Section 9 of LARCO – Assignment of debt or chose in actions

Factoring is a widely used mechanism in the business world. This article discusses the law in relation to
factoring and practical tips to be adopted by companies when it comes to factoring and set off rights.

What is factoring?

Factoring is a form of financing by which a company sells debts that are due to be collected from a
customer to a third party (the Factor) at a discounted price, and in turn assigns its rights to collect the
debts from the customer or customers to the Factor.

After the factoring arrangement is entered into between the company and the Factor, it is the usual
practice for the Factor to send out to the relevant customers a letter giving notice that from the date of
the letter and until further notice, all debts owed by the customers to the company are automatically
assigned and become payable to the Factor. This letter is usually known as an introductory letter.

Law on factoring and its effect on set off rights

Under Hong Kong law, the assignment of debts is governed by both statute and common law principles.
Section 9 of the Law Amendment and Reform (Consolidation) Ordinance (Cap. 23) (the Ordinance)
provides that:-

“Any absolute assignment, by writing under the hand of the assignor (not purporting to be by way of
charge only), of any debt or other legal chose in action, of which express notice in writing has been
given to the debtor, trustee or other person from whom the assignor would have been entitled to
receive or claim such debt or chose in action, shall be and be deemed to have been effectual in law
(subject to all equities which would have been entitled to priority over the right of the assignee if this
section, section 11 of this Ordinance and sections 25 and 49 of the Conveyancing and Property
Ordinance (Cap. 219) had not been enacted) to pass and transfer the legal right to such debt or chose
in action from the date of such notice, and all legal and other remedies for the same, and the power to
give a good discharge for the same, without the concurrence of the assignor.”

[Absolute – must be for whole and not of part of debt; Express notice given to debtor or debtor’s agent
who has authority to receive the notice – by assignor or assignee; consideration not required, see
Harding v Harding (1886)]

This means that when a customer receives (and/or acknowledges) a written notice of assignment
(including an introductory letter) from the Factor, the assignment of debt to the Factor becomes
effective in law.

Section 9 of the Ordinance provides that the Factor takes the assignment of debt subject to all equities
which would have been entitled to priority over the rights of the Factor. Cases have interpreted this
wording to mean that:-

(a) the Factor takes subject to the customer’s right of set off against the assignor; but
(b) if the set off does not arise out of or is not closely connected with the same contract or the
subject-matter of the assignment, the customer can only claim a set off against the Factor if the right of
set off arose before the notice of assignment is given.

Where there is a prior contractual set off agreement in place between the company and the customer,
the law is not as clear cut when it comes to deciding whether such an agreement will also be effective
against the Factor where the transaction out of which the cross-claim sought to be set off arose was
entered into after the notice of assignment is given. There are two competing views arising from the
case law on this issue:-

(a) One view is that the assignee (i.e. the Factor) takes the same interest and is subject to the same
liabilities as the assignor (i.e. the company) at the date of the notice of assignment, and the prior
agreement will allow the debtor (i.e. the customer) to set off cross-claims, both present and future,
including claims which arise out of new transactions.

(b) The competing view is that when the debtor receives notice, the debtor should regulate its
conduct accordingly and should not rely on debts arising out of new transactions to diminish the rights
of the assignee as they stood at the time of notice: in other words, set off is not available in respect of
new transactions.

A set-off agreement entered into by the company and customer after the customer has notice of the
assignment will not ordinarily be effective as against the Factor.

In summary, set off rights will continue to apply after assignment where:

(a) the relevant cross-claim arose before the assignment;

(b) the relevant cross-claim arose out of the same contract or is closely connected with it;

(c) the factor expressly (or, depending on the facts, by implication) agrees to the continuation of a
contractual set off right.

Practical Tips

Below are various measures which can be taken by a company to strengthen its position when it comes
to factoring and set off rights:-

It is prudent for a company to include a clause in their terms and conditions with the supplier providing
that the set off rights which the company has under the contract will continue to be enforceable against
the supplier and their assignees regardless of (a) any existing or future agreements entered into
between the supplier and a third party assigning the right to the third party to collect its receivables or
(b) any future notice of assignment of debt which may be received by the company in relation to the
supplier’s debt. Again, it is also prudent to get an acknowledgement from the Factor and the supplier
that they will adhere to these terms.
Set up measures to ensure that Factors are kept up to date with the set off arrangements which the
company has in place with their customers e.g. by periodically sending letters to Factors (especially if
the Factor is involved in a long term trading relationship) reminding them that the company’s set off
rights against the customer and Factor will continue to apply to future assigned debts of the customer;
and

In the event the company’s right to set off crystallises (e.g. default by the supplier), the company should
put the supplier and Factor on immediate notice that the company will exercise their set off rights
against any assigned debts which are the subject of any existing or future invoices which may be issued
by the supplier.

Note: Assignment of liability is not recognized under the law, can only be done by novation.

Section 11 LARCO Stipulations not of the essence of contracts

Section 11 of LARCO adopts equity’s approach and the time of performance is not of the essence unless
otherwise stipulated by the parties. Performance must be within a reasonable time. Exceptions where
“not of the essence” rule will not apply: (1) where it is stipulated that time is of the essence (“at the
latest” or “not later than” – see Harrold Wood Brick v Ferris; Chong Kai Tai v Lee Gee Kee); (2) where
one party gives notice to the other that time should be of the essence, where it wasn’t initially so –
provided that the notice should afford reasonable opportunity for a party to perform its obligations, see
Behzadi v Shaftesbury); (3) where the nature of the subject matter or surrounding cicumstances of the
contract may show that the parties intended time to be of the essence.

Section 13 LARCO Action not maintainable on representations of character etc unless in writing

No action shall be brought whereby to charge any person upon or by reason of any representation or
assurance made or given concerning or relating to the character, conduct, credit, ability, trade or
dealings of any person, to the intent or purpose that such other person may obtain credit, money or
goods thereupon, unless such representation or assurance is made in writing, signed by the party to be
charged therewith.

***

PRIORITY OF FLOATING CHARGES

2014 年 02 月 17 日, Insolvency & Restructuring, Legal Alert

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1. A floating charge is a type of security which may be created over a class of moveable assets (such as
current assets, trading stock or cash on hand), and are commonly sought by banks and other credit-
providers as security for money which has been lent to a borrower. Under a floating charge, the
borrower (or chargor) may continue to deal with its assets subject to the charge in the ordinary course
of business until the charge crystallises and the creditor takes steps to enforce it. However, a creditor
holding a floating charge over some or all of a borrower's assets may find such security challenged by
other secured creditors in the event of the borrower's insolvency, giving rise to questions of priorities
between them.

2. Under Hong Kong law, priorities between competing interests over the same property of an insolvent
company are determined in accordance with a complex set of priority rules. These priority rules vary
depending on the type of property involved, as well as the type(s) of security which have been granted
in respect of such property.

3. In this note, we provide an overview of the general Hong Kong law priority position of a bank ("Bank")
which holds a floating charge ("Floating Charge") over all of a Hong Kong company's assets, where the
company ("Borrower") has also granted to a third party creditor ("Other Creditor") a later:

legal assignment of receivables owed to the Borrower by its customers (i.e. receivables assigned in
accordance with s9 of the Law Amendment and Reform (Consolidation) Ordinance (Cap. 23) ("LARCO"));

pledge of (i) bills of lading, and (ii) warehouse receipts, in respect of goods (located in Hong Kong)
owned by the Borrower, in each case where the Other Creditor is in possession of them; and

fixed charge over cash margin held in an account in Hong Kong with the Other Creditor (which is a bank);

and the Borrower subsequently becomes insolvent.

I. Floating charge v. subsequent legal assignment of receivables

(a) General position

4. Where the Borrower has granted the Floating Charge over all of its assets (including receivables owed
to it by its customers) to the Bank, and has also subsequently legally assigned the same receivables to
the Other Creditor, a question of priority between the competing interests of the Bank and the Other
Creditor with respect to such receivables may arise.

5. Under Hong Kong law, the general rule governing priority between assignments or charges over the
same debts or receivables is the rule laid down in the English case of Dearle v Hall (1828) 3 Russ 1
("Dearle v Hall"): that is the assignee/chargee whose notice to the debtor is the first in time has priority,
provided that at the time of the assignment/creation of the charge, he did not have notice of any earlier
assignment/charge to any other assignee/chargee and he was acting in good faith and gave good value
in return for his charge/assignment.

6. However, where receivables subject to a floating charge are disposed of by way of a legal assignment,
in the absence of any restrictions in the terms of the floating charge against doing so, the rule in Dearle
v Hall does not apply to determine priorities. Rather, the general position appears to be that, as the
chargor under the floating charge is permitted to deal with its assets subject to the charge in the
ordinary course of business until crystallisation (which would include selling or assigning receivables),
the legal assignee of such receivables would take free of the prior floating charge. The rule in Dearle v
Hall would not apply since the floating chargee will be taken to have impliedly authorised the chargor to
effect the legal assignment. Accordingly, in the absence of any restrictions under the terms of the
Floating Charge, the Borrower (as chargor) would prima facie have been permitted to sell/assign the
charged receivables to the Other Creditor, provided no crystallisation event had occurred, so that the
Other Creditor's interest in the receivables would have priority over that of the Bank's. This would be
the position even where the Other Creditor had notice (whether actual or constructive - see para. 12,
below) of the existence of the Bank's prior Floating Charge as its interest would be taken to have been
created with the implied authorisation of the Bank.

7. However, in practice, floating charges in Hong Kong almost always contain restrictive covenants
prohibiting chargors from assigning or otherwise encumbering charged assets with interests ranking in
priority to, or pari passu with, the charge ("negative pledge clause"). Additionally, floating charges
commonly contain clauses stipulating that the charge will automatically crystallise upon the happening
of certain events which may not require the intervention of the chargee ("automatic crystallisation
clause"). The effect which such clauses may have on the Bank's priority position is discussed as follows.

(b) Negative pledge

8. If the Bank's Floating Charge contains a negative pledge clause, such clause would generally not affect
the Other Creditor except where the Other Creditor had actual notice (see paras. 12-15, below) of the
clause at the time it took its legal assignment. If, at that time, the Other Creditor did have actual notice
of such a clause, the Bank's interest in the receivables would likely gain priority. The Other Creditor
could also be liable to the Bank for procuring the Borrower's breach of the clause, and the courts could
restrain it from enforcing its rights so as to cause a breach of a prior agreement of which it had
knowledge.
(c) Automatic crystallisation

9. A typical automatic crystallisation clause in a floating charge instrument will provide that if the
chargor acts in breach of a negative pledge clause and creates, or attempts to create, a subsequent
interest without the consent of the prior floating chargee, the floating charge will automatically
crystallise, and rank ahead of any subsequent interest. If the Bank's Floating Charge contains such an
automatic crystallisation clause, it is possible that the Floating Charge will have crystallised before the
Other Creditor's legal assignment of receivables was effected, as any attempt to create a prior ranking
interest would cause the Floating Charge to crystallise.

10. Where the Other Creditor's legal assignment is effected after crystallisation of the Bank's Floating
Charge, it would seem that the Bank's interest in the receivables would take priority being first in time,
as from crystallisation, it will no longer be taken to have impliedly authorised the Borrower to dispose of
the receivables to the Other Creditor. Thus, as between a crystallised floating charge (which takes effect
as an equitable fixed charge) and a subsequent equitable assignment of receivables (i.e. a legal
assignment which has not yet been perfected by notice to the contract counterparty, notice being one
of the requirements for a legal assignment under s9 LARCO), the rule in Dearle v Hall can still apply.

11. Accordingly, priority between the Bank's and the Other Creditor's interests in the receivables would
be determined according to the order in which notice is given to the customers (i.e. the contract
counterparties). If the Other Creditor perfects its legal assignment by giving notice of its assignment to
the customers first in time, and does not have notice of the crystallisation of the Bank's Floating Charge,
the Other Creditor would take priority under the rule in Dearle v Hall. However, if it is the Bank that
gives notice of crystallisation of its Floating Charge first in time, the position would be reversed and the
Bank would take priority instead (note that the holder of a floating charge can only give notice of its
charge to contract counterparties upon crystallisation, as only at that time does the charge
attach/fasten to the assets subject to the charge).

(d) Does registration of a charge confer notice of a negative pledge clause or automatic crystallisation
clause?

12. Under the Companies Ordinance (Cap. 32), certain types of charges (including floating charges)
created by Hong Kong companies and non-Hong Kong companies with a place of business in Hong Kong
must be registered with the Companies Registry within 5 weeks of creation. Registration of a charge will
generally constitute at least constructive notice of the existence of that charge to any subsequent
chargee/assignee. Constructive notice means that in the absence of actual notice (i.e. personal
knowledge), a subsequent chargee/assignee will generally be taken to have constructive notice of an
earlier registered interest.

13. A common practice has arisen in Hong Kong whereby negative pledge and automatic crystallisation
clauses in charge documents are included in the particulars which are submitted to the Companies
Registry upon registration. The existence of such registered negative pledge and automatic
crystallisation clauses may therefore be revealed by way of a company search conducted by any
member of the public.

14. Previously, it was unclear as to whether the doctrine of constructive notice by registration extended
to notice of all particulars (including negative pledge and automatic crystallisation clauses) which had
been registered with the Companies Registry. That area of the law has now been clarified in the Hong
Kong case of ABN Amro Bank NV v Chiyu Banking Corp Ltd & Ors [2000] HKC 3 381 ("ABN Amro") in
which it was held that registration of a negative pledge or automatic crystallisation clause does not
confer constructive notice of such clause on a subsequent assignee/chargee. In that case, the court held
that the doctrine of constructive notice by registration only operates in a narrow sense – it means
constructive notice is only of (i) the existence of the prior interest; and (ii) the particulars of the prior
interest statutorily required to be registered. Inclusion of particulars of a negative pledge or automatic
crystallisation clause which is contained in a charge document is not a statutory requirement.
Accordingly, the practical effect of the decision in ABN Amro is that, for a subsequent chargee/assignee
to have notice of any negative pledge or automatic crystallisation clause contained in a prior floating
charge document, it must have had actual notice of it (constructive notice of registered particulars of
the prior floating charge will not be sufficient).

15. However, with the commencement of the new Companies Ordinance (Cap. 622) ("new CO") on 3
March 2014, certified copies of the charge instruments, together with a statement of the particulars, of
registrable charges, must be registered with the Companies Registry and made available for public
inspection (Part 8 of the new CO). As the doctrine of constructive notice means constructive notice of (i)
the existence of a prior interest; and (ii) the particulars of the prior interest which are statutorily
required to be registered, for charges which are registered in accordance with the new CO, subsequent
chargees/assignees will likely be deemed to have constructive notice of all of the terms of the relevant
charge instruments, including any negative pledge and/or automatic crystallisation clauses (since the
entire charge instruments will be statutorily required to be registered).
II. Floating charge v. pledge of bills of lading and warehouse receipts

(a) Bills of lading

16. Under Hong Kong law, a bill of lading is a document of title to the underlying goods it represents at
common law. Thus, assuming that the Borrower's pledge of bills of lading to the Other Creditor has the
effect of transferring constructive possession of the underlying goods they represent to the Other
Creditor (and provided such goods are situated in Hong Kong), it seems likely that such pledge of bills of
lading would be recognised in Hong Kong as a pledge of the goods themselves.

17. In the absence of any restriction in the terms of the Floating Charge against creation of subsequent
pledges, as between the Bank's prior Floating Charge over the Borrower's assets (including goods owned
by the Borrower) and the Other Creditor's pledge of bills of lading (representing pledged goods), the
Borrower (as pledgor) would have been impliedly authorised by the Bank to pledge the bills of lading to
the Other Creditor prior to crystallisation of the Floating Charge as this would be in the ordinary course
of its business (see para. 6, above). Alternatively, it may be argued that the time of crystallisation is not
relevant, as a pledge (a legal interest) will always take priority to a floating charge (an equitable interest)
provided that the pledgee did not have notice of crystallisation of the floating charge (see para. 18,
below). Accordingly, the Other Creditor's interest with respect to the bills of lading and underlying goods
(as pledgee) would take priority ahead of the Bank's interest (as floating chargee), as long as it retained
possession of the pledged bills of lading (possession being an essential element of a pledge under Hong
Kong law).

18. However, if the Bank's Floating Charge contains a negative pledge clause, the Other Creditor may
lose priority where it had actual notice of such clause (see paras. 8, 12-15, above). If the Floating Charge
had crystallised before the creation of the Other Creditor's pledge (e.g. by the joint operation of a
negative pledge clause and automatic crystallisation clause), it is likely that the Other Creditor would
retain priority with respect to the pledged bills of lading (provided that it did not have actual notice of
the negative pledge and automatic crystallisation clauses). This is because a floating charge takes effect
as a fixed charge as at the time of crystallisation (an equitable interest), and as between an equitable
charge and a subsequent pledge (a legal interest), the general rule is that the subsequent pledgee's
interest will take priority as a legal purchaser for value, provided that he did not have notice of the
crystallisation of the prior equitable charge.

(b) Warehouse receipts

19. For Hong Kong law purposes, warehouse receipts are not documents of title to the underlying goods
they represent at common law. Accordingly, under Hong Kong law, a pledge of a warehouse receipt by
itself is not sufficient to create a pledge of the underlying goods it represents as there is no delivery of
possession of the goods (unlike a bill of lading). However, a valid pledge of the underlying goods to a
warehouse receipt may still be created by other methods, such as by way of "attornment". Creation of a
pledge by way of "attornment" was described in Official Assignee of Madras v Mercantile Bank of India
[1935] AC 53 ("Madras"), where was held that "If…the goods [are] in the custody of a third person, who
held for the bailor…the pledge could be effected by a change of the possession of the third party, that is
by an order to him from the pledgor to hold for the pledgee, the change being perfected by the third
party attorning to the pledgee, that is acknowledging that he thereupon held for him; there was thus a
change of possession and a constructive delivery".

20. If the Other Creditor has a valid pledge of goods under pledged warehouse receipts, its priority
position as against the Bank would likely be the same as that under pledged bills of lading (see paras. 16-
18, above)

(c) What is the position where the Other Creditor does not have a perfected pledge of underlying goods?

21. If the Other Creditor for any reason does not have a perfected pledge of the underlying goods under
pledged bills of lading or warehouse receipts (e.g. where the bill of lading is not negotiable, or a third
party bailee is found not to have properly "attorned" the goods to the Other Creditor), it may
nevertheless still have a pledge of the paper bills of lading or warehouse receipts. In that situation, the
Other Creditor would generally be able to retain the bills of lading or warehouse receipts, but would not
be able to use them to dispose of the goods for value (since it would not be able to pass constructive
possession of the goods to a purchaser). However, if the Other Creditor is named as consignee on the
bills of lading or warehouse receipts it would be entitled to call for delivery of the goods. Upon taking
delivery of the goods, the Other Creditor's pledge of such goods would then likely be perfected (as it will
have taken actual delivery), and its priority would likely be determined as above (see paras. 16-18,
above).

III. Floating charge v. fixed charge over cash margin

22. As the Bank's Floating Charge covers all of the Borrower's assets, the Bank would also have a floating
charge over all of the Borrower's cash. However, where the Borrower grants a later fixed charge over
cash which has been deposited with another banking institution such as the Other Creditor, particular
issues with respect to priority may arise.

(a) Where cash subject to a fixed charge

23. In the absence of any restriction under the terms of the Floating Charge prohibiting the Borrower
from granting subsequent interests, as between the Bank's Floating Charge over the Borrower's cash
(including cash deposited with the Other Creditor), and the Other Creditor's fixed charge over such cash,
prima facie, the Borrower would have been impliedly authorised to grant the subsequent fixed charge to
the Other Creditor, as this would have been in the ordinary course of its business (see para. 6, above).
Accordingly, the Other Creditor's fixed charge would have priority ahead of the Bank's Floating Charge in
the event of the Borrower's insolvency.

24. If the Floating Charge instrument contains a negative pledge clause, as with the scenarios mentioned
above, the Other Creditor may lose priority where it had actual notice of such clause (see paras. 8, 12-15,
above).

25. However, if the Floating Charge had crystallised before the creation of the Other Creditor's fixed
charge (e.g. by the joint operation of a negative pledge clause and automatic crystallisation clause), the
Other Creditor's fixed charge should still take priority (provided that it did not have actual notice of the
negative pledge clause). Although the general position is that the rule in Dearle v Hall will apply to
determine priority between the Bank and Other Creditor (see para. 10, above), since the Borrower's
cash is held in accounts with the Other Creditor, there is no need for the Other Creditor to give notice to
itself (as the account debtor) and such notice will generally be presumed. Accordingly, provided that the
Other Creditor did not have notice of crystallisation of the Bank's Floating Charge at the time it took its
fixed charge over the Borrower's cash, the Other Creditor will have priority under the rule in Dearle v
Hall.

(b) Where not subject to any security

26. As regards the Borrower's cash which is held in an account with the Other Creditor, but with respect
to which the Other Creditor has not taken any security over, the relationship between the Borrower and
the Other Creditor (as banker) would be that of an ordinary creditor and debtor. However, where such
cash is "collateral" for any amounts which may become owing to the Other Creditor ("cash margin"),
upon the Borrower's insolvency, the Other Creditor would normally be able to assert a claim over such
cash margin pursuant to the mandatory insolvency set-off rules under s35 of the Bankruptcy Ordinance
(Cap. 6) ("BO") to set-off the cash margin against debts owed to it by the Borrower.

27. Under s35 BO, insolvency set-off is available where:

there have been credits, debts and other dealings between a company in liquidation and a creditor
which permit a financial balance to be struck;

the credits, debts and other dealings must have been mutual, meaning they must be between the same
persons and in the same right;

the claim must be provable in liquidation; and

the creditor did not, at the time of giving credit to the insolvent company, have notice that the winding
up had commenced.

28. However, as the Borrower has granted the Floating Charge to the Bank, upon crystallisation, the
Floating Charge would operate to transfer the beneficial ownership in the cash margin to the Bank. This
means that crystallisation will likely destroy the mutuality of claims required for a set-off to take place
between the Other Creditor and the Borrower under para. 27 b., above, and the Bank will take priority
free of the Other Creditor's set-off right under s35 BO.

IV Conclusion

29. The above analysis illustrates some likely priority outcomes where creditors have taken competing
security interests over the same property of a borrower. In particular, the analysis demonstrates the
importance of including negative pledge and automatic crystallisation clauses in floating charge
instruments.

30. The effect of the new CO remains to be seen. However, based on the existing legal principles under
Hong Kong law, it appears likely that banks and other creditors seeking to take security over a
borrower's assets will be deemed to have constructive notice of all the terms of any existing security
taken over such assets (where such security is registered pursuant to, and in accordance with the new
CO). Banks and creditors should therefore conduct thorough searches and review the terms of any pre-
existing registered charges carefully so that they will not be caught unaware by any terms which they
would be deemed to have notice of.

Section 13A Part Performance and damages

Doctrine of part performance (oral contracts); damages can be sought, if specific performance is not
available.

Section 14 Consideration for guarantee need not appear by writing

Section 15 Right of surety who discharges liability to assignment of all securities held by creditor

Section 15A Charges and mortgages over choses in action

Charge-back security arrangement is valid under HK law.

See page 124, Secured Finance Law in China and Hong Kong by Mark Williams, Haitian Lu, Chin Aun Ong

Section 16 Adjustment of rights and liabilities of parties to frustrated contracts

Consequences of frustration are governed by legislation – definition of frustration is governed by

common law or sometimes, by contract. Courts have wide discretion in apportioning loss in case of
frustration.

Section 19 LARCO – Contribution (in tort) [see also Civil Liability (Contribution) Ordinance Cap. 377]