Locus stand to enforce pledged receivables during the insolvency proceedings in the light of Supreme Court decision making practice

Locus stand to enforce pledged receivables during the insolvency proceedings in the light of Supreme Court decision making practice

In the banking sector, a pledge of client’s receivables towards his business partners is an instrument commonly used by banks to secure their credit exposures. The secured creditor (i.e. the bank) has a right to demand that the debtor of the pledged receivable (i.e. the customer or so-called sub-debtor) pays him the debt as it becomes due and, correspondingly, the sub-debtor is obliged to pay the debt only to the secured creditor.

As explained above in line with the obligation of the sub-debtor comes the right of the secured creditor to demand the performance directly from the sub-debtor which includes also the right to file a direct court action. However, the question is, what happens when insolvency proceedings against the client is initiated and continuing?

Opinion of the Supreme Court

The Supreme Court of the Czech Republic stated in its decision file no. 29 Cdo 3963/2011 of January 26, 2012 that: “After the effects under Section 109 (1) of the Act no. 182/2006 Coll. associated with the initiation of insolvency proceedings towards the debtor, who created a pledge over its receivable in favor of the secured creditor, occur, the secured creditor is no longer entitled to pursue a direct legal action for payment of the receivable towards the respective sub-debtor, regardless of the fact that the secured receivable was not duly and timely settled and the pledge over receivable is considered effective towards the sub-debtor… As of the moment when the effects of the initiation of the insolvency proceedings take place, the right to demand the payment of the pledged receivable passes back to the debtor and consequently, if a bankruptcy of the debtor is declared, it passes to the insolvency trustee of the debtor (Section 246 of the Act no. 182/2006 Coll.).”
We deem that the opinion of the Supreme Court is highly arguable, especially given the purpose of the insolvency proceedings, and it is possible to raise a question whether the applicable law provides more appropriate alternative.

Relevant legal regulation

Under Section 109 of Act no. 182/2006 Coll. the “Insolvency Act”, as amended (hereinafter as “IA”), the following effects are associated (inter alia) with the initiation of the insolvency proceedings:
a) receivables and other rights relating to the insolvency estate cannot be pursued by a court action if they can be exercised via the insolvency application,
b) a right to satisfaction from security that relates to the property owned by the debtor or the property belonging to the insolvency estate can be exercised and newly acquired only under the conditions stipulated in the IA.

Although the interpretation of the Supreme Court properly reflects the provisions of the IA and therefore can be considered in line with the IA, it is at the same time rather problematic and it we deem it is appropriate to contemplate whether the interpretation could be less rigid or whether an amendment of the law is necessary.

After the initiation of the insolvency proceedings

The Supreme Court presented an opinion that as of the moment of the initiation of the insolvency proceedings the right to file a so-called sub-debtor action passes from the secured creditor back to the insolvency debtor, i.e. the creditor of the pledged receivables. This quile illogically means the insolvency debtor as a result of the initiation of the insolvency proceedings against himself acquires more rights than he had before the initiation which is hardly the intention of the insolvency proceedings. This impact itself makes the Supreme Court’s opinion highly questionable.

It should be noted that the above-mentioned effects take place as of the very moment of the initiation of the insolvency proceedings when there is no assurance whatsoever that the debtor is indeed in a state of insolvency. It also cannot be excluded that the filing of the insolvency petition may seek to achieve results which are not compatible with the purpose and intention of the insolvency proceedings as would be the case of a debtor purposefully petitioning for his insolvency and subsequently withdrawing such petition.

Additionally, it should be taken into account that at this stage of the proceedings the debtor is not restricted or supervised by anybody with respect to the disposals of his assets (unless a preliminary injunction is granted and a preliminary insolvency trustee is appointed).
If we were to respect the opinion of the Supreme Court, the creditor (to whom the receivables of the insolvency debtor are pledged) could easily loose his security after the initiation of the insolvency proceedings since these receivables can be recovered and collected solely by the insolvency debtor who generally shall not have much motivation to remit the collected funds to the secured creditor to whom these funds belong. On the contrary, it can be expected the debtor will spend the funds rather quickly. Even if the debtor does not resort to such bad faith behavior, it is quite unlikely that debtor will take active measures towards recovery of receivables if the collected funds ultimately belong to someone else (the secured creditor).

The insolvency petition in these circumstances behaves as an instrument which can be used by the debtor to improve (although temporarily) its economic situation to the detriment of the secured creditor. Such interpretation of the insolvency law (even if founded on the literal wording of a legal provision) is not acceptable.

Last, but not the least, it must be also noted the interpretation of the Supreme Court puts the sub-debtors in a very difficult position as well. Even if the sub-debtor has a clear instruction from the creditor of the pledged receivables (the insolvency debtor) or the secured creditor that the pledged receivables are to be paid to the secured creditor, the sub-debtor is forced (in the light of the Supreme Court decision) to disrespect such instruction. At the same time the sub-debtor shall not be entitled to pay to the insolvency debtor since such performance shall not (under the substantive law) release him from the obligation to pay to the secured creditor. On top of that the sub-debtor will have to inspect the insolvency register on a daily basis to ascertain whether it is still “entitled” to pay to the secured creditor or not. Such results of the Supreme Court’s interpretation of the law cause quite a disruption to the legal certainty principles for the participants of civil law relations.

Possible solution

When seeking an appropriate solution we must take into account not only the literal wording of the IA but also the principles and aims of the insolvency proceedings as well as the position of a secured creditor.

The IA grants to secured creditors a privileged position with respect to the secured assets. This should be in our opinion reflected towards the pledged receivables. It is the secured creditor who should be primarily satisfied from the proceeds of the pledged receivables. Only in case the proceeds exceed the amount of secured creditor’s receivables such balance can be used to satisfy the receivables of other creditors.

This being said we deem it is entirely in line with the principles of the insolvency law if the right to recover the pledged receivables stays with the secured creditor until the time the rights of disposal of the assets pass (in compliance with IA) to the insolvency trustee. Only the secured creditor who is motivated to satisfy its receivables is able to secure (at this stage of the insolvency proceeding) the most effective recovery of the pledged receivables. Similarly it is in complete accord with the principles of the IA if the secured creditor keeps the funds collected from the secured receivables in order to settle its outstanding receivable. 
If, in the meantime, the insolvency proceedings is terminated, it is all the more reason to consider such interpretation in compliance with the law.

The same applies if the debtor is declared insolvent in the meantime. As of the declaration of bankruptcy the rights of disposal of the insolvency estate pass to the insolvency trustee. In this situation we consider appropriate and in line with Section 249 of the IA if the pledged receivables are recovered by the insolvency trustee who shall dispose of the proceeds in accordance with Section 298 of the IA. In case the sub-debtor shall pay to the secured creditor based on a demand or a court action and the respective funds shall be received by the secured creditor only after the declaration of bankruptcy, we deem that in such case it is legitimate (although the insolvency trustee had not contributed to the recovery efforts in any way) to act in accordance with Section 298 of the IA.

Conclusion

We consider the Supreme Court’s interpretation regarding the recovery of pledged receivables after the initiation of insolvency proceedings towards the creditor of these receivables as unfortunate and non-compliant with the purposes which the insolvency law should serve to, i.e. to secure a fair satisfaction of all creditors. We trust this issue shall be approached by our colleagues who provide their opinions.

This article was published on EPRAVO.CZ Digital no. 2/2015.