arbitral award.
It may be tricky to draft an effective escalation clause that mandates a party to first engage in negotiation or mediation as a condition precedent before referring a dispute to arbitration because requirements for a party to engage in negotiation or mediation have traditionally been seen as “agreements to agree” and are thus unenforceable.
This was the case in Tang v Grant Thornton International Ltd, whereby the requirement for the parties to attempt to resolve their dispute by submitting a request for conciliation “of an informal nature” as a condition precedent prior to referring the dispute to arbitration was held to be too “equivocal in terms of the process required and too nebulous in terms of the content of the parties’ respective obligations to be given legal effect as an enforceable condition precedent to arbitration”. The test was whether the condition precedent/obligation imposed was sufficiently clear and certain to be given legal effect. Note that the effect of the ruling was that the arbitral tribunal in question did have jurisdiction to hear the dispute despite failure by the defendant to comply with the condition precedent.
However, in Emirates Trading Agency LLC v Prime Mineral Exports Pte Ltd, a condition precedent requiring the parties to “first seek to resolve the dispute…by friendly discussion” was upheld as enforceable because it was neither incomplete nor uncertain. It was in the public interest for such conditions precedent to be enforceable as commercial men expect the courts to enforce obligations they have freely undertaken, and the object of such agreements is to avoid expensive and time-consuming arbitration. The condition precedent was held to have been fulfilled in that particular case and the challenge to the jurisdiction of the arbitral tribunal failed.
It appears that the Hong Kong courts have not expressed a general view on the enforceability of similar conditions precedent in escalation clauses. However, they may have few opportunities to do so because whether such conditions precedent have been complied with are not an issue of jurisdiction (an award of which may be set aside under Art. 34 of the UNCITRAL Model Law/s.81 of the Arbitration Ordinance [Cap. 609]) but rather an issue of admissibility of the dispute to arbitration (which cannot be challenged under that same article). This posåition has been confirmed in the recent Hong Kong Court of Appeal decision C v D affirming the jurisdiction/admissibility distinction under Sierra Leone v SL Mining.
The escalation clause between the parties in C v D required them to attempt in good faith to resolve their dispute by negotiation by written notice prior to referring the dispute to arbitration. However, the respondent to the arbitral claim challenged the jurisdiction of the arbitral tribunal due to the alleged absence of a written request for negotiation by the claimant before a notice of arbitration was issued. The arbitral tribunal made a partial award on jurisdiction in favour of the claimant. The respondent applied to the court to set aside the partial award. The Court of Appeal agreed with the court below and found that issue of whether the claimant had complied with the condition precedent was a question of admissibility of the claim to arbitration and not a question of jurisdiction, and thus not subject to review by the courts. This means arbitral tribunals are likely to have a final say on whether conditions precedent in escalation clauses have been complied with.
Parties should also be careful about inadvertently waiving by their right to challenge compliance with such conditions precedent by their own acts. This was one of the findings in Sierra Leone v SL Mining where the respondent in the arbitration insisted on service of the request for arbitration and was found to have waived compliance with the condition precedent under s.73 of the Arbitration Act 1996 and/or Art. 40 of the ICC Rules.
What can we learn from all of these cases? The enforceability of conditions precedent in escalation clauses depends on the certainty and clarity of those clauses, but it is in the public interest for such conditions precedent to be enforced. Also, the issue of whether such conditions precedent have been met is an issue of admissibility and not jurisdiction. As such, challenges to whether such conditions precedent have been met should be raised and dealt with by the arbitral tribunal and cannot be subject to recourse to the Hong Kong courts. Parties should endeavour to comply with these conditions precedent to avoid unnecessary delay or postponement to having their dispute arbitrated if they cannot be resolved by negotiation, conciliation or mediation. They should also be careful to raise challenges to jurisdiction and admissibility before they have submitted to the arbitral tribunal’s jurisdiction or otherwise waived their right to raise such challenges (under the relevant arbitral rules or as a matter of fact).
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