What is the purpose? A landmark ruling in Hong Kong on Quistclose trusts and insolvency

Introduction 

What happens when monies are loaned for a specific purpose but that purpose fails? Should those monies fall within the general assets of the recipient upon bankruptcy or insolvency?

On 14 June 2024, the Court of Final Appeal in Hong Kong (“CFA”) handed down the judgment in China Life Trustees v China Energy Reserve and Chemicals Group [2024] HKCFA 15. This is the first instance in which the CFA has considered the principles regarding Quistclose trusts in Hong Kong, and unanimously reversed the decision of the Court of Appeal in Hong Kong (“CA”).

Key Takeaway 

This landmark decision plays a pivotal role in all areas of commerce, particularly Hong Kong insolvency where it is not uncommon for multiple parties to be competing against each other for the same pool of general assets.

More than ever before, lenders to distressed companies should avail themselves of the protection of a Quistclose trust. A well-crafted purpose clause in loan agreements will be of significant benefit to ringfence a loan against competing unsecured creditors should that loan fail to be applied for the specified purpose.

For groups of companies spanning multiple jurisdictions, this CFA case will help ensure that funds could be applied most appropriately to address the group’s priorities, while preserving the ability to remobilise the funds if plans fail to materialise.

Background

In China Life Trustees, there were two bond series, both issued in 2015 by two special purpose vehicles (“SPVs”) under a corporate group (the “Group”) headed by China Energy Reserve and Chemicals Group Company Limited, namely the “2022 Bonds” issued by SPV1 and the “2018 Bonds” issued by SPV2.

SPV1 had an HKD sub-account exclusively for the 2022 Bonds; while SPV2 did not open its own USD bank account and used SPV1’s USD sub-account exclusively for the 2018 Bonds (the “Account”). In each case, bond funds were later transferred to the Group’s treasury company (the “Treasury”) for the Group’s management and operations.

When the 2018 Bonds fell due in the principal sum of USD 350 million plus interest, the Treasury was only able to assemble USD 120m (“the Funds”) via debt restructuring and were transferred to the Account. As there was a shortfall, the 2018 Bonds defaulted, triggering cross-defaults on other bonds including the 2022 Bonds.

China Life Trustees Ltd (“China Life”) (the only bondholder of the 2022 Bonds) and the Ad Hoc Committee (a bondholder of the 2018 Bonds) each obtained judgment against SP1 and SPV2 for the respective bond defaults. China Life obtained a garnishee order in respect of the Funds, and the Ad Hoc Committee intervened to set aside the order contending that the Funds are subject to a Quistclose trust and are not property of SPV1 and hence not available to China Life for execution.

The CFA considered whether or not a Quistclose trust was established, which would trump the CA’s decision that upheld the China Life’s garnishee order.

Origins of the Quistclose Trust

Historically, the Quistclose trust originated from the decision in Barclays Bank Ltd v Quistclose Investments Ltd [1970] AC 567, where the courts stated that such a trust comes into existence when X intends to pay money (or transfers other property) to Y by way of loan or otherwise, with the parties objectively intending the money to be applied for a specific purpose and no other, such that the same is not at the free disposal of the transferee. If for any reason that purpose fails to be achieved, the funds should not become part of the recipient’s general assets and are simply held on a resulting trust for the benefit of the transferor.

The transferor’s retention of a beneficial interest in the property is not something that the parties need to have intended, whether subjectively or objectively, or even anticipated or foreseen, in order for the trust to arise in the first place. Rather, the retention of a beneficial interest in the property is the legal consequence of the existence of a Quistclose trust.

Notably, the said objective intention to restrict the use of the money for a specific purpose may be implied and need not be made expressly. A Quistclose trust can arise where such an intention could be inferred based on circumstantial evidence.

Application of the Quistclose Trust in Hong Kong

For the CFA in China Life Trustees, it was evident from the contemporaneous correspondence that the Funds (in USD) were transferred to the Account in response to the fallen due 2018 Bonds; and that the 2022 Bonds, denominated in HKD, were not due until 2022. It would therefore have defied commonsense to suggest that the monies would be freely disposable by the recipient, SPV1.

Since the Funds failed to be used for its specific purpose (i.e. to meet SPV2’s obligations under the 2018 Bonds), the CFA unanimously overturned the CA’s decision and ruled that SPV1 held the Funds on resulting trust for the Treasury for the Group’s purposes. The Funds did not form part of SPV1’s general assets such that it could be garnished by China Life.

Conclusion

The touchstone requirement for a Quistclose trust is whether there is an objective intention for the property to be used for a specific purpose. It is not required for the parties to intend that the transferor retains a beneficial interest of the property.

A Quistclose trust prevents a recipient from obtaining beneficial interest in the property while the designated purpose is being carried out and will operate to revert the property to the transferor should the monies fail to be applied for the specific purpose.