Directors beware!
Under section 275 of the Companies (Winding Up and Miscellaneous Provisions) Ordinance, if during the winding-up of a company liquidators discover that the business was carried on with intent to defraud creditors (or for any fraudulent purpose), then they can apply to the court for a declaration holding those individuals responsible personally liable. This provision offers a mechanism for creditors and liquidators to seek redress and recover losses from those responsible, usually directors, preventing them from being able to hide behind the corporate veil.
For many years courts seemed reluctant to make such findings, usually because of the applicant's inability to prove one of the key elements, dishonesty. This is because the required "intent to defraud" involves a subjective test, rather than an objective one. The difficulty in establishing subjective dishonesty has often deterred liquidators from pursuing proceedings, even in cases where there was (arguably) a strong basis for recovering compensation from directors or others.
On 22 November 2024, Hong Kong witnessed its first reported judgment on fraudulent trading in the case of Re Days Impex Ltd and Re Days International Ltd [2024] HKCFI 3386, when a director was held liable for participating in the carrying on of the business with the intent to defraud creditors. This landmark decision is encouraging for liquidators and creditors and provides helpful guidance on the legal principles governing fraudulent trading.
Background
The case involved two companies, Days Impex Limited and Days International Limited, which were wound up in 2011 after being placed into provisional liquidation. The liquidators discovered that the companies' directors, including Mr. Mahesh Nanik Dayaram, had procured fraudulent loans totaling over US$51 million.
The fraudulent scheme involved fictitious transactions with a purported supplier, Oscoda Electronics Limited, whereby funds obtained from import loans were funneled back to the companies to repay existing debts, in what was essentially a circular flow of funds. This scheme was designed to mislead creditors, particularly banks, about the companies' financial health. The liquidators commenced proceedings against Mr. Dayaram, seeking declarations of liability and compensation for the losses incurred by creditors.
Elements of fraudulent trading, burden of proof
The court revisited the elements of fraudulent trading, which require the plaintiff to prove that:
(1) certain business of the subject company was being carried on with intent to defraud creditors, or for any fraudulent purpose; and
(2) the defendant was knowingly a party to the carrying on of such business in such a manner.
As noted, proving "subjective dishonesty" on the part of the defendant is often challenging for the claimant. It has to be shown that the defendant either had an intension to defraud, or else acted with reckless indifference as to whether creditors were defrauded. A distinguishing feature of this case was that Mr. Dayaram had already been convicted on nine counts of conspiracy to defraud in relation to the same transactions. In the criminal proceedings it had been established that the transactions were fictitious, involving no underlying goods, and that Mr. Dayaram acted dishonestly as a party to the fraudulent scheme. As a result, the court held that the burden of proof shifted to Mr. Dayaram to demonstrate that the transactions were genuine or that he was not knowingly involved in the fraud.
Decision
The court concluded that the transactions were fraudulent and relied upon the conviction which found that the companies made false representations to the banks claiming Oscoda was a genuine supplier and submitted false invoices to obtain loans.
It was further found that the proceeds were funneled through Oscoda and back to entities associated with the companies, primarily to repay previous loans.
The court relied on the conviction and concluded that Mr. Dayaram was knowingly a party to the fraud. Further, the evidence showed that:
(1) Mr. Dayaram had direct control over Oscoda or knowingly acted in concert with Oscoda to perpetrate the fraud;
(2) he was the head of the Accounts and Finance Department of the group, which gave him knowledge of the fraudulent loan applications; and
(3) he was actively involved in orchestrating the circular flow of funds, which was a central element of the fraud.
Mr. Dayaram failed to produce substantive evidence to refute these findings, and the court declared that he was knowingly a party to the fraudulent business practices and held him to be personally liable for the debts of the companies directly attributable to the fraud.
Comment
Notwithstanding the features of this case, and the shift in the burden of proof as a result of the defendant's prior conviction, the judgment establishes an important precedent for fraudulent trading cases in Hong Kong. It delivers a clear message that individuals who knowingly conduct business with the intent to defraud creditors will face serious legal consequences, will not be able to hide behind the company, and may have to pay the price of their wrongdoings.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
