The Czech Supreme Court recently issued two decisions having significant impact on the position of secured creditors (i.e. generally financial institutions) within insolvency proceedings. Both decisions stem from one of the first major insolvencies conducted under the (then new) Czech Insolvency Act effective from 2008 in respect of the group of companies in a glass-making business. This article briefly reviews those decisions and points out their practical effects on the rights of secured creditors.
Security interest in rental income
In the first decision1, the Supreme Court clarified an issue on which the two Czech High Courts held differing views. A bank, whose receivables were secured by a mortgage, claimed the right to the rental income collected from such property during the insolvency proceedings. The court ruled that the mortgagee had no such right, unless agreed otherwise with the debtor (mortgagor) before insolvency. The Supreme Court based its ruling on the (correct) principle that the content of the security interest within insolvency proceedings shall be determined based on the pre-insolvency arrangements (if there is no reason to diverge). Out of insolvency, secured creditors have no right to collect the fruits (profits) of the collateral (such as rent), if not agreed otherwise. As the court saw no reason for other arrangement in insolvency, rents earned from the mortgaged real estate during insolvency proceedings must belong to unsecured creditors.
The result may be theoretically avoided through a pledge of lease contract receivables or through an explicit provision allowing the bank to collect the rental income upon default in the mortgage agreement. However, both approaches may encroach upon principles announced in other Supreme Court decisions. The reasoning of the discussed ruling remains debatable and it cannot be ruled out it will be overruled in the future by the Constitutional Court.
Consumption of proceeds
The second case arose from the debtor collecting and then consuming (for its operations) its pledged accounts receivable after the commencement of the insolvency proceedings. Upon declaration of bankruptcy liquidation, the proceeds of these receivables were no longer at the debtor’s bank accounts. The insolvency trustee subsequently received proceeds from the sale of other assets and requested the court to grant a leave to distribute such proceeds to the secured creditor, i.e. making up for the missing proceeds of collateral. Lower courts agreed, but the Supreme Court2 reversed, holding that the secured creditor was entitled only to the proceeds, which could be directly traced to the respective collateral. If the proceeds of collateral (including receivables collected) were missing in the estate, the secured creditor was not entitled to a compensation from the general estate.
Mechanisms to avoid the risk of such loss (of collateral proceeds in further operation of debtor’s business) include a pledge over debtor´s enterprise (a kind of a floating charge) or the use of the mechanisms designed for post-petition credit financing, including establishment of new security interests. The former, however, may not always be practicable or acceptable for the debtor. The latter, on the other hand, while already tested, still lacks legal certainty.
The recent Supreme Court decisions will make the life of secured creditors a bit more difficult, but the practice should be able to provide appropriate solutions. This is, however, not always the case. For example, in summer 2014, the court decided that if a bank guarantee issued on behalf of the debtor is drawn after commencement of insolvency proceedings, no security granted by the debtor to secure such (contingent) liability is effective in insolvency3. That decision was clearly wrong and will need to be revisited.