Substance vs. Form Conflict in True Sale | Hong Kong Court Goes by the Language Used by the Parties

following post is contributed by Soma
, who is a Legal Advisor at Vinod Kothari & Company in Kolkata.
She can be reached at
In every assignment transaction, there
has been a constant conflict of whether the substance or form shall dominate
while determining the nature of a transaction. There are two schools of thought
on this: one which gives dominance to substance over form and the other which
prefers the dominance of intention that is expressed rather than that not
expressed, i.e. prefers the form over substance.
Generally speaking, when the nature of a
transaction goes for determination, while respecting the intention of the
parties set out in the documents, it shall be preferable to probe into the
substance of the transaction rather than the plain label and language used so
as to decipher what actually the transaction is all about. As has been said by
many, language as an indicator is good but cannot be a determinant.
Recently, the Hong Kong High Court in
the case of Hallmark Cards Incorporated
v. Yun Choy Limited and the Standard Chartered Bank (Hong Kong) Limited[1]

(an insolvency law matter), where the document in question was the Receivables
Purchase Agreement (“RPA”), has given
supremacy to the form over substance and held a transaction as a sale even
though, as discussed hereunder, the elements of a sale were absent.
1. Arguments
of the Liquidator of the Company (Yun Choy Limited)
1.1. The liquidators of the Company
argued that (a) the transaction amounted to a lending secured by a charge on
the book debts of the Company; (b) since the charge is not registered, the same
is invalid; (c) the transaction amounted to a general assignment of book debts
and hence void by reason of non-registration under the applicable bankruptcy
laws of Hong Kong.
1.2 The liquidators harped on the
substance of the RPA arguing that even though the transaction was expressed as
a sale and purchase of the debts due from the Company’s customers, in substance
it was an assignment by way of security creating a fixed charge over the book
1.3 The Company retained the risk of
non-repayment of debt by a customer. Hence, in absence of transfer of risk, being
an essential ingredient of sale, the transaction cannot be a sale.
1.4  In
the transaction:
(a) In a termination event, the Bank
could require the Company to purchase all the outstanding debts and sum of the
funds in use;
(b) The Bank had to account to the
Company who could recover full value of its book debts, i.e., if the payment by
the Company’s customers to the Bank exceeds the sums debited in the factoring
account, the credit balance would be payable to the Company;
(c) In case of a shortfall, the Bank could
recover the balance from the Company;
(d) There was no fixed price for the
purchase of a debt.
1.5. It was,
therefore, argued that the elements set out in the case of In re George
Inglefield Ltd.[2]
satisfied in the transaction, and hence, the same would not amount to a sale
but a mortgage. George Inglefield case has set out clear differences
between a true sale and a mortgage:
True Sale
No recourse
Seller is not entitled to get
back the asset sold by returning the money to the purchaser.
Mortgagor is entitled, until
foreclosed, to get back the asset by returning the money to the mortgagee.
Account of profit
Purchaser does not have to
account the seller of any profit realized by sale of the asset purchased from
the seller.
Any amount realized in excess
of the amount sufficient to repay the mortgagee shall be accounted back to
the mortgagor.
Right to receive the shortfall
Purchaser cannot recover from
seller any amount which upon resale of the purchased property was
insufficient to recoup the money paid to seller.
A mortgagee is entitled to
recover from the mortgagee the difference between the amount from sale of
asset and the amount due from mortgagor, if the amount from the sale of asset
is insufficient to meet such amount due.
Looking at the clauses in the RPA, it
could be validly argued that the principles of a true sale transaction (as
discussed below) were missing, and looking at the substance it may not appear
as a true sale.
2. Arguments
of the Bank (i.e. the Standard Chartered Bank)
2.1  The
Bank argued that:
(a) The Company’s entitlement to be paid
the credit balance in the factoring account did not amount to an equity of
(b) There is nothing wrong in a sale of
debt for the purchase price to be fixed by the amount to be collected by the
purchaser later.
(c) A sale with recourse is still a sale.
2.2 In support, the Bank relied on two
famous cases of Welsh Development Agency v. Export Finance Co Ltd[3] and
Orion Finance Ltd v. Crown Financial Management Ltd[4].
(a) In Welsh Development case, the Court had held a transaction to be sale
even though the same apparently looked like a financing transaction but was
documented as a sale, setting out the following principles of determination:
(i) The agreement shall be looked
at as a whole and its substantial effect shall be seen.
(ii) It is only by a study of the
whole of the language that a substance can be ascertained.
(iii) The plain meaning of any
term in the agreement cannot be discarded unless there can be found within the
agreement other language and stipulations which necessarily deprive such term
of its primary significance.
(iv) Factoring amounts to a sale
of book debts, rather than a charge, even though under the purchaser of the
debts is given recourse against the vendor in the event of default in payment
of the debt by the debtor.
(v) There may be a sale of book
debts, and not a charge, even though the purchaser can recover the shortfall if
the debtor fails to pay the debt in full.
(b) Further in the Orion Finance case, the Court had said that unless
the documents taken as a whole compel a different conclusion, the transaction
which they embody should be categorized in conformity with the intention which
the parties have expressed in them.
3. Verdict
of the Hong Kong High Court
The transaction
was held to be a sale.
4. Analysis
of the decision
Hong Kong Court did not give any basis for its decision and neither did it
discuss the parameters of a sale transaction. This case is a clear case of a
form over substance ruling.
looking at some of the factors of a sale, it cannot be said that the
transaction was a sale
4.1 Going the US way – substance over
form approach
In the United States, the Courts have
normally refused to go by the label of the contract rather than looking into
the nature of the agreement. One important aspect to be seen, which was
elaborated in the case of Major’s
Furniture Mart v. Castle Credit Corp
is whether the risks have been retained by the seller. In this case the Court
had said that it shall be seen whether the nature of recourse is such that the
legal rights and economic consequences of the agreement bear a greater similarity
to a financing or a sale transaction.
Therefore, primarily, the US Courts have
preferred a substance over form approach, which is different from the form over
substance which the UK Courts have preferred.
4.2 Revocable Transaction
If the transaction is revocable, i.e.
presence of a repurchase agreement has the effect of being treated as a secured
4.3  Failure
of the transaction to satisfy the determinants for a true sale transaction
(a) No
recourse against the seller
The risks and rewards shall be
transferred by the seller to the buyer, thereby eliminating a possibility of
any recourse against the seller. This is primarily a negative attribute and may
not in itself be a determinant factor as recourse is like a warranty given by
the seller on the quality of the assets sold.
The transaction for determination before
the Hong Kong Court gave the Bank a recourse against the Company, in spite of
which the transaction was upheld as a sale. The Hong Kong High Court accepted
the Bank’s contention that even though there may be recourse against the
seller, a transaction could be sale.
(b) Retention
of residual interest by the seller
In a sale transaction, the seller cannot
have control on profits of the buyer that arise after the sale. This was also
clearly highlighted in the George
case by the liquidator of the Company. As has been stated, the
rewards shall also stand transferred along with the risk in a sale transaction.
(c) Uncertain
sale consideration
Where the amount of sale consideration
is not ascertained or fixed, it cannot be said to be a sale transaction. This
factor makes the transaction move closer to a financing transaction.
5. Conclusion
The tendency
of the UK Courts and those following the UK principles to accept the language
of the contract as the primary indicator of substance continues. The ruling
does not help resolving the substance v. form conflict, which still continues
as an unresolved debate.

– Soma Bagaria

[1]  [2012] 1 HKLRD
[2] [1933] Ch 1
[3] [1992] BCLC 148
[4] [1996] 2 BCLC 78
[5] 602
F.2d 538 (3d Cir. 1979). This is one of the most cited cases when determining a
sale v. financing question.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.


  • kmusionImpromptu:

    The very concept of 'intention', in the nature of things, underlying or forming the core of the cited court case , is, by and large, a highly nebulous or unfathomable one. For practical purposes, 'intention' , which has something to do with 'frame of mind', a natural phenomenon, has come to be looked upon differently for different purposes. For instance, 'intention' , for any of the purposes of each of the man-made laws (i.e. criminal law on the one hand, and others e.g. civil law, income-tax law, arbitration law, so on, on the other), are, as is the practice, based on sound reasoning, to be approached from a mutually varying outlook. As, for each such purpose, the concept assumes a mutually varying color / complexion.

    Under the criminal law, in dealing with 'intention' , which, in legal parlance, is referred to as 'mens rea' , any related contention of either side (prosecution and accused) calling for examination , especially by a court for adjudication or jury, what assumes importance is the frame of mind of the accused person (if it is more than one, the case gets all the more complicated ). Again, at that very point in time / moments when the crime is alleged or believed to have been committed. The court , in deciding to convict or acquit, has no option or alternative, except to go by what is eventually established, to its full satisfaction, through adduced 'evidence'; to be precise,- 'circumstantial evidence'. What are known as 'alibi', 'benefit of doubt', etc., are of peculiar significance or consideration only to/in criminal cases. Needs to be specially noted, these do not have any relevance at all or do not come into play, being alien to, should the dispute calling for examination and adjudication is one under any other law, being 'civil' by nature.

    (may be contd.)

  • (contd)

    Turning to income-tax law:

    As one may be aware, there is an ongoing but seemingly endless controversy on the recent budget proposals seeking to rewrite the extant law, so also the case law developed over decades.

    Further, the FM and the coterie, as ever before, has been making every effort to defend and justify that the referred proposals are fault-proof.

    According to an independent but objectively balanced view, however, there is a sane case to urge that, the in formulating such ideas, he men responsible therefor have, unwittingly or otherwise, misled self, misconceived the concept of 'intention' itself
    (intentionally or otherwise), by not understanding the fundamental grouse of the taxpaying community. That is, that it is not against the legislators exercising its powers to legislate. But it is that, even in doing so, and on the first occasion itself, to ‘express its intentions’ clearly and truthfully , thereby giving no room, -for either the taxpayers to speculate or make a guess, or for the judiciary to having been obligated to ‘interpret’.

    To put it succinctly, any enactment must bear out, upfront, in no unmistakable terms, the ‘intention’; not, what was intended but not simply and clearly expressed to be so. Thereby, save the nation from a relentlessly useless, foolhardy exercise of trying to understand what was the 'intended' 'intention'; OR when it was going to be made clear, that too once for all.

    On the concept of 'intention', which, even of a first grade, judged by its basics, by its very inherent nature, is a highly dubious or nebulous one. That being so, 'intended intention', left to be expressed (i.e. clarified)only at a later point in time, more so after an enactment has been taken through due legal process, and finally interpreted and adjudicated upon by courts, after years, can in no way be subjected to a retroactive (= retrograde) legislation.

    That the FMs in power from time to time, for decades now, have nonetheless ruthlessly/mindlessly chosen to use it as a shield, and/or to rely on it as a fail proof defense is, to put it mildly, nothing short of a national tragedy. All the more it is so, that the present FM is noted to have brazenly sought to stick to his gun, by relying on the fictional concept, by hanging on it his newly- stitched-coat.

    For a critique on the related aspects throwing more light, one the article @ (2008) 169 Taxman pg. 14, 18 may make for a useful read.

  • An interesting discussion of the case. As a Chinese lawyer, the issue under Chinese laws may be presented in a different picture.

    My first question is why we pursue the question of whether it is a true sale. Under Chinese Contract Law, assignment of contractual right is different from a sale in its general sense. Assignment of contractual right is arranged in the "general provisions" of this law as part of the Chapter titled "novation and assignment of contract" while "sale contract" is put in the "Specific Provisions" of this law under which specific contracts of various kinds are provided.

    In a strict sense, a sale under Chinese contract law is about the transfer of ownership in "goods" only. A receivable is not a type of "goods" and therefore it is not appropriate to discuss assignment of receivable by reference to rules in respect of sale of goods.

    Chinese contract law provides for rules for assignment of contractual right (i.e. receivables) but fails to gloss the aftermath of such assignment, leaving it to be decided by the parties thereto.

    Given that understanding, loan or advance extended by factors shall not be considered as consideration or "sale price" for the assignment. If we have to find consideration for the assignment of receivables, it should be a combination of discounted money value plus a lending service.

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