Hong Kong Court comments on the interplay between the Rule in Gibbs and Chapter 15 recognition

In a recent decision, the High Court of Hong Kong sanctioned a scheme of arrangement proposed by a Bermuda company to restructure certain debt governed by Hong Kong law. See Re Rare Earth Magnesium Technology Group Holdings Ltd [2022] HKCFI 1686. The sanctioning of such schemes is not uncommon in Hong Kong. However, the High Court took the extra step of elaborating on the meaning of the Rule in Gibbs, which continues to be the law in the UK and many other jurisdictions, by effectively stretching the Rule in Gibbs to cover US law-governed debt despite the fact that the US does not follow the Rule in Gibbs as a matter of US law. The decision highlights risks for Hong Kong or any other companies that try to restructure US law-governed debt through an offshore scheme of arrangement and then need to seek recognition and enforcement in Hong Kong or another common law jurisdiction that follows the Rule in Gibbs. This article examines the court's discussion of the Rule in Gibbs and the potential risk to companies that restructure their US law-governed debt using offshore tools. In order to best set the stage, the first part of this article provides a brief background of the Hong Kong case.

Case background

Rare Earth Magnesium Technology Group Holdings Limited is an investment holding company incorporated in Bermuda. Its shares are listed on the Hong Kong Stock Exchange. The company, which is a member of a broader group, operates through its subsidiaries that are principally based in Hong Kong, the British Virgin Islands, and mainland China. The company's principal indebtedness consisted of approximately HK$852,533,000 of unsecured interest-bearing bonds issued by the company that are governed by Hong Kong law. Rare Earth's parent guaranteed the bond debt.

After suffering financial losses due to COVID-19, the company filed a winding-up petition in Bermuda and sought the appointment of soft-touch provisional liquidators to restructure the company's debt. In a soft-touch provisional liquidation, the company remains under the day-to-day control of the company's directors but has the benefit of a moratorium to protect the company from creditor enforcement actions. In general, a soft-touch provisional liquidator will work with the directors to restructure the company's debts. In this instance, the company (with the provisional liquidator's assistance) asked the High Court to sanction a scheme of arrangement to restructure the company's unsecured debt, including the bond debt governed by Hong Kong law.

The scheme generally provided for a discharge of the company's bond debt and included a release of the parent's guarantee. Pursuant to the scheme, a creditor could choose from several options: (i) the term of repayment of the existing bonds would be extended for five years which would entitle creditors to payment of interest and interim payments over a five-year period with additional payment and enforcement rights against Rare Earth's parent; (ii) creditors would receive convertible bonds in the amounts of their claims with a five-year maturity with the option to convert the bonds to shares in the company or redeem the bonds on the maturity date at an amount equal to 100 percent of the outstanding principal amount of their claims; or (iii) a combination of the two options.

In determining whether to sanction the scheme, the High Court considered several factors, including whether (a) the scheme is for a permissible purpose, (b) the requisite majorities of creditors voted in favor of the scheme, (c) creditors had been given sufficient information about the scheme to enable them to make an informed decision on whether or not to support it, and (d) an intelligent and honest person acting in accordance with their interest might reasonably approve the scheme. Given the transnational nature of the company, the Rare Earth court focused on an additional factor: whether the scheme would be effective in other jurisdictions relevant to the company's business and operations. According to the court, it would not be a proper exercise of its discretion, and it would serve no purpose to sanction a scheme if it would not be effective in the primary foreign jurisdictions where the company operates. Thus, the court evaluated whether the compromise of the company's Hong Kong law-governed debt under the scheme, which was to be sanctioned under Hong Kong law, would be recognized by courts in Bermuda, the company's place of incorporation, and the Cayman Islands, the company's parent's place of incorporation, particularly in light of the Rule in Gibbs.

The Rule in Gibbs and its application by the High Court to the Scheme of Arrangement

The Rule in Gibbs is an English common law rule derived from an 1890 decision by the English Court of Appeal in Antony Gibbs and sons v. La Societe et Commerciales des Metaux (1890) 25 QBD 399. The rule provides that a contract, including a loan, can only be discharged or amended in accordance with its governing law. Accordingly, under the Rule in Gibbs, debt governed by, for example, English law can generally only be discharged under English law, including by a scheme of arrangement sanctioned by an English court. However, there is an exception. Under the Rule in Gibbs, debt can be discharged or compromised under the law of a jurisdiction other than the situs of the governing law if the creditor to whom that debt is owed submits to the jurisdiction of that foreign court.

In this instance, the High Court concluded that the Rule in Gibbs would be followed by the courts in the offshore jurisdictions, particularly Bermuda and the Cayman Islands. Consequently, the court found that the company's Hong Kong scheme of arrangement that discharged Hong Kong law-governed debt would be recognized in Bermuda, the Cayman Islands, and the other offshore jurisdictions in which the company operates. The court was silent as to whether China, another place where the company operated, would recognize the scheme. However, it noted that "[t]here is no requirement for a scheme to be effective in every jurisdiction worldwide, provided that it is likely to be effective in the key jurisdictions in which the company operates or has assets." Thus, the court sanctioned the scheme finding that the company satisfied all of the pertinent factors, including demonstrating the scheme would be effective in the other jurisdictions relevant to the company's business.

Relying on the rule in Gibbs, the Rare Earth court further noted that if a substantially similar scheme had been sanctioned by an offshore jurisdiction (and not in Hong Kong), the scheme would effectuate a restructuring of the Hong Kong law-governed debt only as to those creditors that had submitted to that jurisdiction. Creditors that did not submit to the offshore jurisdiction would not be bound to the scheme and could pursue their remedies against the Hong Kong company in Hong Kong.

Recognition of foreign restructurings under Chapter 15 of the Bankruptcy Code

In addition to elaborating on the applicability of the Gibbs rule to Hong Kong law-governed debt, the court took the opportunity to express a risk to a company that uses an offshore scheme to restructure US denominated debt. The court observed that many mainland businesses listed on the Hong Kong Stock Exchange carry US denominated debt and instruments governed by US law. According to the court, under the Gibbs rule, US law-governed debt may be discharged or restructured only under US law notwithstanding that US law does not impose such a requirement or have an equivalent legal doctrine. In its analysis, the court highlighted the differences between Chapter 11 and Chapter 15 of the US Bankruptcy Code. Thus, a brief explanation of the differences between the chapters follows.

Chapter 11 of the Bankruptcy Code allows companies to reorganize and restructure their debts. The Chapter 11 debtor usually remains "in possession," may continue to operate its business, is given certain powers and duties of a trustee, and, with court approval, may borrow money, sell assets, and reject undesirable contracts, among other things. The culmination of a Chapter 11 case is generally confirmation of a Chapter 11 plan that will typically provide for the discharge and/or restructuring of debt regardless of the governing law. In other words, a US court may, and often does, approve a Chapter 11 plan that restructures debt governed by non-US law.

In contrast, Chapter 15 of the Bankruptcy Code, which is based on the Model Law on Cross-Border Insolvency promulgated by the United Nations Commission on International Trade Law, provides a statutory framework for recognizing foreign restructuring proceedings and specifically provides for comity, assistance, and cooperation by the US bankruptcy court with foreign courts. It does not provide for a mechanism to discharge or restructure debt. That occurs in the foreign insolvency case. Under Chapter 15, a US bankruptcy court must recognize a foreign proceeding if certain requirements are satisfied. Following recognition, a US bankruptcy court may enter an order enforcing a foreign restructuring plan or a scheme of arrangement, provided that certain additional requirements are met, particularly that the court is satisfied that the interests of creditors and other interested entities, including the debtor, are sufficiently protected. Similarly, a confirmed Chapter 11 plan that restructures US law-governed debt should be recognized by foreign courts in countries that have adopted the Model Law, subject to any additional requirements of those countries' insolvency laws.

Based on the court's understanding of the Bankruptcy Code, the court concluded that, because Chapter 15 does not independently provide for a mechanism to discharge debt, the enforcement of a foreign restructuring plan by a US bankruptcy court under Chapter 15 would not be sufficient to satisfy the Rule in Gibbs. Thus, according to the court, a scheme approved in an offshore jurisdiction and recognized by a US bankruptcy court under Chapter 15 would not be consistent with the Rule in Gibbs and would not be treated by a Hong Kong court as compromising US law-governed debt. Thus, a creditor of a company that implements a scheme to restructure US law-governed debt may take action against the company in Hong Kong unless the creditor submitted to the jurisdiction of the primary court sanctioning the scheme. Chapter 15 recognition or enforcement of the scheme alone would not suffice.

To reach this conclusion, the court examined a decision by the US Bankruptcy Court for the Southern District of New York in In re Agrokor d.d., 591 B.R. 163 (Bankr. S.D.N.Y. 2018). In Agrokor, the court considered whether to enforce a Croatian restructuring plan that restructured English law-governed debt under Chapter 15. Although the High Court of England and Wales had previously recognized the Croatian proceeding, it did not decide whether to approve the Croatian court's treatment of the English law-governed debt. In analyzing the issues, the bankruptcy court acknowledged the Gibbs rule's application under English law and noted that the plan may not be effective under English law but nevertheless extended comity to the Croatian court's treatment of the English law-governed debt within the territorial jurisdiction of the US.¹

Relying on the Agrokor court's comments concerning its territorial jurisdiction, the Rare Earth court reasoned that recognition under Chapter 15 means US law-governed debt may not be discharged outside the US. Thus, according to the High Court:

A scheme in an offshore jurisdiction purporting to compromise debt governed by United States law will not be effective in Hong Kong. Recognition of the scheme under Chapter 15 does not constitute a compromise of debt governed by United States law, which satisfies the Rule in Gibbs. The result is that if a company has a creditor, which did not submit to the jurisdiction of the offshore court the creditor will be able to present a petition in Hong Kong to wind up the Company and if, for example, the creditor is a bond holder whose debt is not disputed, obtain a winding up order unless the debt is settled.

Based on this analysis, the court opined that a creditor holding US law-governed debt could seek relief from the High Court notwithstanding recognition of a foreign insolvency proceeding by the US bankruptcy court (unless that creditor had previously submitted to the US court's jurisdiction).

Conclusion

The Rare Earth decision provides guidance on the application of the Rule in Gibbs in Hong Kong. According to the High Court, Hong Kong law-governed debt can be restructured under substantive Hong Kong law. Hong Kong law-governed debt may also be restructured under an offshore scheme and binding on a creditor that submits to the offshore jurisdiction. However, according to the High Court, a company should be wary of using offshore tools to restructure US law-governed debt (or any debt governed by the laws outside of the offshore jurisdiction) if it would like the scheme to be effective in Hong Kong. Under the Rule in Gibbs, which is applicable in Hong Kong, US law-governed debt can only be restructured in the US, principally under Chapter 11. There is, however, no such requirement in the US. Indeed, a US court may, and often does, approve a Chapter 11 plan that restructures debt governed by non-US law and may recognize or enforce foreign plans or schemes of arrangement that restructure US law-governed debt under Chapter 15. While such restructurings may be allowed under US law (and elsewhere), they may not be effective in Hong Kong or in a jurisdiction that applies the Rule in Gibbs in the manner described by the Rare Earth court.

The High Court also noted that a creditor may take action against a company in Hong Kong, notwithstanding the terms of the offshore scheme or that it was enforced under Chapter 15, but tempered this conclusion when it noted this risk may not be significant where the creditors that hold "debt of any material value have agreed to the terms of the" offshore restructuring. However, given the apparent risk that an offshore restructuring of US law-governed debt may not be enforced in a jurisdiction that applies the Rule in Gibbs, a company that is contemplating restructuring US law-governed debt should consider US alternatives, including Chapter 11 of the US Bankruptcy Code. Absent a US restructuring of US law-governed debt, creditors in a jurisdiction that applies the Rule in Gibbs may be able to derail the restructuring.