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Subordination of related party claims under the amended Slovak bankruptcy act

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Kollar Renatus
Renatus Kollar

Partner

Bratislava

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Kudlak Matus
Matus Kudlak

Counsel

Bratislava

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30 May 2012

Amendments to the Slovak Bankruptcy Act (the Act) may have a significant impact on lenders. The amendments concern claims against an insolvent debtor by related parties.

​The new definition of a related party is extremely broad and could, on a literal interpretation of the new rules, include commercial lenders extending financing in the ordinary course of business. Related parties’ interests are subordinated to the interests of unrelated parties under the Act regardless of whether they hold security or not.

The Act provides that, on bankruptcy, any claims that belong or belonged to persons who are or were related parties of the debtor (the Related Party Claims) will be treated as subordinated claims, ie only paid once all other (unsubordinated) claims have been satisfied. A related party is also given very limited rights in a formal court-ordered restructuring.

Meaning of "related party"

The definition of a related party under the Act is very broad. It includes the bankrupt’s affiliated entities, statutory representatives, members of supervisory bodies, managing employees and entities in which such persons act in similar positions as the bankrupt. Moreover, an individual or an entity having a mere 5% direct or indirect interest in the registered capital of a bankrupt (or in the voting rights of a bankrupt or a comparable participation in the bankrupt’s management) could qualify as a related party.

A creditor may thus be or become a "related party" of a debtor if, inter alia:

  • an individual serves as a statutory representative (eg member of the board of directors, executive director or head of local branch of a foreign legal entity) or as a member of the supervisory board for both the creditor and the debtor;
  • a member of the supervisory board or the board of directors of the creditor marries a statutory representative or a member of the supervisory board of the debtor;
  • an individual is appointed to a management position in the creditor who has a close relationship (eg a family tie) with representatives of the debtor, or vice versa; or
  • a shareholder in the creditor or its direct or indirect holding company acquires at least 5% interest in the debtor or its direct or indirect holding company, or vice versa.

Such a broad definition of related parties and Related Party Claims will affect not only the quasi equity claims against a bankrupt, but also any Related Party Claims irrespective of their substance and irrespective of whether the relevant Related Party Claims originated on an arm’s length basis under the conditions prevailing in the ordinary course of business or not. Consequently, it will equally affect a claim arising out of a supply relationship as well as a claim arising out of a financing arrangement.

Effect on security

The Act provides that any security provided by the bankrupt for the Related Party Claims will be disregarded, ie the relevant secured creditor will have no right to be satisfied from the proceeds of the sale of the assets provided as collateral in respect of its Related Party Claim in priority over any other creditors.

The amendment to the Act also removes the voting rights associated with Related Party Claims and the right to be elected onto the creditors’ committee as creditor of a Related Party Claim. Therefore, a related creditor will have the right only passively to monitor the course of the bankruptcy proceedings and wait for their result, to see if it receives at least a part of the proceeds of realisation of the assets (which, in vast majority of bankruptcies, is very unlikely).

Why were the changes made?

In several previous insolvency cases, shareholders and other related parties have influenced the course of bankruptcy proceedings and manipulated the outcome to the detriment of other creditors by making claims (often created with opportunistic objectives) against the bankrupt.

  • However, the literal interpretation of the amendments to the Act arguably goes beyond the legitimate aim of improving the position of unrelated creditors. There is a concern that such an interpretation may have significant negative or even absurd consequences. For example:
  • claims between persons that were related in the past, but ceased to be related, may be automatically subordinated upon the bankruptcy of one of them (this may occur both where the transaction giving rise to the Related Party Claim was entered into prior to or after the related party connection between the creditor and the bankrupt has ceased to exist);
  • a claim of an unrelated creditor may be subordinated where the creditor has acquired a receivable from a bankrupt’s related party. This risk may be relevant for (among others) any factoring transactions entered into on an arm’s length basis where the purchaser, acting in good faith;
  • acquires a receivable owed by the bankrupt to a third party creditor who is or at any time in the past was related with the bankrupt;
  • as regards syndicated loans, any security created for the benefit of lenders and held by a security agent may be disregarded in debtor’s insolvency proceedings where a security agent has become a related party of the debtor;
  • a security agent or a facility agent may not be able to register the full amount of an outstanding debt under a syndicated loan in debtor’s insolvency proceedings if any member of the syndicate has become a related party of the debtor. Lenders in a syndicate should therefore agree a specific exemption to pro rata redistribution of proceeds in case a relevant lender has become a related party of the debtor and therefore its portion of the debt may not be satisfied in the same order of priority as the remaining part of the debt owed to other members of the syndicate;
  • custody products held by a bank, in its own name but for the account of a client (such as portfolio management or safekeeping and administration of financial instruments), may be contaminated by subordination if the bank becomes a related party of an issuer or a debtor regardless of whether the client itself qualifies as a related party of such issuer/debtor or the bank.

Although we do not yet have any guidance from the Slovak courts as to how these new provisions will be interpreted, it is important for lenders to consider how best to mitigate any risk that they will be affected by the related party provisions. This is particularly so as Slovak courts are well-known for their formalistic approach and often prefer a literal interpretation over other methods of interpretation of law.

Unfortunately, in many circumstances a lender may not directly influence (or even be aware of) the fact that its claims against a debtor qualify for the Related Party Claims or that financial instruments held in its custody have been contaminated by subordination. Nevertheless, it is advisable that a financial institution, prior to entering into any transaction with a Slovak counterparty, conducts additional know your customer (KYC) checks to mitigate its risk that its exposure against the borrower would qualify as a Related Party Claim. This particularly applies when transacting with large private equity groups. Large private equity groups have a significant number of own subsidiaries or minority shareholding interests in many (otherwise unrelated) companies, including financial institutions. Therefore, a risk that the subordination of Related Party Claims will materialise is much higher in a scenario where a lender enters into a transaction with a company belonging to the private equity group with a complex (and sometimes unclear) shareholding structure and many personal interconnections.

A financial institution might want to consider conducting regular checks during the lifetime of a transaction to mitigate a risk that the borrower, or its holding company, will take any steps causing subordination of the borrower’s debt. However, conducting such checks will not ultimately exclude a possibility that the borrower’s debt becomes subordinated since the financial institution may not effectively prevent the borrower (or its holding company) from eg acquiring a shareholding interest in the financial institution or its holding company. Such additional checks may also represent a considerable administrative burden.

Further Information

The European Finance Litigation Review is a quarterly publication on recent developments in the finance litigation and regulatory sector in key European jurisdictions. For more information please contact Amy Edwards amy.edwards@alleovery.com.