While historically most bank lending in Hong Kong has been done on an unsecured basis, the rise in leveraged finance transactions and securitization has seen an increase in transactions that require consideration of security concepts and credit enhancement techniques such as guarantees under Hong Kong law.

Types of security and guarantees

Generally Hong Kong law mirrors English law in the type of security that can be taken and the restrictions imposed on companies granting security. The four forms of security that may be taken under Hong Kong law are the pledge, lien, charge or mortgage.

Pledges and liens are commonly used in relation to manufacturing, warehousing and distribution industries. Mortgages can be applied both to tangible and intangible assets and can be either legal or equitable. Charges can either be fixed or floating.

Guarantees are increasingly common in finance transactions and lenders will often make a loan to a PRC subsidiary conditional on receiving a guarantee of the borrower's obligations from its Hong Kong parent company. In leveraged transactions, guarantees are usually taken from operating subsidiaries in addition to taking security over the assets of the group.

Perfecting security

Failure to perfect security will mean the security is void against the company/borrower acting by its liquidator. Any creditors who subsequently take charges over the same assets and register those charges will take priority over an unregistered charge.

The types of perfection required will depend on the type of security taken by the lender and the identity of the chargor.

Hong Kong law is similar to English law in terms of registration of security interests.

Company charges

Prescribed particulars of certain security interests, including all mortgages and charges, created by (a) companies formed and registered under the Companies Ordinance (Chapter 32 of the laws of Hong Kong); and (b) companies incorporated outside Hong Kong that have a place of business in Hong Kong, must be delivered to the Companies Registry within five weeks from the date of creation, if created in Hong Kong, or, if created outside Hong Kong, five weeks from the date on which the relevant instrument or a copy could, in due course of post and if despatched with due diligence, have been received in Hong Kong together with the document (section 80 Companies Ordinance (Chapter 32 of the Laws of Hong Kong)).

Charge of shares

A charge of shares is not, in itself, registrable at the Companies Registry because it does not fall within any of the categories specified in section 80 of the Companies Ordinance. However, the charge will usually contain a specific charge over dividends and distributions arising in respect of the shares and it is likely that those rights amount to book debts in the books of the chargor at least once a dividend is declared. A charge over book debts would require registration under section 80. The safest course is to present the share charge, together with the requisite particulars, for registration at the Companies Registry, within five weeks of the date of the charge's creation. In practice the Companies Registry has often registered charges over shares without raising any query.

Pitfalls

Where security is taken a number of pitfalls need to be avoided:

Unlawful financial assistance

A company cannot give financial assistance for the acquisition of its own shares or those of its holding company. Financial assistance includes assistance given by way of gift, guarantee, security, indemnity or loan or any other assistance whereby the company's net assets are reduced to a material extent. In the case of a private company, the rules are relaxed for unlisted companies, so long as the company complies with a prescribed approval procedure, the so-called whitewash procedure.

The provisions of sector 47A prohibiting financial assistance are premised on there having been an acquisition of shares in a Hong Kong company. Because section 47A uses a defined term of company any reference to company in this section is restricted to companies incorporated in Hong Kong. Accordingly, when shares have been acquired in an offshore parent, Hong Kong companies can provide upstream security without the need to whitewash the transaction, although considerations of corporate benefit still apply.

Corporate benefit

The directors of a company have a duty to act in what they consider to be the best interests of the company they direct and must ask whether they can justify the company securing another company's obligations (in terms of corporate benefit). The risk of giving third party security must be balanced against the actual or potential rewards. A parent company might justify giving security for a subsidiary's borrowings (downstream security) because it will, directly or indirectly, hope to receive dividends from the subsidiary. Conversely, a subsidiary might justify supporting its parent (upstream security) because of the support it receives from its parent in, for example, financial support by way of intra-group loan.

Hong Kong law does not recognize the concept of group benefit. Accordingly, the test must be applied to each company individually (although the financial health of other group companies will be relevant if it has an impact on the position of the directors' own company).

There is authority to suggest that security may still be given even where there is insufficient corporate benefit if the company's shareholders unanimously agree and the company is not insolvent at the time and does not become insolvent as a result of the transaction.

Corporate capacity

A company's memorandum of association will show whether the company has the power to create the relevant security. The validity of an act done by a company cannot now be called into question, on the ground of lack of capacity, by reason of anything in its memorandum. Neither the company, nor the other party to the transaction, may plead ultra vires. However, directors are nevertheless duty bound to observe any limitation on their powers applicable in the company's memorandum and shareholders have a statutory right to bring proceedings to restrain the taking of any act that is beyond the company's capacity.

Directors' powers

The power of a company's board of directors is now deemed, at least in favour of a person dealing with a company, to be free of any limitation under the company's constitution. The Companies Ordinance further removes any constructive notice of the contents of the memorandum of a company as regards a third party – a third party with actual notice might run the risk of transactions being overturned if they know a company is acting in contravention of its powers in granting security.

Loans to directors

Subject to certain exceptions, loans to directors or providing security in connection with loans to directors is generally prohibited. More importantly, in Hong Kong where groups of companies are often in close family contact, companies are prohibited from making quasi loans to or providing credit support for other companies that are within control of their directors. The main relevant exceptions are where the company is part of a group or where the transaction entered into by a private company (not being part of a group of which another member is listed) is approved in general meeting. Accordingly it is particularly important in Hong Kong to understand group structures and common directorship when reviewing security packages and guarantees because any security or guarantee given in breach will not be enforceable against the company providing it. (Section 157H Companies Ordinance)

Reviewable transactions

After new security has been granted by a company, it is vulnerable to being set aside within certain time limits if the company is or subsequently becomes insolvent (hardening periods). The time limit varies depending on whether the lender is an associate of the company. The power to set aside transactions is vested in a liquidator.

Transactions that can be set aside include:

• Preferences: a preference is given where a company puts a creditor or a company guarantor in a better position than it would otherwise have been if the company went into insolvent liquidation. To establish a preference claim, it must be proved that the company was influenced by a desire to prefer.
• Invalid floating charges: a floating charge on the company's property or undertaking may be invalid if: (a) it was a floating charge (or created as a floating charge); (b) it was created within 12 months of the commencement of the winding up; and (c) the company was insolvent when the charge was created. It will not be invalid to the extent of any cash paid to the company at the time of or subsequently to the creation of (and in consideration for) the charge together with interest on that amount at the rate specified in the charge (or at the rate of 12% a year, whichever is less).
• Extortionate credit transactions: the court has wide powers, on a liquidator's application, to make orders in respect of any extortionate credit transaction entered into within a three-year period. An extortionate credit transaction is any transaction that, having regard to the risk accepted by the person providing the credit, either contains terms requiring grossly exorbitant payments to be made in respect of the provision of credit or otherwise grossly contravenes ordinary principles of fair dealing. The three-year period ends either on the date of a winding up resolution of the company, the date of the winding up order or on the commencement of the winding up.

The court can set aside or vary the extortionate credit transaction, or require a person who was party to the transaction to pay the liquidator any sums they have received.

• Fraudulent trading and transactions defrauding creditors: a transaction can be challenged on the basis that it constitutes fraudulent trading and or is a transaction defrauding creditors, but this requires proof of dishonesty on the part of the company's officers.
• Transactions at undervalue: in Hong Kong the concept of transactions at undervalue as a voidable transaction only applies to individuals, not companies.
• Preferred creditors: pursuant to Section 79 of the Companies Ordinance, when a receiver is appointed on behalf of the holder of a floating charge or where the floating charge holder has entered into possession of the assets comprised in or subject to the floating charge, even if the company is not being wound up, the debts that are given statutory priority in a winding up pursuant to Part V of the Companies Ordinance must be paid out of any assets coming into the hands of the receiver or the floating charge holder in priority to any claims of the floating charge holder for principal and interest. Similarly, pursuant to section 265(3B) of the Companies Ordinance, when a company is being wound up, the preferential claims set out in Part V of the Companies Ordinance have priority over the claims of holders of floating charges. In summary, the preferential creditors set out in Part V include employees (in respect of certain limited entitlements) and the government in respect of statutory debts, although there are also priorities afforded to certain claims relating to the winding up of insurers and banks.

Commercial security

Commercial security is an umbrella term for various ways a creditor could try to obtain a better position on the debtor's insolvency, without taking legal security. All of the following structures can be used in Hong Kong:

• sale and leaseback;
• factoring;
• hire purchase;
• retention of title;
• conditional sale; and
• set-off.

Lenders should ensure that their loan documents prohibit the borrower from subsequently creating both legal and commercial security in favour of other creditors (negative pledge). If other creditors have actual notice of the negative pledge they take their interests subject to the existing lender's security. Details of negative pledges are commonly included in the charge particulars of company charges and, once registered, subsequent creditors are deemed to have notice of them.

Case Law: charges and guarantees

On July 1 1997, Hong Kong became the Hong Kong Special Administrative Region of the People's Republic of China. At this time, all laws then in force in Hong Kong were adopted as the laws of the Hong Kong Special Administrative Region of the People's Republic of China. UK common law and rules of equity that applied before that date continue to apply, although their development is now independent of the UK and rests primarily with the Hong Kong courts. However decisions in UK cases are more often than not likely to be followed in Hong Kong.

Charges over book debts

Few issues have generated more case law in the past decade than the degree of control required to create a fixed charge. Recent cases have changed long-standing practices in relation to those securities with potentially serious consequences for lenders. Despite the fact that book debts seem by nature more suited to be subject to a floating charge, the Court in Siebe Gorman Limited v Barclays Bank Limited and more recently Spectrum held that it was possible to create a fixed charge over a company's book debts provided the lender retains control over the proceeds of the book debts once collected as well as having control over the book debts themselves. The House of Lords in Spectrum considered that whether a charge over book debts operated as a fixed or floating charge was not determined by the label given to the charge by the parties. The true nature of the charge depended on whether the account was one that allowed the company to continue to use the book debt proceeds as a source of its cash flow or was effectively a blocked account.

Hong Kong has generally followed the English position in relation to the distinction between fixed and floating charges. The decision in Spectrum is therefore likely to be followed by the Courts in Hong Kong.

As a result lenders will have to consider reviewing their existing security over book debts by taking a fresh charge that is expressed to be a fixed charge over the company's book debts and imposing and implementing greater controls over the collection of book debts and the application of their proceeds. However, what would constitute an acceptable level of control to ensure a fixed charge was not specifically discussed in Spectrum and such increased controls might not be commercially workable.

Guarantees

In two recent cases a guarantee was held not to have effect and the guarantor was released from its obligations because of a change to the underlying obligations that were the subject of the guarantee without the guarantor's consent. This was notwithstanding specific language in the guarantee that permitted changes to the underlying obligations without obtaining the guarantor's consent.

In a recent decision the Court of Appeal held that the variation of the underlying agreement was substantial and could not be said to be clearly for the benefit of the guarantor. The initial obligations comprised an overdraft, an import line of credit and a corporate credit card facility while the variation introduced a HK$2 million ($257,542) fixed term loan. The material variation was also made without the consent of the guarantor.

The court referred to the 19th century case of Holmes v Brunskill, which established the common law principle that a guarantor is released from liability under a guarantee given to a creditor where that creditor and the principal debtor have entered into an agreement, subsequent to the giving of the guarantee, which has the effect of altering the contractual position between them, to the disadvantage of the guarantor and without their prior consent.

The fact that the guarantee referred to "all money" in the definition of "guaranteed moneys," and to the guarantee as a continuing security, did not change the outcome. Neither did the provision in the guarantee providing that the liability of the guarantor under the guarantee "shall not be discharged or otherwise affected by reason of the bank entering into any agreement or arrangement with the [borrower] or any other person".

In a recent English case, Triodos Bank NV v Dobbs, substantial changes were made to the underlying obligation after the execution of the guarantee. The changes were not within the scope of the guarantee. The Court decided that the lender could no longer rely on the guarantee despite a provision in the guarantee allowing the lender to amend the underlying obligation without prior consent from the guarantor. The guarantor could not be taken to have agreed that their liability under the guarantee would be increased or made more onerous by a subsequent agreement (to which the guarantor was not a party) unless there were clear words in the guarantee to show that the guarantor did agree to be bound to a more onerous obligation in the future even without being consulted.

The fact that the guarantor's liability under the guarantee was capped did not change the outcome.

Notwithstanding language in standard form guarantees that underlying obligations can be varied without the guarantor's consent, variations that result in an increase in liability or render the obligations more onerous might result in the validity of the entire guarantee being successfully challenged.

The decision in the English case indicates that a lender can rely on language in the guarantee allowing the underlying obligation to be amended or varied without prior consultation of the guarantor provided that the amendment is within the scope of the guarantee and the language makes it specifically clear that the guarantor is expressly consenting in advance to future amendments or variations which could increase the guarantor's liability or render the obligations more onerous.

Given the above, the prudent approach would be for lenders to always ensure a guarantor is consulted and their written consent obtained where a variation or amendment to the underlying obligation is contemplated, notwithstanding any language in the guarantee that might suggest that such consent is not required.

Author biography

John Hartley Lovells Hong Kong John Hartley heads Lovells' Asia finance practice. He has been based in Hong Kong for over 16 years and has been involved in almost all aspects of debt finance. Hartley is recognized as a leading practitioner in his field and is listed in Asia Pacific Legal 500 as a leading lawyer in banking and finance, and securitization, Asia Law & Practice as a leading lawyer in project finance, PLC Which Lawyer as a recommended lawyer, Who's Who in the Law, Chambers Global 2003 to 2006, IFLR1000 (2005), The Guide to the World's Leading Banking Lawyers and the Guide to the World's Leading Project Finance Lawyers, the Asia Law Guide to Lending Business Lawyers, and The International Who's Who of Professionals. Hartley has been responsible for the structuring, negotiation and documentation of a number of groundbreaking deals in Asia, many of which were market firsts. He acted for the lenders on a US$12 billion leveraged financing for PCCW's acquisition of Cable and Wireless HKT Limited and most recently for SoftBank on its US$15 billion leveraged financing for the acquisition of Vodafone Japan, the largest LBO to date in Asia.