Contributed By CHSH Kališ & Partners s.r.o.
Resurgent Economic Climate Drives Fall in Insolvencies
According to the latest statistics derived from the Czech insolvency register, the number of insolvency applications in the Czech Republic has been continuously decreasing since its peak in 2013 as a result of the financial crisis and its subsequent impact on the economy. The reduction from the total amount of 36,909 insolvency applications filed in 2013 to 23,146 applications in 2017 represents a 37% decrease.
The vast majority of the above-mentioned insolvency applications relate to the insolvencies of natural persons, especially consumers, as out of the 23,146 insolvency applications filed in 2017, 21,343 cases were related to natural persons and only 1,803 represented corporate insolvencies. Therefore, focusing solely on corporate insolvencies, the decrease would be even more obvious when comparing the number of 6,021 cases in 2013 with the 1,803 corporate insolvencies in 2017. The provisional figures for 2018 show that the downward trend in the amount of corporate insolvencies shall remain.
Such a huge decrease in corporate insolvencies arises especially from the positive macroeconomic environment in the Czech Republic. GDP is steadily growing, the inflation rate is within inflation expectations and the unemployment rate is one of the lowest in all of Europe.
Despite the favourable macroeconomic situation, there is a significant group of people living in the so-called debt trap in the Czech Republic. Recently, this socio-economic issue has been addressed by many NGOs and political parties, resulting in numerous proposals to amend the Insolvency Act. The main intention of a government bill that passed the lower house in October 2018 but has yet to be approved by the Senate and signed by the President in order to become effective is to enable private debtors to enter the debt relief process irrespective of how much they will be able to pay off during the process. Currently a debtor has to be able to pay at least 30% of all their debts within five years as a condition for entering debt relief. The suggested amendment would abolish such a condition and a rise in the amount of consumers entering insolvency who were previously unable to do so due to the restrictive condition can be expected should it become effective.
With regard to corporate insolvencies, in recent years the economic situation in the Czech Republic has been positive so they were usually caused by difficulties in certain market segments rather than the overall situation on the market. For example, numerous energy supply and trading companies undergo difficulties due to the unstable prices on the electricity market. Similarly, the low price of hard coal was one of the reasons leading to the insolvency of OKD, the only producer of hard coal in the Czech Republic. However, the most common factors leading to big corporate insolvency cases now are most likely issues connected with large investment projects that later affect the economy of a whole company or its entire group. This relates especially to construction and production companies.
Several Steps Available on the Path to Reaching a Resolution
Creditors can usually choose between two methods of resolving a debtor’s insolvency: a bankruptcy order or reorganisation. In a pre-insolvency situation there is, of course, room for distressed M&A transactions and other creative out-of-court solutions. However, a distressed M&A transaction can be very well implemented during ongoing insolvency proceedings because, for example, a debt to equity swap, debtor’s merger or transfer of debtor’s assets are directly anticipated by the Czech Insolvency Act as possible manners of reorganisation.
In connection with the pre-insolvency situation, the Czech Insolvency Act also recognises the formal instrument of moratorium, which can provide the debtor with necessary protection from his creditors for up to four months. However, a moratorium can also be relatively expensive because the debtor is not entitled to realise any haircut on receivables that may arise during the moratorium period in the later stages of the insolvency proceedings and all such receivables have to be fully paid to reach successful reorganisation. Therefore, when the insolvency is unavoidable, it does not make much sense to use the instrument of moratorium, which is more suitable in situations where it is possible to reach an immediate turnaround in a debtor’s business operation; for example, by renegotiating important business contracts or executing divestments. Another example of suitable moratorium usage might be using the legal protection provided by a moratorium to keep the operation of the debtor and meanwhile negotiate a distressed M&A transaction, which can be later implemented irrespective of whether in formal insolvency or not. Such a strategy was used in the case of the company ESSA Czech, a leading supplier for the automotive industry, in which the transaction negotiated and executed under the protection of moratorium was subsequently successfully finalised and realised within formal reorganisation under the Czech Insolvency Act.
With regard to the financing of distressed M&A deals, financing via an investor’s private funds still prevails. Nevertheless, some of the banks and other financial institutions are already available to provide financing for acquisition and the handling of distressed assets or the refinancing of distressed debt. Bank financing provided not to the investor but directly to the debtor is still rather a curiosity, but some products such as factoring are feasible for banks even during the ongoing insolvency proceedings.
Amendment Loosens Restrictions on Reorganisation
In terms of numbers, it is evident that the bankruptcy order still largely prevails as a manner of resolving corporate insolvency over reorganisation, which is a primary instrument anticipated by the Czech Insolvency Act for debtor’s recovery. As of the introduction of reorganisation in 2008 with the effectiveness of the new Insolvency Act, on average around 20 reorganisations are being approved by pertinent insolvency courts each year. In accordance with the trend visible across all of Europe, the Czech legislators are also trying to support the sanitation of insolvency companies through the reorganisation procedure. In this regard, an amendment of the Insolvency Act relieving conditions for entering reorganisation became effective in January 2014. Companies applying for reorganisation before 2014 had to meet both the following conditions: at least a CZK100 million turnover and at least 100 employees. With the amendment, the benchmarks were decreased to a CZK50 million turnover and 50 employees. In 2014 the number of allowed reorganisations reached its peak at 31 cases.
However, there is also a possibility to undergo reorganisation – called a pre-pack or pre-agreed reorganisation – even for the smaller companies not meeting the previously mentioned conditions. Should the company submit to the insolvency court a reorganisation plan approved by the majority of secured and unsecured creditors calculated according to the amount of their receivables, the insolvency court shall approve the reorganisation of such a company irrespective of not meeting the turnover and/or employment conditions. The pre-packed reorganisation is nevertheless used also in the case of bigger companies that meet the criteria for regular reorganisation, as the pre-packed reorganisation enables creditors to agree on the appointment of a particular insolvency trustee and typically takes less time than the regular reorganisation. For instance, both of the biggest reorganisations on the Czech market in 2018, Vítkovice Heavy Machinery (a steel producer and engineering company with around 1,000 employees) and Veba (a traditional producer of jacquard woven cotton fabrics with around 800 employees), were approved by insolvency courts on the basis of pre-packed reorganisation plans with the consent of the majority of secured and unsecured creditors.
Creditors Lose Voting Rights After Change in Legislation
With respect to what was previously said, it might also be interesting to take a look back at the last major amendment to the Insolvency Act, which became effective in July 2017, substantially changing voting right rules among others. The voting right is, of course, one of the strongest rights associated with the enforcement of claims within the insolvency procedure. Originally, since 2008, the Insolvency Act was based on an assumption that no one should be able to vote on his or her own matter or on a matter of a person associated or constituting concern with him or her. As of 2014 a completely different approach took over, because creditors forming concern and other group creditors were no longer restricted in their voting rights. This led to numerous reorganisations approved mainly by creditors from a debtor’s group or directly by its shareholders, as these creditors are naturally the most interested in the rescue of the debtor. This is arguably one of the reasons why the number of allowed reorganisations reached its peak in 2014. However, such a situation did not remain intact for long due to the amendment in July 2017, with the ruling that group creditors are again not entitled to vote, unless the voting right is granted to them under special circumstances by the insolvency court on their request.
The amendment has been effective for more than one year so it can be concluded that insolvency courts rarely grant voting rights and in an overwhelming majority the request is rejected, and therefore group creditors, including shareholders, are restricted from voting. Insolvency courts usually refuse to acknowledge voting rights irrespective of whether the claim was challenged by other participants of the insolvency or not. Such an approach puts even higher demands on persons negotiating support for reorganisation as they cannot count on eventual votes from shareholders and other creditors who are usually the ones supporting reorganisation.
In this context, it should also be pointed out that creditors are entitled to assign their receivables throughout the duration of the entire insolvency proceedings, which means that group creditors might assign their claims on a third party not affiliated with a debtor and by such assignment voting rights are established regardless of the origin of the receivable. It is important to note that this also works the other way around, meaning that when a receivable that is originally not limited by the above-mentioned voting limitations is assigned to a creditor who forms a concern with the debtor or is affiliated with the debtor, it becomes a subject of these voting limitations. Simply put, according to the current approach, the position of a creditor is more important than the quality of a claim itself.
It is obvious that this might lead to the deliberate transfer of receivables to obtain voting rights. This shall be restricted by a newly introduced obligation to declare an ultimate beneficial owner of the creditor in a case in which a claim in the amount of at least EUR10,000 is acquired during the insolvency or six months prior to its initiation. Until the beneficial owner is declared, the voting right associated with the claim shall remain restricted.
Expert Valuation Reports are the Pressing Issue
Finally, if any forecast for the future should be made, it can be expected that the topic of expert valuation reports will have to be addressed soon by legislators, which is mainly because the current statutory regulation in the Czech Insolvency Act seems to be insufficient. It only states that during the reorganisation an expert report evaluating, among others, security of particular secured creditors with a presumption of stopped business operation shall be executed and later approved by the creditors. The insolvency praxis came to a conclusion that the report shall set the liquidation value of the debtor’s assets as of the day before declaring the debtor’s insolvency. However, there are not any generally binding rules on how to set such liquidation value and the methodology of valuation is left solely to the valuator. This leads to the current situation where there are big differences between particular expert reports and the methodology used in the reports. So far, this issue has not been satisfactorily resolved by the case law or interpretation. The topic of expert reports is especially important for the banks because they usually represent the biggest secured creditors in reorganisation and the level of their recovery is evolved from the value of their security over the debtor’s assets.