Hong Kong Court of Final Appeal Clarifies Uncertainty Related to Quistclose Trusts in Landmark China Energy Case

On 14 June 2024, the Hong Kong Court of Final Appeal (the CFA) handed down its landmark decision in China Life Trustees Limited v China Energy Reserve and Chemical Group Overseas Company Limited & Ors, Ad Hoc Committee as intervener [2024] HKCFA 15 concerning Quistclose trusts. Kirkland & Ellis’ Hong Kong disputes team acted for the successful intervening ad hoc committee (the Committee). The key takeaways are as follows:

• The case concerned special purpose vehicle bond issuers coupled with treasury type accounting practices. Given their prevalence among corporate groups in the Greater China region, this judgment will likely be of interest to bondholders and other creditors of distressed groups in the region and may provide additional avenues for recovery, especially where transaction documentation provides that issuance/loan proceeds must be used for a particular purpose.
• Subject to any special agreement, where a transferor transfers property (usually money) to a transferee to be applied for a specific purpose and that purpose only, such that the property is not at the free disposal of the transferee, a trust of the property arises, with the transferee holding the property in favour of the transferor subject to the power or duty of the former to apply the property for the specific purpose.
• For these purposes, it is not necessary to show a positive statement of intention to retain some beneficial interest in the property by the transferor; nor must the parties have subjectively intended, anticipated or foreseen the transferor’s retention of a beneficial interest in the property, as this is only the legal consequence of the requisite intention.

Background

China Energy Reserve and Chemicals Group Company Limited is the holding company of a group of companies (the Group) engaged in oil and natural gas exploration and the production and marketing of related chemical products. Between April 2015 and May 2018, eight members of the Group issued series of bonds to finance the Group’s operations. The first series was denominated in Hong Kong dollars; the other 7 were in US dollars. All were guaranteed by the holding company of the Group.

As is common accounting practice regionally, the funds generated by the bonds were transferred to the Group’s treasury company (Trading) for internal distribution, which transfers were accounted for as loans to Trading/intra Group receivables. As and when interest fell due on the bonds, Trading would remit funds to designated bank accounts so that payment could be made.

The 1st Appellant, China Energy Reserve and Chemicals Group Overseas Company Limited (SPV1), a special purpose vehicle and Group member with no assets or business, issued the first series of bonds, maturing in 2022 (the 2022 Bonds). The Respondent, China Life Trustees Limited (China Life), was the sole bondholder of the 2022 Bonds. A second series of bonds, issued by another special purpose vehicle of the Group, likewise with no assets or business, China Energy Reserve and Chemicals Group Overseas Capital Company Limited (SPV2), was to mature on 11 May 2018 (the 2018 Bonds). The 2018 Bonds were held by several investors, including the 2nd Appellant, the Committee.

Both SPV1 and SPV2 used a bank account (the Account) maintained with Bank of Communications in the name of SPV1 to receive the funds from Trading and to facilitate transactions relating to the 2022 Bonds and the 2018 Bonds respectively, including the payment of interest. The Account opened by SPV1 comprised two sub-accounts denominated in HK$ and US$. The HK$ subaccount was used exclusively for the 2022 Bonds, whereas SPV2, for convenience, designated SPV1’s US$ sub-account exclusively for the 2018 Bonds.

The 2018 Bonds matured on 11 May 2018, but the Group lacked the funds to pay the principal (US$350 million) plus interest falling due. The Group urgently tried to procure the required funds, but ultimately was unable to come up with enough funds, only raising a total of US$120 million (the Funds). Trading remitted the Funds in three tranches into the US$ sub-account in May 2018. The Group’s inability to raise sufficient funds resulted in SPV2 defaulting on the 2018 Bonds, which triggered cross-defaults on the other bonds including the 2022 Bonds. Thereafter, China Life obtained judgment against SPV1 in respect of the 2022 Bonds for HK$2 billion plus interest and costs and a garnishee order nisi over the Funds remaining in the Account.

Throughout the proceedings, the Committee and SPV1 contended that the Funds in the Account were subject to a Quistclose trust, the effect of which was that the Funds did not belong to SPV1 and the Group could apply the Funds towards its restructuring efforts. China Life, on the other hand, contended that the Funds wholly belonged to SPV1, meaning that they benefitted China Life exclusively as the only holder of the 2022 Bonds by virtue of its judgment and garnishee order.

The Court of First Instance and the Court of Appeal both rejected the Quistclose trust argument and held that China Life was entitled to a garnishee order over the Funds in the Account, albeit the Court of Appeal granted the AHG and SPV1 leave to appeal to the CFA.

The CFA’s Judgment

The CFA unanimously allowed the appeal of the AHG and SPV1 and discharged the garnishee order. In a comprehensive judgment, the CFA concluded that the facts of the case did give rise to a Quistclose trust.

The CFA conducted a thorough review of the case law, including the recent judgment of the Privy Council in Prickly Bay Waterside Ltd v British American Insurance Company Ltd [2022] UKPC 8. The CFA explained that it is now firmly established that subject to any special agreement, where a transferor (i.e. Treasury in this case) transfers property (usually money) to a transferee (i.e. SPV1 in this case) to be applied for a specific purpose and that purpose only, such that the property is not at the free disposal of the transferee, a trust of the property arises, with the transferee holding the same in favour of the transferor subject to the power or duty of the former to apply the property for the specific purpose. A trust of this type is generally known as a Quistclose trust.

The CFA explained that where the evidence objectively points to this restrictive intention, whether expressly or by implication, it follows logically that the property is not intended to form part of the recipient’s general assets to be at its free disposal. The legal consequence is that the beneficial ownership of the property does not pass to the recipient, who instead holds it as a fiduciary to apply it only for the specific purpose and if that purpose fails, must return it to the transferor.

The CFA made clear that it is not necessary — as the Court of Appeal may have interpreted Prickly Bay to require — to show a positive statement of intention to retain some beneficial interest in the Funds by the transferor. Nor must the parties have subjectively intended, anticipated or foreseen the transferor’s retention of a beneficial interest in the property, as this is only the legal consequence of the requisite intention.

The CFA held that the uncontroverted evidence clearly established that (i) the Funds were paid into the US$ sub-account solely to be used to meet SPV2’s obligations under the 2018 Bonds; (ii) the Funds were not intended to become part of SPV1’s general assets or to be freely at SPVl’s disposal; and (iii) that the Funds were assets of the Group, and on failure of the designated purpose, reverted, as a matter of legal consequence, to be used for the Group’s purposes, particularly as part of its efforts at restructuring its debt. On that basis, the CFA unanimously allowed the appeals and discharged the garnishee order.

Conclusions

The CFA’s decision contains a thorough exposition and application of the law of Quistclose trusts (a complex and challenging area of the law at the best of times) and provides clear guidance as to the interpretation of Prickly Bay.

Given the prevalence of special purpose vehicle bond issuers coupled with treasury type accounting practices among corporate groups in the Greater China region, this decision will be of particular relevance to bondholders and other creditors of distressed groups in the region and may provide additional avenues for recovery, especially where transaction documentation provides that loan proceeds must be used for a particular purpose.

It should also be of interest to lenders at the transaction stage when considering the utility of incorporating purpose provisions in loan documentation, and how trust type arrangements may be utilised to provide additional comfort.

Willa Wang also contributed to drafting this Alert.