Introduction
Transactional avoidance rules
Fixation principle
Comment
The restructuring practice often calls for creative solutions, especially when the stakes are high and the debtor is in serious financial distress. Many restructuring lawyers have at times faced the question of whether it is possible for a debtor to transfer assets to a creditor subject to the condition precedent of the debtor being declared bankrupt.
At first sight, this seems to be an attractive option for a creditor that not only is seeking extra security, but also wants to be able to take control over the relevant assets (assuming that they are not subject to more senior security interests) if and when the debtor becomes insolvent. However, there is arguably a substantial risk that a transfer conditioned on the transferor's bankruptcy will be set aside by the transferor's bankruptcy trustee under the Dutch transactional avoidance provisions (the so-called actio pauliana).
Suppose that A-Retail has an inter-company claim against its subsidiary, B-Supplies. B-Supplies owns a large warehouse in the Netherlands in which all of its inventory is stored. If B-Supplies becomes insolvent, A-Retail would like to be able to continue B-Supplies' business and therefore to obtain full legal title to the warehouse and its contents. To this end, A-Retail enters into an agreement with B-Supplies under which these assets are sold and, subject to the condition precedent of B-Supplies being declared bankrupt, transferred to A-Retail. However, under transactional avoidance rules, there is arguably a substantial risk that such a transfer will be set aside by B-Supplies' bankruptcy trustee.
The Bankruptcy Act contains several provisions that allow the bankruptcy trustee to avoid those pre-bankruptcy transactions that are detrimental to the creditors of the bankrupt debtor, provided that certain conditions are met. Under these provisions, assets transferred by the debtor can in some cases be reclaimed by the bankruptcy trustee for the benefit of the bankruptcy estate. The avoidance provisions distinguish between:
- voluntary transactions (ie, transactions not based on an existing obligation); and
- obligatory transactions (ie, transactions based on a prior legal obligation).
An asset transfer conditioned on the transferor's bankruptcy, as described in the above hypothetical case, will usually be characterised as a voluntary transaction (for further details please see "Preference risks for buyers of assets from financially troubled companies"). This update therefore discusses only transactional avoidance rules applicable to such transactions.
If a bankruptcy trustee wants to avoid a pre-bankruptcy voluntary transaction entered into for consideration, such as the hypothetical conditional transfer referred to above, he or she must prove that:
- the transaction has caused prejudice to the creditors; and
- at the time of entering into the transaction, both the debtor and its counterparty knew or should have known that this prejudice would occur.
Prejudice to creditors
For a transaction to cause prejudice to the creditors, their position as a result of the transaction must be worse than it would have been had the transaction never occurred; for example, if an asset has been sold and transferred by the debtor for less than its fair market value, this reduces the value of the remaining assets from which creditors can recover their claims. Alternatively, without the value of the total available assets being reduced, a shift in possibilities for creditors to recover their claim can result in prejudice - for example, if a bank grants extra loans to the debtor, which the debtor then uses to pay some of its creditors, in exchange for extra security rights. The de facto result is that the debtor's other creditors are being confronted by a secured creditor, instead of an unsecured creditor. Finally, even if an asset has been sold at market value, prejudice can still result.(1)
This is illustrated in our hypothetical case. If A-Retail satisfies its obligation to pay the purchase price for the asset by offsetting that obligation against its outstanding inter-company claims on B-Supplies, the other creditors will be prejudiced even if the price is equal to the market value, since the amount offset will not be available to satisfy the other creditors. A-Retail in essence obtains full payment of its claim while all other creditors continue to rank pari passu.
A transaction such as a transfer of assets subject to the condition precedent of the debtor's bankruptcy will in most cases be regarded as prejudicial to the creditors; an asset is being taken away from the debtor's estate just before the debtor's bankruptcy and will no longer be available to the bankruptcy trustee to satisfy the unpaid creditors. The fact that the transferee of the asset may have paid a purchase price, even if the purchase price was at market value, does not have to mean that the creditors were not prejudiced.
Knowledge of prejudice
Assuming that the transaction has caused prejudice to the creditors, the next consideration is whether the debtor and its counterparty knew, or should have known, at the time of entering into the transaction that prejudice would occur.
If the debtor and its counterparty could have foreseen with a reasonable degree of probability that the debtor would be declared bankrupt and that there would be a deficit in the bankruptcy estate, the debtor is assumed to possess the relevant knowledge.(2) In general, the shorter the time period between the transaction and the bankruptcy, the easier it will be for the bankruptcy trustee to prove that the parties had the requisite knowledge. Moreover, in the case of transactions concluded less than a year before the transferor is declared bankrupt, knowledge of prejudice will be presumed to exist - a presumption that will be very difficult to rebut - in certain 'suspect' circumstances. These include where the transaction in question is between two companies within the same group or between a company and a member of its management board.
If the agreement described in our hypothetical case is entered into at a time when B-Supplies is in a worrisome financial position, it will be fairly easy for a bankruptcy trustee to prove that both A-Retail, as B-Supplies' parent company, and B-Supplies itself knew or should have known that B-Supplies would ultimately be declared bankrupt and that there would be a deficit in the bankruptcy estate. If the agreement is entered into less than one year before B-Supplies' bankruptcy, A-Retail's position will be even weaker in that it will be presumed to have the requisite knowledge.
If B-Supplies' assets are conditionally transferred at a time when the parties could in no way have foreseen B-Supplies' bankruptcy, strictly speaking, the transaction cannot be set aside on the basis of the transactional avoidance rules if the parties had no inkling that B-Supplies would later go bankrupt. However, a transfer conditioned on the debtor's bankruptcy can be set aside even if the parties could not have foreseen the bankruptcy at the time of the conditional transfer. The same applies to a substantial obligation that will come into existence upon the debtor being declared bankrupt (eg, a penalty clause which is linked to the debtor's bankruptcy).
A strong argument can be made that these are transactions in which the debtor and its counterparty deliberately postpone the effect of the transactions until a time at which it is certain that the (other) creditors are prejudiced, and the parties are therefore deemed to have 'constructive knowledge' of prejudice.
There is another reason to doubt the survival of a transfer conditioned on the transferor's bankruptcy: such a transfer conflicts with the fixation principle, one of the core principles of Dutch bankruptcy law. Under this principle, all legal relationships with respect to the bankruptcy estate are fixed at the time that the debtor is declared bankrupt. Any attempt to change or deviate from these fixed legal relationships is void. A transfer subject to the condition precedent of the transferor's bankruptcy puts one creditor in a more favourable position with respect to the other creditors than it would have had based on fixation; thus from a technical legal perspective, it causes the transaction to have an 'illegitimate cause' and renders it void.
In determining whether a transaction is void or can be avoided, each case must be reviewed on its own merits. However, it is safe to say that any transfer of assets subject to the condition precedent of the transferor's bankruptcy faces a high risk of being successfully challenged if the transferor goes bankrupt.
For further details on this topic please contact Willem Keukens at NautaDutilh by tel (+1 212 218 2990), fax (+1 212 218 2999) or email ([email protected]).
Endnotes
(1) Dutch Supreme Court, May 22 1992, NJ 1992, 526 (in re Montana).
(2) Dutch Supreme Court, December 22 2009, RvdW 2010, 35 (in re ABN AMRO).