Implications of the Rule in Gibbs on the Effectiveness of Schemes of Arrangement to Compromise US Law-governed Debt

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In summary

Use of schemes of arrangement, coupled with Chapter 15 recognition, to restructure US law-governed debt has become common practice over recent years in certain jurisdictions that have a scheme of arrangement similar to that found in the United Kingdom, including Hong Kong. Recent obiter dicta comments by the Hong Kong Court in Re Rare Earth in relation to the applicability of the rule in Gibbs to such schemes of arrangement have placed this restructuring technique under scrutiny.


Discussion points

  • Recent decision of the Hong Kong Court commenting on the use of schemes of arrangement to compromise US law-governed debt and Chapter 15 recognition
  • The Hong Kong Court’s view that the rule in Gibbs means certain jurisdictions (including Hong Kong) will not recognise the effect of such schemes of arrangement
  • The United States Bankruptcy Court’s view on the effect of Chapter 15 recognition and whether it substantively discharges US law-governed debt

Referenced in this article

  • Re Rare Earth Magnesium Technology Group Holdings Limited (Provisional Liquidators Appointed) (For Restructuring Purposes Only) [2022] HKCFI 1686 (Re Rare Earth)
  • Antony Gibbs & Sons v La Société Industrielle et Commerciale des Métaux [1890] LR 25 QBD 399 (Gibbs)
  • Chapter 15 of the United States Bankruptcy Code
  • In re Modern Land (China) Co Ltd, 22-10707 (MG) (Bankr. SDNY 18 July 2022) (In re Modern Land)

Introduction

The recent and ongoing property sector crisis in the People’s Republic of China (PRC) has brought into focus how the sector has, for a long time, been financed by the Hong Kong capital markets through, among other things, the issuance of New York law-governed bonds.

Owing to the levels of consent[1] commonly required for the amendment or waiver of New York law-governed bonds, restructuring such bonds through the use of schemes of arrangement (which require lower levels of consent)[2] has become common practice in certain jurisdictions.

Comments made in the Hong Kong Court of First Instance (the Hong Kong Court) decision in Re Rare Earth have recently led to some scrutiny of this practice. In this article, we consider the Re Rare Earth decision and the implications of the rule in Gibbs on recognition in Hong Kong of a foreign scheme of arrangement that purports to compromise US law-governed debt.

What is the rule in Gibbs?

The rule in Gibbs originates from the English case Gibbs, where it was held by the English Court of Appeal that contracts could only be discharged in accordance with the law governing the contract (subject to certain exceptions). By extension, an English law contract can only be extinguished under an English law proceeding, and the discharge of a contract governed by the law of a foreign country would only be recognised in England to the extent the law of such foreign country recognised the discharge of such contract.

In Gibbs, the defendant agreed to buy copper to be delivered and paid for in England from the plaintiff. After the contracts were made, the defendant went into liquidation in France, and refused to accept delivery of the copper, arguing that the French liquidation operated as a discharge from liability on the contracts under French law. The English Court of Appeal held that the contracts were governed by English law, because they were made in and due to be performed in England. Accordingly, English law would govern the discharge of the contract, in whatever country the action was brought and the English Court of Appeal did not recognise the purported discharge of obligations under French law.

The rule in Gibbs is also followed in Hong Kong.

What is a scheme of arrangement?

A scheme of arrangement (as it exists in the UK, as well as in Hong Kong and certain other jurisdictions) is an arrangement or compromise proposed by a company to be entered into with the company’s creditors (the scheme creditors).[3] If the scheme creditors approve the scheme of arrangement with the requisite majorities, it can then be sanctioned by the relevant court if certain criteria are met, following which the scheme of arrangement is binding on all scheme creditors. In the UK and Hong Kong, for the court to sanction a scheme of arrangement, it must be satisfied that, among other things, there is sufficient connection with the jurisdiction and the scheme is likely to be effective in achieving its purpose. The principal way in which the English and Hong Kong courts determine the effectiveness of a scheme of arrangement in a multi-jurisdictional context is to consider whether the scheme of arrangement is likely to be recognised in the relevant foreign jurisdictions, if it is not proposed for there to be parallel schemes of arrangement in such jurisdictions.

A scheme of arrangement can be proposed by a company in one or more jurisdictions where such a procedure exists, including the company’s place of incorporation or where the company otherwise has a sufficient connection (which can include its centre of main interests (COMI) being located in that jurisdiction). If there is a material risk of challenge to the effectiveness or validity of a scheme of arrangement in a relevant jurisdiction, the company may wish to consider whether it should propose a parallel scheme of arrangement in such jurisdiction (where the relevant jurisdiction also has such a procedure) or if the scheme of arrangement should be accompanied by an application for recognition.

For example, a company incorporated in the Cayman Islands with a Hong Kong COMI may consider promoting a scheme in the Cayman Islands to compromise debt governed by New York law. In deciding whether to sanction the scheme, a key question for the Grand Court of the Cayman Islands (the Cayman Court) is likely to be whether the scheme is effective in all the relevant jurisdictions, including in particular, Hong Kong (the company’s COMI). In deciding whether to recognise such a scheme, the Hong Kong Court (applying the rule in Gibbs) will then ask whether, as a matter of New York law, the Cayman Islands scheme has effectively discharged the New York law-governed debt. To avoid any dispute as to whether such scheme is effective as a matter of New York law, especially if there is a material risk of challenge in Hong Kong by dissenting creditors (with sizeable claims), practitioners have generally in such circumstances made an application under Chapter 15 of the United States Bankruptcy Code (Chapter 15) for the recognition of the Cayman Islands scheme.

Does recognition of a scheme of arrangement under Chapter 15 constitute a discharge of debt under New York law?

The Honourable Mr Justice Harris of the Hong Kong Court (Harris J) expressed views on this question in the recent judgment of Re Rare Earth.

Re Rare Earth concerned a company (Rare Earth) incorporated in Bermuda and listed on the the Stock Exchange of Hong Kong Limited (HKEx). Rare Earth has subsidiaries located in Hong Kong, the PRC and the British Virgin Islands (BVI) and is part of a group of companies (the Century Sunshine Group) ultimately held by Century Sunshine Group Holdings Limited (Century Sunshine). The Century Sunshine Group’s key businesses consists of the development and production of fertilisers, with their primary production bases located in the PRC. The scheme was being proposed by Rare Earth to achieve, among other things, the discharge of its unsecured indebtedness and release of guarantees granted by Century Sunshine.

Although not applicable to Rare Earth’s scheme, Harris J nevertheless took the opportunity to express his views on the use of a scheme of arrangement to compromise debt governed by United States law’, proposed in an offshore jurisdiction (such as Bermuda or the Cayman Islands) by a debtor with its COMI in Hong Kong, where an application for recognition under Chapter 15 was also sought, stating that:

32. A scheme sanctioned in an offshore jurisdiction and recognised under Chapter 15 in the United States will not be treated by a Hong Kong court as compromising US$ debt. The Rule in Gibbs requires the substantive alteration of contractual rights to be sanctioned by some substantive provision of the relevant law. In the insolvency context in the United States this as I understand is achieved under Chapter 11 of United States Bankruptcy Code.[4]

Harris J took the view that the Hong Kong Court could apply the rule in Gibbs to refuse to recognise the effect of an offshore scheme of arrangement proposed by a debtor with a Hong Kong COMI to compromise US law-governed debt, on the basis that the US law-governed debt would not be discharged (as a matter of US law) through the offshore scheme and Chapter 15 process. As a result, creditors who had not participated in the offshore scheme would still be entitled to take action against the debtor in the Hong Kong Court.

However, Harris J also noted that a scheme of arrangement purporting to compromise US law-governed debt proposed by a debtor with a Hong Kong COMI in Hong Kong (instead of in an offshore jurisdiction) could be sanctioned by the Hong Kong Court and would (as a matter of Hong Kong law) prevent claims from being brought in Hong Kong in respect of the US law-governed debt.

Soon after Harris J’s decision in Re Rare Earth, the question of the effect of recognition under Chapter 15 came before Glenn J of the US Bankruptcy Court in In re Modern Land.

In re Modern Land involved an application by Modern Land (China) Co, Limited (Modern Land) for the recognition of its scheme of arrangement pending before the Cayman Court. Modern Land is a company incorporated in the Cayman Islands and listed on the HKEx. Modern Land is the ultimate holding company of a group of companies (the Modern Land Group) including subsidiaries incorporated in the BVI, Hong Kong and the PRC. The Modern Land Group’s main business is the investment into and development of real estate in the PRC and the United States. Modern Land’s scheme proposed to compromise obligations under its bonds with a total outstanding principal amount of approximately US$1.34 billion listed on the HKEx and the Singapore Exchange Limited.

Glenn J explained that Harris J had misinterpreted US law in his comments in Re Rare Earth and clarified that:

[although] Chapter 15 limits a US bankruptcy court’s authority to enjoin conduct outside the territorial jurisdiction of the United States . . . it does not make a discharge of New York law governed debt any less controlling[5]

and

[so long as] the foreign court properly exercises jurisdiction over the foreign debtor in an insolvency proceeding, and the foreign court’s procedures comport with broadly accepted due process principles, a decision of the foreign court approving a scheme or plan that modifies or discharges New York law governed debt is enforceable.[6]

In, In re Modern Land, the US Bankruptcy Court was satisfied that it was appropriate to recognise and enforce the discharge of debt under the scheme of arrangement that had been proposed under Cayman Islands law and orders were made accordingly.

What does this mean for the parties interested in a scheme?

At the time of writing, the Hong Kong Court has not made further comments regarding the use of offshore schemes of arrangement to restructure debt governed by ‘United States law’. There is a high likelihood that, following the US Bankruptcy Court’s decision in In re Modern Land, the Hong Kong Court will find an offshore scheme of arrangement recognised under Chapter 15 that purports to compromise New York law-governed debt to: (1) have effectively compromised such debt; (2) bind scheme creditors who did not participate in the relevant scheme proceedings; and (3) prevent scheme creditors from commencing proceedings to enforce their claims in connection with the compromised debt in Hong Kong.

Debtor companies proposing to use schemes to restructure debt governed by New York law should take comfort from the current state of the law – schemes of arrangement recognised under Chapter 15 should be considered to be effective by the Hong Kong court. Dissenting scheme creditors who have not participated in the scheme proceedings will find it difficult to challenge the effectiveness of the scheme of arrangement in Hong Kong.

It is likely that other jurisdictions following the rule in Gibbs will take a similar view given the US Bankruptcy Court’s clarifications in its decision in In re Modern Land.

Trustees can also be confident (as a matter of New York law) in complying with the steps commonly proposed in foreign schemes of arrangement that are recognised under Chapter 15, including to modify or discharge existing debt and related guarantees governed by New York law and to issue new debt and guarantees governed by New York law. A sanction order granted by a foreign court in respect of such a scheme of arrangement, together with an order of the US Bankruptcy Court under Chapter 15, should typically be sufficient to authorise the trustee to take the steps contemplated by such orders.

* The authors would like to thank Daniel Anderson and Janice Ng for their contributions to the article.


Notes

[1] New York law governed bonds typically require consent from holders with 100 per cent of the outstanding principal amount to amend principal and interest payment dates or to waive a non-payment default.

[2] Schemes must be approved by a majority in number and 75 per cent in value of the members of each class of scheme creditors (as defined below), present and voting.

[3] In the restructuring context, it is common for the debtor company to propose to enter into a scheme with its creditors. However, schemes can also be used in other situations. For example, a company can propose to enter into with a scheme with its members for the privatisation of the company. In addition to the company, creditors or members can also apply for the scheme to be sanctioned. Where a company is being wound up, only a liquidator (or provisional liquidator) can apply.

[4] At [32] of Re Rare Earth.

[5] At page 9 of In re Modern Land.

[6] See footnote 5, above.

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