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The basics of insolvency – what to watch out for when dealing with an insolvent counterparty?

Insolvency proceedings mean a great number of restrictions not only for the insolvent debtor. They have also consequences for third parties, their transactions, and their relations to the debtor...

Insolvency has an impact on court disputes, the collection of claims, contracts with the insolvent debtor and performances rendered under the same, and legal transactions of the debtor (or legal transactions in which a third party engages toward the debtor).

Given all this, one will always want to check, in relations with third parties, whether an insolvency procedure has been initiated against them, and if so, to what stage such procedure has progressed. As a rule, this will have impact on whether we want to enter into a relationship with them in the first place, or what limitations must be borne in mind.

But how to establish whether a contractual partner is insolvent or whether they are exposed to the imminent risk of an insolvency procedure?

Debtor’s insolvency

The basic requirement for opening an insolvency procedure is the existence of insolvency (legally defined as the inability to make payments or as overindebtedness) on the part of the debtor. Insolvency is a factual condition – it cannot be established without doubt solely based upon public records, lists, or other sources of information.

The debtor will know best whether they have entered into insolvency; everyone else will have to make do with circumstantial evidence: the debtor’s accounting (in which debts exceed the available assets), or the fact that the debtor has been defaulting on overdue debts. Various commercial resources (with paid access) provide information on the existence of certain kinds of debt, and the Central Debt Enforcement Register contains information on debt which has been collected by bailiffs under the Debt Enforcement Act. Information of this kind also allows one to infer that there exists an elevated risk of insolvency (though the specifics of the individual case must always be taken into account). Another important clue pointing to the insolvency of the debtor is the conduct of other market participants, and so is the "rumor mill".

Effects of insolvency and of the opening of an insolvency procedure

The mere fact of being insolvent may trigger legal effects, even before an insolvency procedure has been initiated. For instance, the court may, upon opening that procedure, nullify certain transactions which the debtor performed before the initiation of proceedings (but after they became insolvent). In such a case, the performances received on the basis of such transactions must be surrendered to the insolvency estate (i.e., returned by the recipient).

Further, the opening of the insolvency procedure immediately makes certain legal transactions impossible – namely, those which seek the satisfaction of a receivable outside of insolvency proceedings. This means e.g. that foreclosure and the enforcement of decisions are no longer possible. The opening of the insolvency procedure also imposes constraints on the exercise of rights by the creditors involved in the insolvency procedure. In particular, no new security may be established over assets of the debtor in order to attain a more favorable position in the final distribution of the debtor’s estate once it has been turned into cash.

Given all the above, the protection of third parties who are engaged in relations with the debtor crucially requires that they learn as early as possible of the fact that the debtor has become insolvent and is exposed to the risk of an imminent insolvency procedure.

How to make sure to learn of another party’s insolvency in due time

Third parties generally enjoy some basic level of comfort thanks to the fact that the members of the statutory body (i.e., the management) of any corporation are obliged under the law to file timely for the opening of insolvency proceedings (Sec. 98 et seq. of the Insolvency Act). This basic protection may be further enhanced e.g. by incorporating a representation of the relevant parties in the agreement to the effect that they have not entered insolvency, or by including a clause under which the debtor must inform the other party promptly of the fact that they have entered into insolvency, which may be tied to certain measures such as calling the debt due for payment (acceleration), an option to suspend or discontinue contractual performances, or the right to walk away from the contract on grounds of the other party’s insolvency. Case law principally recognizes such contractual arrangements as valid, and they may have a certain preventative effect. However, if the debtor’s representation as to the (non-)existence of insolvency is found to be false, or if the debtor fails to notify the other party in time of its insolvency, then there are not many avenues to recourse for the affected counterparty: it may demand compensation for damages from the debtor, or impose a contractual penalty or other sanctions (if agreed between the parties), but only ever within the context of the insolvency procedure, and thus with little or no prospects of return (we shall see in a future installment of this article which insolvency protection clauses actually can and should be incorporated in business contracts). Not infrequently, the debtor’s management may actually be liable under criminal law.

How to find out about the opening of insolvency proceedings

By contrast, it is perfectly straightforward to find out about an insolvency procedure which has been opened. The initiation of such proceedings has substantial and immediate consequences for everyone who is in, or enters into, relations with the insolvent debtor. Because of this, the court announces the opening of proceedings in an official notice, which is published in the so-called insolvency register along with the motion for insolvency and other documents belonging into the insolvency file. The insolvency register can be publicly accessed on the website of the Czech Ministry of Justice, at https://isir.justice.cz/isir/common/index.do (where all data is listed for all insolvency procedures initiated on or after 1 January 2008). In addition, a number of commercial solutions is now available in the market which allows prudent players to monitor the insolvency register on an on-going basis with respect to their contractual partners or their debtors (whereas these solutions will usually operate with "customized" data from the insolvency register)

Why it is so important to determine the current stage of the insolvency procedure

The insolvency register not only reveals the fact that an insolvency procedure has been opened but also tells us the stage to which the insolvency procedure has progressed.

In the case of business entities, one may principally differentiate between the following procedural stages, each of which has its own effects: initiation of the insolvency procedure; moratorium; declaration of insolvency; declaration of bankruptcy; approval of reorganization. The concrete effects of the opening of an insolvency procedure and of its subsequent stages may be altered by preliminary injunctions and orders by a court (such as the appointment of an interim insolvency trustee). All such court decisions are also listed in the insolvency register... (in the next installment of this series, we shall have a closer look at the effects of the insolvency procedure and its various stages).

Source:
Act No. 182/2006 Coll, on insolvency and the methods for resolving it (Insolvency Act), as amended.