Ineffectiveness of security granted by insolvent debtor

Interpretation of sec. 241 (5) (a) of the Insolvency Act – ineffectiveness of acts where a debtor grants (additional) security of its debts

A decision of Czech Supreme Court file no. 29 ICdo 13/2012 was published recently which significantly refines the interpretation of so-called preferential acts of debtor which the debtor – being in a state of insolvency – makes in a certain period of time before the initiation of insolvency proceedings. This particular decision relates to provision of Sec. 241 (5) (a) of the Insolvency Act under which a security granted by a debtor in exchange for a duly received consideration shall not be considered a preferential act (i.e. an act where one creditor receives an undue advantageous position in comparison to other creditors whereas such act is therefore towards creditors ineffective under the insolvency law). A practical problem occurs when assessing whether a due consideration was indeed provided which is exactly the issue addressed by the Supreme court in the respective decision.

In this particular case a debtor accepted goods from his creditor but did not pay the purchase price. The debtor acknowledged its debt from unpaid purchase prices by signing a notarial deed in which he undertook to pay the debt in monthly instalments whilst also agreed to a direct enforceability clause in case of non-payment. The debtor also granted a pledge of its real estate to secure the aforementioned receivables of the creditor. At the time of the creation of pledge the debtor had multiple payables towards several creditors which were past due more than 30 days. The debtor was not able to settle these past due debts, therefore was insolvent under the definition of the law.

The Supreme court stated that:

1) As a result of the said act of debtor (creation of pledge) the creditor obtained (to the detriment of other creditors) an increased satisfaction of its claims in comparison to what could be obtained in bankruptcy,

2) The act of debtor was made whilst meeting the conditions for insolvency,

3) The debtor provided its assets as a security of an existing debt whereas such security did not arise as a result of changes of internal contents of a pledged aggregate of assets.

In general the debtor would have to obtain a due consideration for the creation of the pledge otherwise such act would be considered preferential under the law. The Supreme Court in this case stated that "neither prolongation of instalments of the debt nor a potential waiver of penalties connected to a non-performance of contractual obligations by the debtor can be viewed as such due consideration.

Unfortunately, the Supreme Court has not elaborated on the issue why a prolongation of maturity (which usually in case of many debtors improves their cash-flow and sometimes even averts the insolvency status since free funds can be allocated to settle other outstanding payables) cannot be viewed as due consideration.

In light of this Supreme Court decision we deem appropriate to adjust internal procedures with regard to decisions whether it is prudent (in insolvency or pre-insolvency situation of debtors) to accept additional collateral and under what terms.