Harmonisation of insolvency avoidance rights from the Czech perspective

The right to effectively avoid the illegitimate removal of assets from a company in financial difficulties is a key element of any insolvency law that protects the rights of creditors and maximises the recovery of value from the insolvent company.

Czech insolvency law, and in particular the insolvency avoidance rights, play a significant role as a recovery tool for creditors in insolvency proceedings, but in practice mainly act as a preventive warning signal for a debtor and its creditors when trading, even before financial problems arise.

The EU directive harmonising certain aspects of insolvency law (a proposal or Proposed Directive published by the European Commission on 7 December 2022) aims to set minimum harmonisation standards in all member states regarding avoidance actions. The Proposed Directive does not prevent member states from adopting and maintaining stricter avoidance rules that provide greater protection to general creditors.

The following article is an overview of current avoidance rights in the Czech Republic and outlines the expected impact the Proposed Directive will have on current practice.

Existing insolvency avoidance rights in the Czech Republic

Transactions through which a debtor curtails the possibility of satisfying its creditors, or favours certain creditors to the detriment of others, can be declared ineffective by the insolvency court. This ineffectiveness can be declared on the insolvency practitioner’s petition, which may be filed within one year following the declaration of the debtor’s insolvency. Czech insolvency law recognises the following main types of avoidable transactions:

1. Preferential treatment transactions

A debtor’s legal act leading to satisfaction for a creditor higher than this creditor would have received in bankruptcy liquidation, to the detriment of other creditors, can be declared ineffective if made while the debtor was insolvent or the transaction led to the debtor’s insolvency. The debtor’s insolvency is presumed if the preferred creditor was a person or entity closely related to the debtor or a member of the same group.

Preferential transactions include those where the debtor repaid its debt before maturity, amended or novated its obligations to its own disadvantage, waived its rights, or granted collateral to secure a pre-existing debt. Czech case-law also includes the repayment of the debtor’s due debt (i.e. congruent coverages) as potentially voidable if all other conditions for the avoidance actions are met. In this respect, Czech rules are even more protective to the general body of creditors than the Proposed Directive, under which avoidance can only be invoked if the preferred creditor knew, or should have known, that the debtor was insolvent at the time of the transaction.

The insolvency practitioner may challenge preferential treatment transactions made up to one year before the insolvency was opened, or three years if made in favour of a party closely related to the debtor, and if the transactions were perfected after the opening of the debtor’s insolvency.

The law protects a couple of specific transactions by excluding them from the definition of preferential transactions. These include transactions by the debtor in which the debtor receives fair consideration for its security established in favour of a creditor, and in which the creditor was not able to recognise the debtor’s insolvency and the transaction was otherwise made at arm’s length for fair consideration benefiting the debtor.

In addition, avoidance actions will not be challenged against payments to or collateralisation in favour of the providers of new or interim financing during a restructuring attempt during preventive restructuring proceedings. Those payments and collateralisations are generally protected under Czech law and will remain unaffected under the Proposed Directive.

2. Transactions at undervalue

An insolvency practitioner may also challenge a debtor’s transaction made without consideration, or for consideration substantially lower than the fair market price, if at the time of the transaction the debtor was insolvent or the transaction led to the debtor’s insolvency. The debtor’s insolvency is presumed if the creditor was a party closely related to the debtor or a member of the same group.

A transaction at undervalue is voidable if it was perfected within one year before the opening of the debtor’s insolvency, or within three years if made in favour of a party closely related to the debtor, or thereafter.

A voidable action will not be permitted for occasional gifts of a reasonable value, a debtor’s performance that is imposed by law, or a transaction which the debtor reasonably expected to receive a reasonable benefit from and the beneficiary (if not a party closely related to the debtor) was not able to recognise the insolvency situation of the debtor.

3. Intentionally detrimental transactions

Any legal act taken by the debtor with the actual intent to curtail the creditors’ rights (provided that the beneficiary knew or must have known about such intent) is voidable and can be challenged by the insolvency practitioner if perfected within five years before the opening of the debtor’s insolvency. It is not required to prove that the debtor was insolvent at the time of the transaction. Knowledge of the beneficiary about the debtor’s intent is presumed in the case of parties closely related to the debtor, or members of the same group.

4. Transactions breaching disposal limitations

Opening insolvency proceedings against a debtor triggers restrictions on the disposal of the debtor’s assets. The debtor needs to avoid performing any legal acts leading to a substantial change in the structure, use or determination of the debtor’s assets, or to any reduction of assets that is not insignificant. Unless otherwise decided by the insolvency court, the debtor may continue operating in the ordinary course of business, act as necessary to avert imminent damage, and fulfil its statutory obligations. Similar obligations apply to debtors seeking preventive restructuring of their business once the general moratorium is approved.

If the debtor fails to respect the above restrictions, the insolvency practitioner may challenge the disposals and require the insolvency court to declare them ineffective. There is no time limit for the insolvency practitioner to challenge the avoidance action. The practitioner, however, must act without undue delay so that the negative effects of the wrongful disposal are minimised.

For completeness, the debtor’s legal acts affecting the insolvency estate carried out after the insolvency court declares bankruptcy liquidation are considered ineffective by operation of law since, for bankruptcy liquidation, all disposal rights are by law transferred to the insolvency practitioner.

Consequences of avoidance actions

The debtor’s performance of a voidable legal act becomes part of the insolvency estate on the judgment upholding the insolvency practitioner’s petition. Although no other party may file a petition to challenge the debtor’s voidable act, the insolvency practitioner must file the petition if requested by the creditors’ committee.

A party that benefits from a voided transaction must surrender the debtor’s performance to the debtor’s estate. If new security over a debtor’s asset was avoided, the security instrument is considered void. The same obligation applies to the heirs and legal successors of the beneficiaries if they were parties closely related to the debtor or must have been aware of the voidability circumstances. No set-off is permitted.

What changes are expected under the Proposed Directive?

Surprisingly, the principles and solutions suggested by the Proposed Directive appear to be similar to those currently applicable in the Czech Republic. In any case, the following main changes are expected to be incorporated into Czech insolvency law in order to comply with the minimal harmonisation requirements relating to avoidance actions under the Proposed Directive:

Preferential treatment transactions: Current Czech rules appear to comply with the minimum conditions set out by the Proposed Directive. The Czech Republic, however, may incorporate an exemption to the preferential treatment transactions as set out in Article 6 (3)(b) of the Proposed Directive relating to payments on bills of exchange and cheques where the law that governs bills of exchange and cheques bars the recipient’s claims arising from the bill or cheque against other bill or cheque debtors such as endorsers, the drawer, or drawee if the debtor refuses the debtor’s payment.

Consequences of avoidance actions: As the Proposed Directive requires that the limitation period for all voidable claims is three years from the date of the opening of insolvency proceedings, the current one-year limitation period under Czech insolvency law will need to be extended.

In addition, Czech law will need to incorporate the requirement under the Proposed Directive to enable the assignment of a receivable to obtain full compensation from the voidable transaction to a creditor or a third party. This change may increase the number of the avoidance actions by professional third-party investors, bring additional value to the insolvency estate, and accelerate insolvency proceedings in some cases.

Liability of third parties: Heirs and universal successors of the party that benefited from a voidable act are required to compensate the insolvency estate in full for the detriment caused to creditors by that legal act under the same conditions as the direct beneficiary. No previous knowledge or close relationship to the beneficiary is required under the Proposed Directive, as it is currently required under Czech law. The position of individual successors will remain protected unless they acquired the asset against no or manifestly inadequate consideration or the successor knew or should have known the circumstances of the avoidance transaction.

Avoidance actions in simplified winding-up proceedings: Under the Proposed Directive, if simplified winding-up proceedings apply, avoidance actions should only be brought by a creditor or, where appointed, by the insolvency practitioner. Although in this situation Czech insolvency rules do not contain any specific avoidance action principles, the standards suggested by the Proposed Directive for simplified winding-up proceedings may not be implemented since Czech rules also require mandatory pursuit and enforcement of avoidance actions in simplified winding-up proceedings, and therefore provide the general body of creditors with enhanced protection.

Tracing assets that belong to the insolvency estate: The effectiveness of avoidance actions rules and asset recovery for creditors may be significantly disrupted if the insolvency practitioner does not possess broad and effective tools for tracing the debtor’s assets that belong to the insolvency estate. Such tools should enable the insolvency practitioner in any member state to trace all the debtor’s current assets, and assets that the debtor owned before the opening of its insolvency. For this purpose, the Proposed Directive obliges member states to provide non-domestic insolvency practitioners with access to registers that are not publicly available, particularly through the central bank account registry (via a court), beneficial owners’ registry and national asset registers.

For more information on current Czech avoidance actions, possible changes to these actions, and opportunities under the Proposed Directive, contact your CMS client partner or local CMS experts.