Quistclose trust helps lenders protect loans to failing firms
When a company is struggling to stay afloat its directors will find it increasingly difficult to raise finance, even if they have a viable business opportunity that may save the company and the jobs of its employees. The statutory liquidation regime in Hong Kong is quite strict on its division of property and lenders take great risks in lending to companies that are insolvent.
Unlike other jurisdictions with "rescue regimes", Hong Kong has a very limited restructuring regime and so there is little incentive for any lender to try to help save the company. Recent proposals for changes to the legislation, which may come into force in 2014, focus on creditor protection rather than rescuing the company. But the common law has developed to protect lenders to firms in financial difficulty to encourage bids to save them.
When a company is liquidated it must gather and realise all its assets and then distribute them in strict priority. First the costs of the liquidation must be paid, then the interests of certain preferential creditors, such as employees, must be met, then floating charges over the company's undertakings, and finally unsecured creditors, who comprise all of the remaining creditors, should share any remaining funds in proportion, if there is anything left.
Usually loans are considered contractual arrangements where default by the borrower gives rise to a right to take action for the recovery of the debt. The lender may sue the borrower and receive a judgment for the debt, which may be enforced against the lender. Such judgment debts rank as unsecured debts in insolvent liquidation. Therefore, if a company tries to borrow funds to keep trading, the best it can usually offer a lender is the status of an unsecured creditor and the chance of a proportionate share in a fund, which is unlikely to cover the entire loan. Unsurprisingly, this is not an attractive proposition.
The common law has developed the Quistclose trust, which protects lenders to insolvent companies in certain circumstances. The general principle is that the loan must have been made for an agreed purpose, usually the payment of an existing creditor. If the company is placed in liquidation before it made the agreed payment then the company may be considered to hold the loan on trust for the lender. As the lender is seen as the beneficial owner of the loan fund, the fund does not form part of the assets of the company for distribution to the general creditors, but must be returned to the lender.
There is confusion over the relevant legal principles which allow for the recognition and enforcement of such trusts, but they have been recognised and enforced because they serve a usual public purpose; permitting an attempt to save a business.
Originally it was considered that the loan fund should be segregated from the general funds of the company to permit recognition of the trust, but there have been cases in Britain and Hong Kong which have recognised Quistclose trusts when the loan fund has been mixed with other funds.
Quistclose trusts have also been recognised when the fund advanced has not just been a loan, but has been in recognition of existing and agreed future liabilities the company has incurred and will incur on the lender's behalf.
If the directors of Hong Kong's companies wish to save their businesses then the Quistclose trust is a useful method of raising finance when the insolvency regime in Hong Kong remains focused on liquidation rather than rescue.
Steven Gallagher is professional consultant and assistant dean (undergraduate student affairs) of Chinese University's Faculty of Law