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Analysis of existing securities under loan agreements if the Borrower is declared bankrupt

Aughtor Valeri Koev

March 22, 2012

This case study describes a case taken as example only!

RE: Analysis of existing securities under loan agreements in case the Borrower is declared bankrupt. Alternative options for protection of the interests of the Bank in eventual default of the Borrower. Suggestions and advice in relation to the proposed options.

We have prepared this review of agreements and documents which guarantee a Bank’s rights in terms of securities if bankruptcy proceedings are initiated by a borrower or another creditor of a borrower. We have analyzed a number of cases in our practice to try to summarize the position of shareholders as subordinated lenders as well and the position of third party creditors – other than banks which had delivered goods or services to a special purpose company – borrower – a Project Company, incorporated to construct and run a project asset.
There have been several loan agreements between the Bank and the Borrower at the total amount outstanding of 45 million Euro investment loan and 2 million Euro revolving loan:

  1. an Investment Loan Agreement between the Bank and the Borrower as amended four times to allow additional disbursements of cash to cover amendments to design the Project;
  2.  a Revolving Loan Agreement between the Bank and the Borrower as amended three times – to finance the value added tax during the construction phase of the Project;
  3. three Mortgage of Real Estate agreements – for the creation of additional security to guarantee repayment of the increased amount of investment loan (additional disbursements) and the revolving loan;
  4. Pledge of shares – three Pledge of Shares Agreements to secure the banking loans in the same manner as the mortgages;
  5. Particular pledge of money available in bank accounts – three agreements to cover larger obligations of the Borrower and the Shareholders to guarantee the receivables of the Bank.
  6. Particular pledge of future revenues derived from the business activity when the construction phase of the Project is over and the operating phase starts.
    There have been several shareholder loan agreements by which the shareholders have financed the Project at the total amount outstanding of 34 million Euros:
  7. Three short-term loan agreements dating before the banking loan in 2007. One of the three loans has been fully repaid before the banking loan was created, the other two are subordinated in terms of payment to the banking loans;
  8. Several more shareholder loans granted at the same time when a new disbursement of a portion from the banking loan was disbursed – to match the required rate of shareholder funding of the project in 2008 and 2009;
  9. The shareholder loans are not secured, repayment is subject to full and unconditional repayment of the banking loan. Notwithstanding the previous sentence, pursuant to clause 6 of the shareholder loan agreements, obligations for repayment may become due and payable if: (i) the Project real estate of the Borrower is transferred to a third party, (ii) the bank accounts of the Borrower are blocked due to enforcement proceedings by an enforcement judge, or (iii) the Borrower is in the course of bankruptcy proceedings.

There are lease agreements for renting out commercial space in the real estate which is object of the investment. The Banking Loan and the lease agreements contain an obligation of the Borrower to finish the construction phase of the Project and to Open the Object of the investment before or on the 1st of April, 2010. This date has been deferred several times to prolong the term by one year so far due to delay in the construction works. It is unlikely that any further extension of the term is possible, especially bearing in mind the fact that there is a new agreement with a tenant under which severe penalties are payable by the Project Company in case of delay of the obligation to Open the Object of investment in due time.
After detailed review and analysis of the agreements and data of fact or documents, we deliver to your attention the following opinion:
The Bank in general has three alternative options to protect its interests in case of default of the Borrower under the financing agreements with the Bank:

  1. Foreclosure on the mortgaged real estate, pledged shares and takings of money in pledged bank accounts under security agreements.
  2. Requesting the bankruptcy of the Borrower. In such case, two alternative outcomes are possible – restructuring of the Borrower with a Rehabilitation Plan or repayment of debt to creditors upon winding up of the company’s activity and sale of assets by the trustee appointed by court.
  3. Implementation of measures to enhance the financial stability of the Borrower and overcome the state of overindebtedness or insolvency for the completion of the Project construction phase and move on to the next phase – management of the property, hopefully accumulating enough revenues to cover the operating costs and obligations for repayment of principal and interest to the bank, eventually to shareholders.

І. Foreclosure on the mortgaged real estate, pledged shares and money in bank accounts

1.1 At any time upon actions to foreclose on securities the Bank, the Borrower, another creditor or the state agency on collection of public debt has the right to file a petition to institute bankruptcy proceedings. If the court institutes the bankruptcy proceedings, all monetary and non-monetary (non-pecuniary) obligations of the debtor become due and payable according to Art. 617 of the Commerce Act (CA).
Creditors keep the security over assets in the bankruptcy proceedings. On the other hand: (1) The institution of bankruptcy proceedings shall stay all enforcement proceedings against the property in the bankruptcy estate. (2) Where a step has been taken in favour of a secured creditor for foreclosure on the security, the court may allow the proceedings to continue, should there exist a danger of injuring the creditor’s interests. (3) The stayed proceedings shall be terminated if the claim is presented and allowed. Any garnishments and preventive attachments imposed in the enforcement proceedings shall be inopposable to the bankruptcy creditors. It shall be inadmissible to impose precautionary measures according to the procedure established by the Code of Civil Procedure or by the Tax and Social-Insurance Procedure Code in respect of the debtor’s property after institution of bankruptcy proceedings.

1.2 Share Pledge. Under the Pledge of Shares Agreement the Bank has the right to sell the shares in a quick and effective manner. In addition to contractual arrangements, there is protection under Art. 43 of the Specific (particular) Pledges Act (SPA) – (1) the institution of bankruptcy proceedings does not stay the foreclosure under the SPA although, technically, in this case the pledgor is the shareholder and not the debtor-borrower and bankruptcy will not be in respect of a shareholder and, (2) in case marshalling of proceedings under the SPA prevails, the trustee shall hand over any asset of the debtor in bankruptcy which is a security to be subject to foreclosure.
Risk: if shares are sold by the Bank, the shareholders may claim that their takings under the shareholder loan agreements fall in class 8 (all unsecured obligations) instead of class 9 (shareholder loans) of Art. 722 of the Commerce Act and therefore have the same rights to receive payment as the Bank. This risk is subject to more detailed review below.

1.3. Specific (particular) Pledges. The Borrower has pledged in favour of the Bank its future takings and revenues derived from the activity – rent from tenants as well as pledged money available in bank accounts.
(Under the revised shareholder loan agreements there is a clause that in case the money in bank accounts becomes subject to foreclosure by an execution judge (not applicable in the case of foreclosure under the Specific Pledges Act as the Bank has the right to foreclose directly without any starting proceedings under the general Civil Procedures Code) exceeds 400,000 Euro, then the subordinated shareholder loans become due and payable immediately and are no more subordinated to repayment of the bank loans.)

2. Risk analysis of the likelihood that mortgages and pledges be proclaimed nil and void in respect to other bankruptcy creditors upon institution of bankruptcy.
The main risk in the described circumstances is that any third party creditor, the Borrower itself, or its shareholders may file a claim to institute bankruptcy proceedings. Generally, all securities shall be in force irrelevant of the bankruptcy. Other creditors may plea that the initial date of insolvency or over-indebtedness dates before all or some of the securities granted to the Bank. If the court rules so the securities cannot be opposed to third party bankruptcy creditors as nil and void under art. 646 of the Commerce Act.

2.1 Securities granted in 2007. Bankruptcy proceedings shall be instituted for merchants who are insolvent. In addition to cases of insolvency, bankruptcy proceedings shall be instituted also in the case of over-indebtedness of a limited liability company, a joint-stock company, or a partnership limited by shares. A joint – stock company is over-indebted if its assets are not enough to cover its monetary obligations. In order to form an opinion whether there was over-indebtedness at the time of creation of securities, the court takes into account all assets and obligations and finally the company’s own capital. If the capital of the company is a negative figure, then over-indebtedness is declared.
As far as the accounting information was disclosed, by 18th July, 2007 – the date of the first mortgage agreement securing partially an investment loan of 27,600,000 Euro and a revolving loan of 2,000,000 Euro as well as pledges to secure the same obligations, the Borrower’s own capital was 46,000 BGN, it was a positive figure. On the other hand, there was no monetary obligation of the Borrower remaining unpaid at that time. Therefore, it is unlikely that the court shall rule these securities nil and void.

2.2 Validity of the securities granted in 2008. In 2008 two new mortgage agreements were executed (the last one on 24.11.08.) and several annexes to the share pledge agreements, the pledge of money in bank accounts and additional pledge of receivables from tenants agreements to guarantee additional disbursements of the investment loan up to the total amount of 47,900,000 Euro. At that time the company’s own capital of the Borrower was a negative figure due to payments of interest accrued to the bank as well as payment of operating costs and payments to the construction company without generating any income, revenue nor receipt of equity contributions in the form either of capital contributions or contributions to the reserves fund from its shareholders. Therefore the courts may hold that at that time the Borrower was already over-indebted. The initial date of over-indebtedness shall date before all securities granted in 2008.

2.3 Yet another risk to the Bank is the statutory requirement that all payments of money made after the initial date of over-indebtedness shall be nil and void and have to be delivered back to the bankruptcy estate. Therefore all payments of interest and principal made so far to the Bank under the repayment plan should be paid back to the bankruptcy estate in case of insolvency.

2.4 As a result at distribution of proceeds from sale of the assets falling in the bankruptcy estate under Art. 722 of the Commerce Act, all claims for receivables which are not secured shall receive payment in the class under item 8. On the contrary, all secured claims fall in class 1.
Any claim falling in item 8 shall receive payment upon full repayment of claims falling in the preceding classes 1-7, the more important of which are: 1. claims secured by a pledge or mortgage, or garnishment or preventive attachment, recorded according to the procedure established by the Specific Registered Pledges Act – from the proceeds from foreclosure on the security; 4. ensuing from employment relationships, which have arisen before the date of the judgment on institution of bankruptcy proceedings; 6. public law receivables of the State and the municipalities; 7. claims which have arisen after the date of the judgment on institution of bankruptcy proceedings and have not been paid when due, ensuing from continuing operations of the debtor; 8. any remaining unsecured claims that have arisen prior to the date of the judgment on institution of bankruptcy proceedings;
In the next classes 9, 10, 11 fall and therefore their receivables shall be payable only upon full repayment of all other claims in preceding classes: 9. Takings of interest accrued after initiation of bankruptcy proceedings; 10. loans granted to the debtors by shareholders, takings which arose for free, costs of creditors incurred in bankruptcy proceedings.
ІІ. Proposed actions to overcome the state of over-indebtedness
The state of being over-indebted or insolvent may be permanent or temporary. If a debtor has financial difficulties only from time to time but the general prospect is of good balance sheet indicators, the court is obliged to rule against initiation of bankruptcy proceedings. In order to improve the financial health of a Borrower, financing may be disbursed as long as certain additional obligations of shareholders are undertaken. In practice such measures or transactions substitute a restructuring – rehabilitation plan in the bankruptcy process. We believe that any bank seeks to conclude the following agreements or contractual obligations of shareholders and the Borrower:
Ø  a Sponsor Support Agreement shall be effected under which the shareholders shall undertake directly to the Bank the following obligations and liabilities:
to make additional funding to the Project Company in order to increase the Borrower’s own capital (equity) which they shall undertake to always keep a positive value (a value higher than zero); to undertake an additional obligation to the Bank directly to provide additional short term financing to cover deficiencies in terms of making payments in timely manner. There are only three sources of financing of the Borrower’s own capital – its own revenues (until the time when the Object of the investment starts operating that is impossible), shareholders’ funding of the equity (not loans) or reserve fund;
Undertaking of the shareholders directly to the Bank that shareholder loans shall be subsidiary and subordinated in repayment to all payments due to the bank. At this moment such obligation exists only between the Borrower and the Shareholder-lenders and therefore may at any time be amended without approval of the Bank;
The shareholders shall undertake to the Bank that no circumstances or conditions shall make the shareholder loans immediately due before the repayment of all sums due to the Bank;
The shareholders shall make a disclaimer in writing that there has been no circumstance which has made any of the shareholder loans repayable at the time of the banking loan;
The shareholders shall undertake directly to the Bank that no dividends, interests or other payments shall be made by the Borrower to themselves nor the capital shall be decreased, no contracts for technical services or similar arrangements shall be concluded and no payments made therefore until full repayment of the Bank Loans.

Ø  An agreement may be requested for granting power of authority and proxy under which the Bank shall represent the shareholders at the meetings of shareholders, especially if and until the Borrower is in default. Such Proxy shall specifically include the right of the Bank to dismiss existing directors and appoint new directors selected and nominated by the Bank. Unfortunately, in Bulgaria such proxy may be cancelled at all times.
Ø  An entity appointed by the Bank may as well acquire a minority participation in the capital of the Borrower as long as the Bylaws of the Borrower be amended in a way to allow this new shareholder to have veto rights in relation to capital changes, appointment of managers, distribution of dividends and the like.
Ø  The bank may structure the repayment schedule to make it feasible that at certain foreseeable point in time the Borrower shall gain enough revenue to repay the loans to the Bank and its operating costs without becoming overindebted.
Ø  Under an agreement between the Bank and the Shareholders they shall undertake to increase the capital of the Borrower by at least the loss accumulated so far, and in addition with a greater amount allowing the creation of a “cushion” which shall be used during the coming years to keep the value of the Borrower’s own capital a positive figure, regardless whether the revenues of the Borrower shall, during such period, be enough to cover its operating costs and the Bank’s dues. The Borrower’s own capital may be increased in 2 ways:
A contribution-in-kind of the takings of Shareholders under the Shareholder loans. Unfortunately, the evaluation of such receivables is done by an expert appointed by the Company Registrar keeping the Company Register, which takes time and, secondly, the value of the receivables is likely to be much lower than the nominal value of the debt due to the risk of non-collection.
Increase of the “reserves fund” of the Borrower by way of cancellation of the Borrower’s obligation to repay the shareholder debt (part of the debt). If a shareholders’ resolution is made to this effect, then the receivables of shareholders shall be accounted for as “reserves”. This could be done at any time by a resolution of the general assembly but in any case before any security agreements are concluded and securities are perfected. Once the “reserves fund” is increased, the registered capital of the company may be increased as well as a second act at the account of the “reserves fund”.
According to art. 246 of the Commerce Act, the reserves fund may be used only to cover losses from current or previous years or for increase of the capital. There is a minimum amount of the fund – 10% of the registered capital. Notwithstanding the previous provision, there is a risk that the reserves fund may be used for distribution of dividends. Such risk is created by a contradiction in the law – Art. 247a allows the distribution of dividends as long as the net value of the company’s property is a positive figure and as long as the reserves fund does not fall under the minimum required by law. Therefore, the “cushion” which we ask the shareholders to form in the “reserves fund” could be distributed as dividends as long as the loss is covered. In this way, the sub-debt is transformed into dividends and payable immediately even before payment of the Bank loans. In addition, if dividends are paid, no quasi-equity will be available in the “reserves fund” to balance the repayment of the Bank loan and cover operating costs until the time when the Borrower gains sufficient revenues from its own business. There would be a risk that bankruptcy is initiated against the Borrower due to over-indebtedness. Therefore, we advise that the remainder of the “reserves fund” be transformed into registered capital. There are mandatory provisions in respect to decrease of the registered capital in the Commerce Act, Art. 150-153, which rule that all creditors shall either agree to the decrease of capital or shall be granted substantial guarantees for repayment of their receivables.
Other suggested actions:
Ø  The shareholders’ register may be kept by the Bank by way of agreement to prevent any unauthorized entries conflicting with the Bank’s share pledge.
Ø  A notarized copy of the shareholders’ register of the Borrower can be made and kept by the Bank, creating sufficient evidence as to who the shareholders were up to that date. Any further listing shall be done in contradiction to the share pledge agreement and evidence may be created and held by the Bank where the authorized entries are.
Ø  Eventually once the company’s own capital becomes a positive value and no threat of bankruptcy is pending, all security agreements shall be effected.
Ø  A pledge of going concern is a good option to secure the bank’s rights. In this way the total business, assets and even revenues of the Borrower shall be pledged in favour of the Bank and in eventual bankruptcy this enforcement option shall prevail to the bankruptcy proceedings. Furthermore, the going concern of the Borrower shall be a security held by the Bank. In addition to holding the assets, the Bank shall have the right to appoint immediately a new manager of the Borrower if it has started enforcement under the Specific Registered Pledges Act. Listing such pledge is not excessively expensive in terms of state fees.

ІIІ. DECLARATION OF BANKRUPTCY OF THE DEBTOR. RISKS. PROCEDURES.
The proceedings based on submission of a petition for institution of bankruptcy proceedings have two alternative outcomes:
A reorganization plan, and
Conversion of the property into cash;
The petition for institution of bankruptcy proceedings does not stop the carrying out of activities by the debtor, he shall continue his operation (including, shall finish the Investment site and shall Open it, even though with delay), unless ordered otherwise by the court by request of the Bank, the debtor or another creditor. In such case a reorganization plan may be submitted, adopted and accepted whereupon the proceedings shall be terminated.

2.1 A reorganization plan may provide for a deferment or rescheduling of payments, a remission of the debts in part or in whole, etc. The plan may also envisage the sale of the entire enterprise or an autonomous part of it, the manner and the terms of the sale, the buyer, a debt equity swap, novation, or taking other actions or making other transactions. Further, the reorganization plan may provide for the appointment of a supervisory body to exercise control over the debtor’s activity for the term of validity of the reorganization plan, or for a shorter period of time.

2.2 The reorganization plan is accepted by the creditors holding claims allowed in the following classes:

  1. creditors with secured claims and creditors holding a right of retention;
  2. creditors with claims ensuing from employment relationships, which have arisen before the date of the judgment on institution of bankruptcy proceedings;
  3. public law receivables of the State and the municipalities such as taxes, customs duties, fees, compulsory social insurance contributions and others which have arisen prior to the date of the judgment on institution of bankruptcy proceedings;
  4. creditors with unsecured claims;
  5. creditors with legal or conventional interest on an unsecured claim, due after the date of the judgment on institution of bankruptcy proceedings; creditors with credit extended to the debtor by a partner or shareholder; on gratuitous transaction; on the costs incurred by creditors in connection with their participation in the bankruptcy proceedings.
    The reorganization plan is accepted by the creditors only if it has been proposed not later than one month following the date of publication in the Commercial Register of the court judgment accepting the list of claims allowed. More than one plan may be proposed in the bankruptcy proceedings. A plan shall not be considered accepted if creditors holding more than one-half of the claims allowed regardless of the classes in which they are distributed have voted against it. Therefore, any proposed reorganization plan should be accepted by the Bank.

2.3 The court endorses the plan by a judgment if:
Ø  the plan has been accepted by a majority of creditors holding more than one-half of the claims allowed included in the lists approved by the court; if the plan envisages partial payment, at least one of the creditor classes which have accepted it, shall receive partial payment;
Ø  the plan ensures that an opposing creditor and an opposing debtor receive the same payment which they would have received upon distribution of the property under the terms and procedures provided for by the law;

When quoting the above text, we observe a certain contradiction between the above items. For example, if the Bank in its capacity of secured creditor votes “against” the reorganization plan, but this plan provides for such payment which it would have received upon distribution of the property for the secured portion of the investment credit and the full amount of the revolving credit, then the plan would be endorsed. On the other hand, if the votes of the Bank as secured creditor on the grounds of item 1, voting in the class of creditors with unsecured claims (if its securities are proclaimed nil and void because they had been granted after the initial date of overindebtedness) be ignored, then the Bank shall not be a creditor with more than 50% of all claims and the plan may provide for minimal or no satisfaction of the claims of the creditors falling in class under item 8 of Art. 722. The interpretation of this particular text entails certain risk, yet there is the express requirement that the plan should be approved by creditors with claims in excess of 50% of the entire debt which beyond doubt protects the interest of the Bank. After adoption of the plan, the bankruptcy proceedings are terminated and may be resumed if the plan is not fulfilled.

3. Declaration of bankruptcy, conversion of the property into cash, distribution of the property so converted.

3.1 The court declares the debtor to be bankrupt if within the period provided by law
no reorganization plan has been proposed or the plan proposed has not been accepted or endorsed, or
where it is obvious that further continuance of the activity could damage the bankruptcy estate and the court, acting on a motion by the debtor or, respectively, by the liquidator, the trustee in bankruptcy, the National Revenue Agency or a creditor, has declared the debtor bankrupt and terminated its activity concurrently with the judgment on institution of bankruptcy proceedings or later, or where the available property is not sufficient to cover the initial costs and such costs have not been prepaid.

3.2   If no reorganization plan has been proposed or the plan proposed has not been accepted or endorsed, the activity of the debtor is terminated and inevitably the next step is conversion of his property into cash. The sale of property rights included in the bankruptcy estate shall be effected by the trustee in bankruptcy following the court’s permission. The trustee in bankruptcy prepares an announcement on the sale for the conversion of property into cash. There are no specific requirements regarding the evaluation of the property, it is made by 1 appraiser appointed by the trustee in bankruptcy. If no bidders have appeared or no valid bids have been proposed, or if the buyer has not deposited the price, a new sale by open bidding is held with a starting bid of 80 per cent of the evaluation, after a new announcement. If again there are no buyers, a new sale is held – on a motion by the trustee in bankruptcy, the bankruptcy court may permit the sale to be effected through direct negotiations or through an intermediary, where the things and the property rights as a whole, the self-contained part, or an individual thing or the property right were offered but the sale was frustrated because a buyer did not appear or the buyer desisted. In such cases, the sale price may be lower than the starting bid.

3.3 The property converted into cash is distributed when sufficient cash funds accumulate in the bankruptcy estate. The trustee in bankruptcy prepares an account for the distribution of the available amounts among the creditors with claims pursuant to Art. 722, para. (1) of the Commerce Act, in conformity with the order, the privileges and the security. The distribution account is partial until the obligations have been fully paid or the entire bankruptcy estate, with the exception of unsellable things, has been converted into cash. The account for distribution may include claims which have arisen after the date of the judgment on institution of bankruptcy proceedings if the obligation has been undertaken with the consent of the trustee in bankruptcy or has been recognised by him.

3.3.1 Upon distribution of the property converted into cash, claims are grouped in classes and are repaid pursuant to Art. 722 (1) of the Commerce Act (CA) in the following order: for items 1-12; every next class is satisfied after full satisfaction of the claims of creditors in the preceding classes; claims of one and the same class are satisfied commensurably.

  1. claims secured by a pledge or mortgage fall under the item 1 class;
  2. claims which have arisen after the date of the judgment on institution of bankruptcy proceedings and have not been paid when due fall under the item 7 class (potential claims of the company rendering construction services);
  3. all other unsecured claims which have arisen after the date of the judgment on institution of bankruptcy proceedings fall under the item 8 class. The following would belong here (i) Bank’s claims on extended loans which are not secured or whose securities have been declared void as well as the cash for principal and interest received after the initial bankruptcy date; (ii) claims of the construction company on paid invoiced services which have been rendered after the initial bankruptcy date if the contract with it has been entered into before the initial bankruptcy date; (iii) claims of lessees for liquidated damages if the petition for institution of bankruptcy proceedings has been submitted after the date of Opening of the Site but in delay under their lease agreements.
  4. The following classes 9, 10, 11 and 12 are satisfied only after full satisfaction of the other creditors and claims arising from:
    legal or conventional interest on an unsecured claim, due after the date of the judgment on institution of bankruptcy proceedings (including the one due to the Bank also under the loan agreements and for the delayed unpaid claims of the company delivering the construction services);
    credit extended to the debtor by a partner or shareholder;
    gratuitous transaction;
    the costs incurred by creditors in connection with their participation in the bankruptcy proceedings.

3.3.2. Risks of changes of the order of different creditors in the distribution of the property converted into cash in the course of the bankruptcy proceedings:
Ø  In case of assignment of claims, the claim shall be assigned in the condition and as it is with the assignor. The assignee may not have more rights than the assignor; even if the assignee has no characteristics of shareholder, he may not have more rights than the assignor. Therefore the shareholder loans shall still be shareholder loans even if assigned to third parties after the date of disbursement. Such creditors fall in the class under item 10 of Art. 722 of CA – after the banking debt – secured and unsecured.
Ø  The issue is more complex – what would happen if by the time of the judgment on institution of bankruptcy proceedings the creditors do not have the capacity of shareholders anymore because the Bank has sold the shares in result of enforcement on shares pledged in its favour. (art. 616 – bankruptcy creditors in relation to art. 614 CA – bankruptcy estate) or because the shareholders themselves have transferred, even though pledged, their shares to third parties.
Ø  And the opposite, if a creditor who had no capacity of shareholder by the time of extension of the loan but who at the time of the judgment on institution of bankruptcy proceedings has acquired this capacity (for example, if the Bank acquires shareholding in the Borrower aiming to have access to information or change the management, or if it participates as buyer in a potential sale of the pledged shares).
We believe in these cases the time of extension of the loan rather than the following change in the quality of the credit is decisive. Art. 616 (2) item 2 CA reads that credit “extended” to the debtor by a partner or shareholder shall be satisfied only after full satisfaction of the claims of other creditors.

3.3.3 Order of the claims of third party creditors for the liquidated damages under various agreements for delivery of goods or services in the course of bankruptcy proceedings at the stage of distribution of the property converted into cash. Specific risk analysis of penalties and liquidated damages payable to third parties in case of delayed construction works and therefore delay in delivery of services under (preliminary) agreements with third parties.
There are three possibilities depending on the time of initiation of bankruptcy proceedings and time of declaration of debtor in bankruptcy by the court:
Ø  the judgment on institution of bankruptcy proceedings comes after the maturity date for debtor’s liabilities to third parties;
Ø  the judgment on institution of bankruptcy proceedings is before the maturity date for debtor’s liabilities to third parties, but the judgment on declaration of bankruptcy is after this date, and Ø  the judgment on declaration of bankruptcy of the debtor is before the maturity date for debtor’s liabilities to third parties.

3.3.3.1 If the judgment on institution of bankruptcy proceedings comes after the maturity date for debtor’s liabilities under a third party agreement, the liquidated damages would have become payable before the judgment on institution of bankruptcy proceedings, these claims are not secured and shall fall under the class pursuant to art. 722 (1) item 8 – together with the Bank’s claim for the unsecured portion of the investment credit for which the securities provided in 2008 have been declared void. They shall be satisfied proportionately (commensurably) for the unsecured portion of the bank investment credit.

3.3.3.2. If the judgment on institution of bankruptcy proceedings is before the maturity date for debtor’s liabilities under third party agreements, but the judgment on declaration of bankruptcy is after this date and the activity of the debtor continues, then the claim shall fall under item 7 of art. 722 (1) CA, i.e. before the Bank’s claim for the unsecured portion of the investment credit. However, the trustee in bankruptcy may have terminated these agreements before maturity of debtor’s liabilities thereunder (as the trustee has the right to do so); if so after the date of the judgment on institution of bankruptcy proceedings no liquidated damages shall be due and only potential compensation for the really suffered damage. Still, a trustee in bankruptcy usually is appointed approximately 2 months after the submission of petition for initiation of bankruptcy proceedings, and in our opinion a temporary trustee in bankruptcy has no right to terminate agreements unless expressly empowered to do so by the court as measure for protection of the bankruptcy estate.

 3.3.3.3. The judgment on declaration of bankruptcy of the debtor is before the maturity date for debtor’s liabilities under third party agreements.
In one and the same judgment, on request of the debtor, the trustee in bankruptcy, the National Revenue Agency or a creditor together with the initiation of the bankruptcy proceedings the court may declare the debtor in bankruptcy and terminate his activity with the grounds that its continuation would lead to damage to the bankruptcy estate. In such case, the obligation to surrender possession of the Site in favour of the lessee shall become due on the grounds of art. 617 CA.
In this particular case, however, this obligation would not have arisen before declaration of the debtor in bankruptcy. Its only equivalent are the liquidated damages – the liquidated damages specifically set forth in the agreement in case of full non-performance of the obligation to hand over the Site for use by the lessee and not for delayed performance. In case of termination of the activity of the debtor, all obligations that arise or whose maturity date is after that have no grounds because there is no activity.
The obligation to the third party creditor would not arise as a result of the activity – it would be terminated at that time, i.e. it shall not belong to the class under item 7 CA – claims which have arisen after the date of the institution of bankruptcy proceedings (it shall arise even after the second judgment – for declaration of bankruptcy); and it is not an unsecured claim arisen before the date of the judgment on institution of bankruptcy proceedings under item 8 of art. 722 as well. This claim does not fall under any class for satisfaction of the creditors and therefore should not be included at all in the distribution of the property converted into cash. Even if the claim is accepted by the trustee in bankruptcy and the creditor may participate in the creditors’ meeting, upon distribution of the property converted into cash this claim would not be included in the distribution and satisfied. We have also practice in this area – a ruling of the Supreme Cassation Court on one of the cases of Mr. Smilenov in his capacity of trustee in bankruptcy.
In the existence of initiated bankruptcy proceedings, there are several options for defence of the Bank against the third party creditors: (1) Protection of the bankruptcy estate by the trustee in bankruptcy by way of termination of the agreement with the third party creditor immediately at first opportunity. There are several particularities regarding this text – firstly that the agreement is terminated and not rescinded, i.e. only for the future. The liquidated damages due by that time shall be successfully claimed by the creditor whose agreement is being terminated. Most importantly according to this text, a creditor under an agreement terminated by the trustee in bankruptcy is entitled only to damages but not to liquidated damages or penalties; (2) the court may, even before the judgment on institution of bankruptcy proceedings, allow the use of temporary measures pursuant to art. 629a CA, among which the appointment of temporary trustee in bankruptcy, as well as termination of the agreement with a third party creditor due to the obvious prospect of its non-performance and the fact that the agreement shall lead to decrease of the bankruptcy estate; (3) if the right to liquidated damages arises after the date of initiation of bankruptcy proceedings, no claims at all pursuant to art. 134 and 135 of the Obligations and Contracts Act (OCA) may be made (claim by a creditor substituting the debtor for reduction of the liquidated damages as excessive).
An entirely different matter is whether and to what extent a court shall render void the liquidated damages clauses of a third party agreement (liquidated damages between traders to be declared excessive and respectively agreed in contradiction with the good morals). We believe that at this point the Bank may not request from the lessees to reduce the liquidated damages and penalties in a contract. The liquidated damages may be disputed by the debtor (or his creditor if the debtor takes no action) as excessively large only after they are claimed. However, in its recent practice, the court holds that the application of the Obligations and Contracts Act applicable in general, represents evasion of the law and respectively applies directly the text of art. 309 CA – liquidated damages due under a commercial transaction concluded between merchants may not be reduced on grounds of excessive amounts.

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