Court refuses injunction to restrain winding up petition based on unpaid interim payments

In the recent case of Milestone Builder Engineering Ltd v Yau Kwok Contracting Ltd, HCMP 143/2020, the Plaintiff, Milestone, applied for an injunction to restrain the Defendant (YK) from presenting a winding up petition against it based on a statutory demand served on it by YK for HK$4.987 million for unpaid interim payments under a construction sub-contract. The Court refused to grant the injunction, holding that Milestone had failed to establish a bona fide dispute on the alleged debts. It also rejected Milestone’s argument that the statutory demand was bound to fail because the disputed debt arose from the sub-contract which contained an arbitration clause covering disputes relating to the debts, since Milestone had shown no present intention of instituting arbitration proceedings against YK.

Background

By a contract between the Employer and Milestone (Main Contract), Milestone was the main contractor for alteration and addition works. Under a sub-contract between Milestone and YK (NSC), YK became a nominated sub-contractor in respect of mechanical ventilation & air conditioning and electrical installation works. There were three other nominated sub-contractors on the Project, responsible for different types of construction work.

The debts stated in the Statutory Demand (Alleged Debts) concerned interim payments (NSC IP-18, IP-19, IP-20 and IP-21) plus interest owed by Milestone to YK pursuant to the NSC. There was no dispute that Milestone had not made all or any part of those payments.

Under the NSC Clause 33.1, payment for work done by YK was to be made in accordance with the following mechanism:-

(1)     The Quantity Surveyor under the Main Contract (QS) was to calculate the amount owing to each nominated sub-contractor in each Interim Certificate, which was to be issued to Milestone by the Architect under the Main Contract (Architect).    

(2)     Milestone was then required to pay to each nominated sub-contractor, including YK, the amount included in such Interim Certificates, less any amount properly deductible.

(3)     The payment was required to be made to each nominated sub-contractor within 14 days of Milestone receiving payment from the Employer.

(4)     If Milestone withheld an amount due to YK and failed to satisfy the Architect that it had good cause for so doing, the Architect was required under clause 29.8 of the Main Contract to issue a certificate to that effect and the Employer would be entitled, but not obliged, to pay that amount to YK direct.

On 5 March 2019, the Architect issued a notice of default to Milestone pursuant to the Main Contract (Notice of Default), stating that it had committed the following defaults (Milestone’s Defaults):-

(1)     Not proceeding regularly and diligently with works under the Main Contract despite the Architect’s warning letters;

(2)     Persistent failure to complete the external façade lighting control and programming to specification requirements, causing material detriment to the Employer; and

(3)     Refusal or persistent failure to comply with the Architect’s written notices requiring procurement of specified materials and proprietary products for timely completion of the Main Contract works.     

Upon certification from the Architect, on 23 March 2019, the Employer served on Milestone a written notice to end its employment under the Main Contract (Notice of Determination). By operation of NSC Clause 38.1, upon determination of the Main Contract, the NSC was also terminated at the same time.

YK repeatedly demanded Milestone to make payments. However, almost five months after service of the Notice of Determination, Milestone alleged that no outstanding payment was due to YK and instead alleged that because YK had caused delay and was in default, a balance of HK$11,121,000 was owed from YK. In particular, it alleged that YK was “provisional liable” for 224 days of delay (between 11 August 2018 – 23 March 2019) and hence liquidated damages of HK$15,680,000 (Alleged YK LD).   

Between 10 September 2019 and 9 October 2019, YK repeatedly denied that it had caused or contributed to Milestone’s Defaults, and stressed that Milestone had not given any notice of default to YK pursuant to NSC Clause 36. On 30 September, Milestone responded that:-

(1)     the Employer had set-off HK$12,110,000 as liquidated damages, so it did not receive full payment for NSC IP 18 – 21; and

(2)     Milestone had submitted a claim for extension of time (EOT) and requested the Architect to identify the cause of delay. It would thus pay YK only if:

(a)     Milestone had received payment from the Employer, or

(b)     delay was proven not to be YK’s responsibility.

Milestone’s case

Milestone argued that there were bona fide disputes between them and YK because:-

• The LD deducted by the Employer under MC IP-21 far exceeded the total amount of “work done by all nominated sub-contractors”. Milestone did not in fact receive any payment from the Employer in relation to YK’s work and it was not therefore obliged to make any payment to YK.

• Milestone made an application for an EOT and there were disputes with the Employer about the culpability for the alleged delays in the works which, if ultimately found to be valid by the Architect and Employer or by an arbitrator appointed to deal with the disputes, entitled Milestone to an EOT beyond the date of termination of 23 March 2019, and hence no liquidated damages should be deductible against it.

• The events leading to the delays involved YK’s works as well and in the event that YK was found culpable for delays, corresponding LD imposed by the Employer would then be deductible against YK pursuant to NSC Clause 33.1(7). 

YK’s Case

YK argued that there was no bona fide dispute on substantial grounds because:-

• Milestone had in fact received payment from the Employer.
• Milestone was not entitled to any deduction under the NSC.

The Court held that Milestone had failed to discharge its burden of demonstrating a bona fide dispute on the Alleged Debts because:- 

• As regards Milestone’s argument that it had not received payment from the Employer and hence was not liable to pay NSC IP-18 to IP-21, NSC Clause 33.1(7) reads “The Contractor [Milestone] is required to pay the Sub-Contractor [YK] the amount included for him in each interim Certificate, less any amount properly deductible within 14 days, or such other time as may be stated in the Sub-Contract, of the Contractor receiving payment from the Employer.” [emphasis added]. The operative words were: “[Milestone] is required to pay [YK] the amount included for him in each interim certificate…within 14 days…of [Milestone] receiving payment from the Employer”. The words “receiving payment from the Employer” must refer back to the particular interim certificate issued by Milestone to the Employer which included an amount for the sub-contractor’s work done.  The words “receiving payment” refers to payment of the relevant MC IPs in which amounts under the respective NSC IPs had been included. The crucial question was thus whether Milestone had received payment for the MC IP-20 to MC IP-23 which had included the sums claimed by YK under NSC IP-18 to NSC IP-21. 

• On the evidence, MC IP-20 to MC IP-23 had indeed been paid by the Employer albeit after exercising its right of using the LD. It was clearly anticipated by NSC Clause 33.1(10) that the Employer could exercise a right of deduction “from monies due to [Milestone]”.  In other words, whilst an amount is due to Milestone under a certain MC IP, the Employer can make deduction either in partial or in total extinction of such amount due under the MC IP. In that case, it cannot be said that the said MC IP had not been paid by the Employer, albeit through the exercise of a set off. 

• Both the Employer and Architect considered that MC IP-20 to MC IP-23 had been paid.  Pursuant to NSC Clause 33.1(7), the amounts due under NSC IP-18 to NSC IP-21 had become due and payable by Milestone to YK unless Milestone rightfully exercised any right of deduction within 14 days of payment of each of MC IP-20 to MC IP-23. Milestone clearly had not exercised that right of deduction within each respective 14 day period. 

• Milestone had failed to put forward “credible evidence” or “sufficiently precise factual evidence” to substantiate its alleged entitlement to make deductions. Milestone did not even have a clear case as to whether YK would eventually be held responsible for delay, and if so for how many days. It had consciously chosen not to carry out a detailed programme analysis to examine how the net delay may be attributed and apportioned between Milestone and its nominated sub-contractors (including YK). 

• It was relevant to look at NSC Clause 31.1(10) which reads “If the Employer has exercised a right under the Main Contract to deduct from monies due to the Contractor, to the extent that the deduction is due to a breach of contract or other default of the Sub-Contractor or any person for whom the Sub- Contractor is responsible the monies deducted may be recovered by the Contractor from any monies due or to become due to the Sub-Contractor or as a debt.” [emphasis added]

• The interplay of NSC Clauses 33.1(7) and (10) was as follows:-
• Milestone submits one MC IP to the Employer. This MC IP includes an amount in relation to work done by YK under a NSC IP.
• When the Employer exercises its right to charge LD and deduct such amount from that payable under the MC IP, the Employer is in law paying for the MC IP, albeit using the LD to set off the otherwise payable amount. Clause 33.1(7) therefore kicks in.
• If Milestone is able to determine, within 14 days, that a certain extent of the deduction made by the Employer was due to a breach of contract or other default by YK, Milestone can make such extent of deduction.  This may extinguish wholly or in part the sum claimed by YK under the NSC IP. This results from the combined effect of Clauses 33.1(7) and (10).
• If Milestone does not exercise such right within 14 days, Milestone has to pay YK under the NSC IP. Subsequently however, if Milestone is able to identify that a certain extent of the deduction made by the Employer was due to a breach of contract or other default by YK, Milestone can seek to recover that extent of deduction from YK. This is the effect of Clause 33.1(10).
• Milestone had not exercised any right to make deduction within 14 days from the respective payments made by the Employer for the MC IPs (albeit by way of set off using the LD). The full amounts claimed under NSC IP-18 to NSC IP-21 therefore became due and payable.  Furthermore, up to now, Milestone had produced no credible or sufficiently precise factual evidence to identify and establish the extent of the Employer’s LD deduction which were due to YK’s breach of contract or default.

Arbitration Clause

Milestone submitted that YK’s intended petition based on the Statutory Demand was bound to fail and an injunction should be granted because Milestone clearly disputed the Alleged Debts which arose out of the NSC which contained an arbitration clause, the scope of which covered the disputed debts.

The Court said that as made clear in the recent Court of Appeal judgment in But Ka Chon v Interactive Brokers LLC [2019] 4 HKLRD 85 and in Sit Kwong Lam v Petrolimex Singapore Pte Ltd [2019] 5 HKLRD 646 the Court retains a discretion under the insolvency legislation which should not be exercised only in one way by reason of the factor of arbitration, although considerable weight should be given to this factor. An insolvency petition would not be dismissed or stayed because of the mere existence of an arbitration agreement, when the debtor has no genuine intention to arbitrate. To show a genuine intention to arbitrate, the debtor must have taken the steps required under the arbitration clause to commence the arbitration process and file an affirmation showing this.  A formal notice of arbitration must leave the recipient in no doubt of the applicant’s intention to resort to arbitration, and that some action is required of the recipient.

Milestone relied on its current arbitration with the Employer over Milestone’s consolidated EOT claims. However, the Court said that that dispute simply had no connection with YK’s entitlement to NSC IP 18 – 21 owed by Milestone. Further, if Milestone really thought that YK’s debts were “hotly disputed”, it could have applied to join YK to the arbitration with the Employer, seeking a declaration of non-liability in respect of YK’s debts, and then applied for a stay pending that arbitration. Although the Statutory Demand was served almost 9 months ago, Milestone had not taken any steps to initiate any of the dispute settlement procedures under NSC GC Clause 42 and, the Court said, had clearly failed to demonstrate any genuine intention to arbitrate vis-à-vis YK. The mere existence of an arbitration clause in the NSC could not prevent YK from exercising its statutory right to petition for winding up Milestone on the ground of insolvency. At most, Milestone’s conduct amounted to reserving its position pending the resolution of its EOT claim under the arbitration between itself and the Employer. 

Comment

In this case, the Court held that if Milestone did not exercise its right of deduction of NSC IP from YK under Clause 33.1(10), it would be liable to pay YK according to the NSC IP. Whether Clause 33.1(10) is wide enough to exclude a common law right of set-off is not discussed in the judgment. It is a matter of interpretation of the NSC.

In Gilbert Ash (Northern) Ltd v. Modern Engineering (Bristol) Ltd [1974] A.C. 689, the House of Lords decided that the common law right of set-off can only be excluded by way of clear unequivocal words in the contract.

The present judgment did not mention whether the NSC used was the Hong Kong Standard Form for Nominated Sub-Contract. Assuming that it was (as appears from the clauses cited), Clause 41 thereof provides as follows:-

“Contractor’s power to recover damages etc.

(1)  The Contractor may make any deduction authorised by the Sub-Contract or at law including without limitation, deductions for costs, damages, debts, expenses or other sums for which the Sub-Contractor is liable to the Contractor from amounts due to the Sub-Contractor.

(2)  It is a condition precedent to the Contractor’s right of deduction under clause 41(1) that he gives a notice to the Sub-Contractor by special delivery stating the amount of the deduction and the reason for it at least 7 days before making the deduction.”

One may wonder whether the outcome of the case would have been different if Milestone had relied on Gilbert Ash and complied with Clause 41 mentioned above.