Jurisdiction - Hong Kong
Reports and Analysis
Hong Kong – Priority Of Floating Charges.

14 February, 2014

 
 

1. A floating charge is a type of security which may be created over a class of moveable assets (such as current assets, trading stock or cash on hand), and are commonly sought by banks and other credit-providers as security for money which has been lent to a borrower. Under a floating charge, the borrower (or chargor) may continue to deal with its assets subject to the charge in the ordinary course of business until the charge crystallises and the creditor takes steps to enforce it. However, a creditor holding a floating charge over some or all of a borrower’s assets may find such security challenged by other secured creditors in the event of the borrower’s insolvency, giving rise to questions of priorities between them.


2. Under Hong Kong law, priorities between competing interests over the same property of an insolvent company are determined in accordance with a complex set of priority rules. These priority rules vary depending on the type of property involved, as well as the type(s) of security which have been granted in respect of such property.

 

3. In this note, we provide an overview of the general Hong Kong law priority position of a bank (“Bank“) which holds a floating charge (“Floating Charge“) over all of a Hong Kong company’s assets, where the company (“Borrower“) has also granted to a third party creditor (“Other Creditor“) a later:

 

  1. legal assignment of receivables owed to the Borrower by its customers (i.e. receivables assigned in accordance with s9 of the Law Amendment and Reform (Consolidation) Ordinance (Cap. 23) (“LARCO“));
  2. pledge of (i) bills of lading, and (ii) warehouse receipts, in respect of goods (located in Hong Kong) owned by the Borrower, in each case where the Other Creditor is in possession of them; and
  3. fixed charge over cash margin held in an account in Hong Kong with the Other Creditor (which is a bank);

 

and the Borrower subsequently becomes insolvent.

 

I. Floating Charge v. Subsequent Legal Assignment Of Receivables 

(a) General Position

 

4. Where the Borrower has granted the Floating Charge over all of its assets (including receivables owed to it by its customers) to the Bank, and has also subsequently legally assigned the same receivables to the Other Creditor, a question of priority between the competing interests of the Bank and the Other Creditor with respect to such receivables may arise.

 

5. Under Hong Kong law, the general rule governing priority between assignments or charges over the same debts or receivables is the rule laid down in the English case of Dearle v Hall (1828) 3 Russ 1 (“Dearle v Hall“): that is the assignee/chargee whose notice to the debtor is the first in time has priority, provided that at the time of the assignment/creation of the charge, he did not have notice of any earlier assignment/charge to any other assignee/chargee and he was acting in good faith and gave good value in return for his charge/assignment.

 

6. However, where receivables subject to a floating charge are disposed of by way of a legal assignment, in the absence of any restrictions in the terms of the floating charge against doing so, the rule in Dearle v Hall does not apply to determine priorities. Rather, the general position appears to be that, as the chargor under the floating charge is permitted to deal with its assets subject to the charge in the ordinary course of business until crystallisation (which would include selling or assigning receivables), the legal assignee of such receivables would take free of the prior floating charge. The rule in Dearle v Hall would not apply since the floating chargee will be taken to have impliedly authorised the chargor to effect the legal assignment. Accordingly, in the absence of any restrictions under the terms of the Floating Charge, the Borrower (as chargor) would prima facie have been permitted to sell/assign the charged receivables to the Other Creditor, provided no crystallisation event had occurred, so that the Other Creditor’s interest in the receivables would have priority over that of the Bank’s. This would be the position even where the Other Creditor had notice (whether actual or constructive – see para. 12, below) of the existence of the Bank’s prior Floating Charge as its interest would be taken to have been created with the implied authorisation of the Bank.

 

7. However, in practice, floating charges in Hong Kong almost always contain restrictive covenants prohibiting chargors from assigning or otherwise encumbering charged assets with interests ranking in priority to, or pari passu with, the charge (“negative pledge clause“). Additionally, floating charges commonly contain clauses stipulating that the charge will automatically crystallise upon the happening of certain events which may not require the intervention of the chargee (“automatic crystallisation clause“). The effect which such clauses may have on the Bank’s priority position is discussed as follows.

 

(b) Negative Pledge

 

8. If the Bank’s Floating Charge contains a negative pledge clause, such clause would generally not affect the Other Creditor except where the Other Creditor had actual notice (see paras. 12-15, below) of the clause at the time it took its legal assignment. If, at that time, the Other Creditor did have actual notice of such a clause, the Bank’s interest in the receivables would likely gain priority. The Other Creditor could also be liable to the Bank for procuring the Borrower’s breach of the clause, and the courts could restrain it from enforcing its rights so as to cause a breach of a prior agreement of which it had knowledge.

 

(c) Automatic Crystallisation

 

9. A typical automatic crystallisation clause in a floating charge instrument will provide that if the chargor acts in breach of a negative pledge clause and creates, or attempts to create, a subsequent interest without the consent of the prior floating chargee, the floating charge will automatically crystallise, and rank ahead of any subsequent interest. If the Bank’s Floating Charge contains such an automatic crystallisation clause, it is possible that the Floating Charge will have crystallised before the Other Creditor’s legal assignment of receivables was effected, as any attempt to create a prior ranking interest would cause the Floating Charge to crystallise. 

 

10. Where the Other Creditor’s legal assignment is effected after crystallisation of the Bank’s Floating Charge, it would seem that the Bank’s interest in the receivables would take priority being first in time, as from crystallisation, it will no longer be taken to have impliedly authorised the Borrower to dispose of the receivables to the Other Creditor. Thus, as between a crystallised floating charge (which takes effect as an equitable fixed charge) and a subsequent equitable assignment of receivables (i.e. a legal assignment which has not yet been perfected by notice to the contract counterparty, notice being one of the requirements for a legal assignment under s9 LARCO), the rule in Dearle v Hall can still apply. 

 

11. Accordingly, priority between the Bank’s and the Other Creditor’s interests in the receivables would be determined according to the order in which notice is given to the customers (i.e. the contract counterparties). If the Other Creditor perfects its legal assignment by giving notice of its assignment to the customers first in time, and does not have notice of the crystallisation of the Bank’s Floating Charge, the Other Creditor would take priority under the rule in Dearle v Hall. However, if it is the Bank that gives notice of crystallisation of its Floating Charge first in time, the position would be reversed and the Bank would take priority instead (note that the holder of a floating charge can only give notice of its charge to contract counterparties upon crystallisation, as only at that time does the charge attach/fasten to the assets subject to the charge).

 

(d) Does Registration Of A Charge Confer Notice Of A Negative Pledge Clause Or Automatic Crystallisation Clause?

 

12. Under the Companies Ordinance (Cap. 32), certain types of charges (including floating charges) created by Hong Kong companies and non-Hong Kong companies with a place of business in Hong Kong must be registered with the Companies Registry within 5 weeks of creation. Registration of a charge will generally constitute at least constructive notice of the existence of that charge to any subsequent chargee/assignee. Constructive notice means that in the absence of actual notice (i.e. personal knowledge), a subsequent chargee/assignee will generally be taken to have constructive notice of an earlier registered interest.

 

13. A common practice has arisen in Hong Kong whereby negative pledge and automatic crystallisation clauses in charge documents are included in the particulars which are submitted to the Companies Registry upon registration. The existence of such registered negative pledge and automatic crystallisation clauses may therefore be revealed by way of a company search conducted by any member of the public.

 

14. Previously, it was unclear as to whether the doctrine of constructive notice by registration extended to notice of all particulars (including negative pledge and automatic crystallisation clauses) which had been registered with the Companies Registry. That area of the law has now been clarified in the Hong Kong case of ABN Amro Bank NV v Chiyu Banking Corp Ltd & Ors [2000] HKC 3 381 (“ABN Amro“) in which it was held that registration of a negative pledge or automatic crystallisation clause doesnot confer constructive notice of such clause on a subsequent assignee/chargee. In that case, the court held that the doctrine of constructive notice by registration only operates in a narrow sense – it means constructive notice is only of (i) the existence of the prior interest; and (ii) the particulars of the prior interest statutorily required to be registered. Inclusion of particulars of a negative pledge or automatic crystallisation clause which is contained in a charge document is not a statutory requirement. Accordingly, the practical effect of the decision in ABN Amro is that, for a subsequent chargee/assignee to have notice of any negative pledge or automatic crystallisation clause contained in a prior floating charge document, it must have had actual notice of it (constructive notice of registered particulars of the prior floating charge will not be sufficient).


15. However, with the commencement of the new Companies Ordinance (Cap. 622) (“new CO“) on 3 March 2014, certified copies of the charge instruments, together with a statement of the particulars, of registrable charges, must be registered with the Companies Registry and made available for public inspection (Part 8 of the new CO). As the doctrine of constructive notice means constructive notice of (i) the existence of a prior interest; and (ii) the particulars of the prior interest which are statutorily required to be registered, for charges which are registered in accordance with the new CO, subsequent chargees/assignees will likely be deemed to have constructive notice of all of the terms of the relevant charge instruments, including any negative pledge and/or automatic crystallisation clauses (since the entire charge instruments will be statutorily required to be registered).

 

II. Floating Charge v. Pledge Of Bills Of Lading And Warehouse Receipts

 

(a) Bills Of Lading

 

16. Under Hong Kong law, a bill of lading is a document of title to the underlying goods it represents at common law. Thus, assuming that the Borrower’s pledge of bills of lading to the Other Creditor has the effect of transferring constructive possession of the underlying goods they represent to the Other Creditor (and provided such goods are situated in Hong Kong), it seems likely that such pledge of bills of lading would be recognised in Hong Kong as a pledge of the goods themselves.

 

17. In the absence of any restriction in the terms of the Floating Charge against creation of subsequent pledges, as between the Bank’s prior Floating Charge over the Borrower’s assets (including goods owned by the Borrower) and the Other Creditor’s pledge of bills of lading (representing pledged goods), the Borrower (as pledgor) would have been impliedly authorised by the Bank to pledge the bills of lading to the Other Creditor prior to crystallisation of the Floating Charge as this would be in the ordinary course of its business (see para. 6, above). Alternatively, it may be argued that the time of crystallisation is not relevant, as a pledge (a legal interest) will always take priority to a floating charge (an equitable interest) provided that the pledgee did not have notice of crystallisation of the floating charge (see para. 18, below). Accordingly, the Other Creditor’s interest with respect to the bills of lading and underlying goods (as pledgee) would take priority ahead of the Bank’s interest (as floating chargee), as long as it retained possession of the pledged bills of lading (possession being an essential element of a pledge under Hong Kong law).

 

18. However, if the Bank’s Floating Charge contains a negative pledge clause, the Other Creditor may lose priority where it had actual notice of such clause (see paras. 8, 12-15, above). If the Floating Charge had crystallised before the creation of the Other Creditor’s pledge (e.g. by the joint operation of a negative pledge clause and automatic crystallisation clause), it is likely that the Other Creditor would retain priority with respect to the pledged bills of lading (provided that it did not have actual notice of the negative pledge and automatic crystallisation clauses). This is because a floating charge takes effect as a fixed charge as at the time of crystallisation (an equitable interest), and as between an equitable charge and a subsequent pledge (a legal interest), the general rule is that the subsequent pledgee’s interest will take priority as a legal purchaser for value, provided that he did not have notice of the crystallisation of the prior equitable charge.

 

(b) Warehouse receipts 


19. For Hong Kong law purposes, warehouse receipts are not documents of title to the underlying goods they represent at common law. Accordingly, under Hong Kong law, a pledge of a warehouse receipt by itself is not sufficient to create a pledge of the underlying goods it represents as there is no delivery of possession of the goods (unlike a bill of lading). However, a valid pledge of the underlying goods to a warehouse receipt may still be created by other methods, such as by way of “attornment”. Creation of a pledge by way of “attornment” was described in Official Assignee of Madras v Mercantile Bank of India [1935] AC 53 (“Madras“), where was held that “If…the goods [are] in the custody of a third person, who held for the bailor…the pledge could be effected by a change of the possession of the third party, that is by an order to him from the pledgor to hold for the pledgee, the change being perfected by the third party attorning to the pledgee, that is acknowledging that he thereupon held for him; there was thus a change of possession and a constructive delivery“.

 

20. If the Other Creditor has a valid pledge of goods under pledged warehouse receipts, its priority position as against the Bank would likely be the same as that under pledged bills of lading (see paras. 16-18, above)

 

(c) What Is The Position Where The Other Creditor Does Not Have A Perfected Pledge Of Underlying Goods?

 

21. If the Other Creditor for any reason does not have a perfected pledge of the underlying goods under pledged bills of lading or warehouse receipts (e.g. where the bill of lading is not negotiable, or a third party bailee is found not to have properly “attorned” the goods to the Other Creditor), it may nevertheless still have a pledge of the paper bills of lading or warehouse receipts. In that situation, the Other Creditor would generally be able to retain the bills of lading or warehouse receipts, but would not be able to use them to dispose of the goods for value (since it would not be able to pass constructive possession of the goods to a purchaser). However, if the Other Creditor is named as consignee on the bills of lading or warehouse receipts it would be entitled to call for delivery of the goods. Upon taking delivery of the goods, the Other Creditor’s pledge of such goods would then likely be perfected (as it will have taken actual delivery), and its priority would likely be determined as above (see paras. 16-18, above).

 

III. Floating Charge v. Fixed Charge Over Cash Margin

 

22. As the Bank’s Floating Charge covers all of the Borrower’s assets, the Bank would also have a floating charge over all of the Borrower’s cash. However, where the Borrower grants a later fixed charge over cash which has been deposited with another banking institution such as the Other Creditor, particular issues with respect to priority may arise.

 

(a) Where Cash Subject To A Fixed Charge

 

23. In the absence of any restriction under the terms of the Floating Charge prohibiting the Borrower from granting subsequent interests, as between the Bank’s Floating Charge over the Borrower’s cash (including cash deposited with the Other Creditor), and the Other Creditor’s fixed charge over such cash, prima facie, the Borrower would have been impliedly authorised to grant the subsequent fixed charge to the Other Creditor, as this would have been in the ordinary course of its business (see para. 6, above). Accordingly, the Other Creditor’s fixed charge would have priority ahead of the Bank’s Floating Charge in the event of the Borrower’s insolvency.

 

24. If the Floating Charge instrument contains a negative pledge clause, as with the scenarios mentioned above, the Other Creditor may lose priority where it had actual notice of such clause (see paras. 8, 12-15, above).

 

25. However, if the Floating Charge had crystallised before the creation of the Other Creditor’s fixed charge (e.g. by the joint operation of a negative pledge clause and automatic crystallisation clause), the Other Creditor’s fixed charge should still take priority (provided that it did not have actual notice of the negative pledge clause). Although the general position is that the rule in Dearle v Hall will apply to determine priority between the Bank and Other Creditor (see para. 10, above), since the Borrower’s cash is held in accounts with the Other Creditor, there is no need for the Other Creditor to give notice to itself (as the account debtor) and such notice will generally be presumed. Accordingly, provided that the Other Creditor did not have notice of crystallisation of the Bank’s Floating Charge at the time it took its fixed charge over the Borrower’s cash, the Other Creditor will have priority under the rule in Dearle v Hall.

 

(b) Where Not Subject To Any Security 

 

26. As regards the Borrower’s cash which is held in an account with the Other Creditor, but with respect to which the Other Creditor has not taken any security over, the relationship between the Borrower and the Other Creditor (as banker) would be that of an ordinary creditor and debtor. However, where such cash is “collateral” for any amounts which may become owing to the Other Creditor (“cash margin“), upon the Borrower’s insolvency, the Other Creditor would normally be able to assert a claim over such cash margin pursuant to the mandatory insolvency set-off rules under s35 of the Bankruptcy Ordinance (Cap. 6) (“BO“) to set-off the cash margin against debts owed to it by the Borrower.

 

27. Under s35 BO, insolvency set-off is available where:

 

  1. there have been credits, debts and other dealings between a company in liquidation and a creditor which permit a financial balance to be struck;
  2. the credits, debts and other dealings must have been mutual, meaning they must be between the same persons and in the same right;
  3. the claim must be provable in liquidation; and
  4. the creditor did not, at the time of giving credit to the insolvent company, have notice that the winding up had commenced.

 

28. However, as the Borrower has granted the Floating Charge to the Bank, upon crystallisation, the Floating Charge would operate to transfer the beneficial ownership in the cash margin to the Bank. This means that crystallisation will likely destroy the mutuality of claims required for a set-off to take place between the Other Creditor and the Borrower under para. 27 b., above, and the Bank will take priority free of the Other Creditor’s set-off right under s35 BO.

 

IV Conclusion

 

29. The above analysis illustrates some likely priority outcomes where creditors have taken competing security interests over the same property of a borrower. In particular, the analysis demonstrates the importance of including negative pledge and automatic crystallisation clauses in floating charge instruments.

 

30. The effect of the new CO remains to be seen. However, based on the existing legal principles under Hong Kong law, it appears likely that banks and other creditors seeking to take security over a borrower’s assets will be deemed to have constructive notice of all the terms of any existing security taken over such assets (where such security is registered pursuant to, and in accordance with the new CO). Banks and creditors should therefore conduct thorough searches and review the terms of any pre-existing registered charges carefully so that they will not be caught unaware by any terms which they would be deemed to have notice of.

 

Deacons

 

For further information, please contact:

 

Philip Gilligan, Partner, Deacons

philip.gilligan@deacons.com.hk

 

Tiffany Cheung, Deacons

tiffany.cheung@deacons.com.hk

 

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