Restructuring and Insolvency Bulletin: Issue 4 - May 2018: Bad Faith and Misconduct Not a Bar to US Recognition of Hong Kong Liquidation Case

by Dechert LLP
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Manley Toys Limited once claimed to be the seventh largest toy company in the world. Due to ongoing litigation and declining sales, it entered into a voluntary liquidation in Hong Kong. On March 22, 2016, the debtor’s appointed liquidators and foreign representatives filed a motion for recognition under chapter 15 of the Bankruptcy Code. The motion was opposed by ASI Inc., f/k/a Aviva Sports, Inc. (“Aviva”) and Toys “R” Us, Inc. (“TRU”). The main arguments against recognition were that the Hong Kong proceeding was not collective in nature; was not a foreign main proceeding; and that recognition would be manifestly contrary to public policy due to the bad faith and misconduct (including the disregard of orders entered by the district court) exhibited by the debtor in its litigation with Aviva and TRU. The court denied the objections and recognized the Hong Kong proceeding as a foreign main proceeding.   

The Pending U.S. Litigation

Aviva and TRU were both involved in litigation against Manley Toys. After several years of litigation in the district court, Aviva obtained a US$8.6 million judgement by default because Manley Toys failed to comply with numerous court orders. Aviva attempted to collect on its judgment and sought post-judgement discovery, which Manley Toys did not provide. As a result, Aviva sought sanctions, including a bar on the sale, importation, distribution, or shipping of Manley Toys’ products in the U.S.

TRU was a former customer of Manley Toys. TRU alleged that Manley Toys was required to indemnify it in a personal injury case that resulted in a US$24 million judgement against TRU. Manley Toys commenced an action against TRU seeking US$5 million in damages on various counts and TRU counterclaimed. In light of the pending sanctions motion, the upcoming trial with TRU, ongoing litigation with other parties and declining sales, Manley Toys decided to enter into voluntary liquidation.  

The Hong Kong Proceeding 

On March 11, 2016, a notice of a “Creditors’ Meeting” was sent by regular mail to all of the debtor’s known creditors and was published in three Hong Kong newspapers. The notice informed parties that the Creditors’ Meeting would be held on March 22, 2016. The Creditors’ Meeting and an Extraordinary General Meeting of the Company were both held on March 22, 2016. At the Extraordinary General Meeting of the Company, the debtor’s shareholders passed a special resolution for the voluntary winding up under Hong Kong Law. At the Creditor’s Meeting, liquidators were appointed and authorized to obtain recognition of the Hong Kong proceeding in the U.S.  

The U.S. Chapter 15 Case

The liquidators commenced the chapter 15 case and sought recognition of the Hong Kong proceeding as a foreign main proceeding, or in the alternative, as a foreign non-main proceeding. Aviva and TRU opposed recognition arguing that the Hong Kong proceeding was not collective in nature, was not a foreign main proceeding and that recognition would be manifestly contrary to public policy, emphasizing Manley Toys’ bad faith and misconduct in the litigations preceding the bankruptcy filing.  

The Hong Kong Proceeding is Collective

Generally, to be recognized a foreign insolvency proceeding must meet the following criteria: (a) meets the definition of “foreign proceeding;” (b) meets the requirements for recognition under section 1517(a); and (c) is not manifestly contrary to the public policy of the United States. Aviva and TRU argued that the Hong Kong proceeding is not a foreign proceeding since a foreign proceeding is defined as a collective judicial or administrative proceeding, and the Hong Kong proceeding is neither collective, nor judicial or administrative.  

The court held that the Hong Kong proceeding is administrative in nature and that parties in interest may apply to Hong Kong courts to protect their rights and ensure that the proceeding complies with Hong Kong law. Thus, the Hong Kong proceeding qualified as judicial or administrative in nature. 

As to the collective nature of the proceeding, U.S. courts find that a proceeding is collective if it considers the rights and obligations of all creditors. It was essentially undisputed that the Hong Kong proceeding fits that bill. The testimony established that the liquidators’ duties run to all creditors, including foreign creditors, that all of the debtors’ property must be collected and distributed pursuant to a priority scheme and all similarly situated creditors must be treated equally. 

Relying on precedent where U.S. creditors did not receive notice of the foreign proceeding and thus were unable to participate in it, the objectors insisted that the Manly Toys proceeding is not collective due to the short notice period given as to the creditors’ meeting. The court rejected this challenge since in the Manley Toys case, Aviva and TRU did in fact receive notice and any prejudice resulting from the short notice period can be brought before the Hong Kong courts. 

Finally, Aviva and TRU argued that due to various alleged misconduct of insiders, including stripping of assets and manipulation of the creditors list to favor insiders, the Hong Kong proceeding was not collective. The court found that such alleged misconduct may be investigated by the liquidators under Hong Kong law, that creditors may petition the Hong Kong courts to remedy any harm or wrongdoing and that, in any event, these claims do not go to the question of the collective nature of the Hong Kong proceeding.

The Hong Kong Proceeding is a Foreign Main Proceeding

A foreign main proceeding is a foreign proceeding pending in the country where the debtor has its center of main interests (“COMI”). In the absence of evidence to the contrary, the debtor’s registered office is presumed to be the debtor’s COMI. Because Manley Toys’ registered office was in Hong Kong, the presumption was that its COMI was in Hong Kong.  

In determining a debtor’s COMI, U.S. courts consider a variety of factors, including: (1) the location of the debtor’s headquarters, (2) the location of the debtor’s management, (3) the location of the debtor’s primary assets, (4) the location of the majority of the creditors who would be affected by the case, and (5) the jurisdiction whose law would apply to most disputes. 

Aviva and TRU argued that Manley Toys had an employee and an office in the U.S.; that was insufficient, however, to rebut COMI in Hong Kong since the main office and bank accounts were in Hong Kong. Further, the fact that Manley Toys laid off its Hong Kong employees five days prior to the commencement of the liquidation, did not change the analysis since these laid off employees are the individuals with the knowledge regarding Manley Toys’ operations and the timing of their termination was sufficiently close to the start of the liquidation to be considered as a favorable factor in finding COMI in Hong Kong. 

Finally, Aviva and TRU argued Manley Toys’ main asset, a US$5 million receivable from TRU was located in the U.S.  But the court found that the asset was subject to a counterclaim by TRU for US$18.5 million resulting in an uncertain value. Since Manley Toys’ other assets, including litigation claims, were in Hong Kong, the TRU receivable was insufficient to rebut COMI in Hong Kong. 

The Hong Kong Proceeding is not Contrary to Public Policy

Aviva and TRU argued that recognition of the Hong Kong proceeding would be manifestly contrary to the laws of the U.S. because: (i) the notice given to foreign creditors was inappropriately short, (ii) Manley Toys’ liquidation proceeding manifests its continued attempts to violate and avoid U.S. court orders, (iii) under Hong Kong law it is harder to prove fraudulent transfers and (iv) the liquidators are not independent as they are being funded by an insider and the terms of the loan prohibit the use of the loan’s proceeds to pursue the funder. 

The court found that none of these allegations is sufficient to deny recognition. First, the notice was given as required by Hong Kong law and any resulting harm could be addressed by Hong Kong courts. Second, while Manley Toys might have engaged in improper conduct in the prior litigations among the parties, bad actions do not prevent debtors, either domestic or foreign, from utilizing bankruptcy law to liquidate. Third, differences between U.S. law and foreign law do not justify recognition denial unless the differences offend the most fundamental policies of the U.S. Finally, the court noted that parties in interest routinely fund bankruptcy cases in the U.S. while prohibiting the estate’s fiduciaries from utilizing these loans to prosecute actions against the funder.  

Conclusion

While companies often enter liquidation as a last-ditch effort to avoid creditors, an independent fiduciary is tasked with sorting everything out for the benefit of all creditors. Here, that liquidation was commenced in Hong Kong rather than the United States. The court noted that it did not doubt that insiders had taken actions to avoid paying Aviva’s claims and the trial against TRU, and accepted the possibility that there may be significant claims against insiders.  Nonetheless, the court concluded that the fact that Manley Toys may have acted in bad faith in other courts did not mean that the court should refuse to recognize the foreign proceeding, thereby forcing the liquidators to pursue their duties under Hong Kong law without the assistance of the U.S. court and protections of chapter 15. 

The interesting question that the court did not have to address is whether the fact that Manley Toys was pursuing liquidation rather than reorganization makes a difference in the analysis. 

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