The looming effects of the coronavirus pandemic, the energy crisis, a significant rise in inflation and other circumstances are having a major impact on the business of companies. What if a company runs into financial difficulties and is facing the risk of insolvency? At such times, its managers have a legal duty to act.

In the wake of the events of the last two to three years, the time may be approaching when there will be more insolvencies and corporate restructurings. If a company is facing insolvency or has already become insolvent, this imposes certain duties on the management of business corporations. These duties  arise from both the Companies Act and the Insolvency Act.

Insolvency and over-indebtedness

Insolvency includes situations when a business corporation is either unable to pay (in payment default) or over-indebted. Inability to pay ocurs when a company has multiple creditors, financial obligations overdue for more than 30 days, and the company is unable to meet these obligations. A company is deemed to be unable to meet its obligations if the obligations are past due for more than 3 months. The same also applies in cases where the company has suspended payments or where creditors are unable to obtain satisfaction of any of their overdue claims by court enforcement.

Over-indebtedness occurs when a company has multiple creditors and the aggregate sum of all liabilities exceeds the value of the company’s assets. In the case of over-indebtedness, the liabilities do not even have to be due and payable. In practice, over-indebtedness usually manifests itself in a business corporation reporting negative equity in its financial statements. However, when assessing over-indebtedness, future business activities of the company and the potential to continue conducting business can also be taken into account, which can potentially increase the value of the assets, and thus over-indebtedness can still be eliminated.

Whether a company is able to meet its obligations or not can be determined by calculating the so-called liquidity gap. This involves the determination of the difference between the amount of payable liabilities and the amount of available funds. If the liquidity gap is less than 10% of outstanding liabilities, then the company is considered to be able to meet its obligations.

It is also possible to prepare an liquidity gap outlook for the next 8 or 12 weeks, which should show whether or not the liquidity gap will, or will not, exceed 10% of the outstanding liabilities during that period. If it needs to be officially certified that the company is actually not insolvent, a liquidity gap statement or a liquidity gap outlook should be prepared by an auditor or a court-appointed expert in economics.

Obligation to file an insolvency petition

If the financial condition of the company shows that the company is indeed insolvent, then the members of the company’s governing body (i.e. the managing directors or members of the board of directors) are obliged to file an insolvency petition with the competent insolvency court without undue delay, i.e. at the time when they became or, acting with due care and diligence, should have become aware of the insolvency.

This obligation should be taken seriously – if the managing directors or members of the board of directors fail to comply with it, they are exposed to severe sanctions. Under the Insolvency Act, they can be held liable for damages caused to creditors as a result of the late filing of an insolvency petition. The amount of the damages vis-à-vis each creditor for which they are liable is determined by the difference between the amount of the claim that the particular creditor filed in the insolvency proceedings and the amount actually received by the creditor in the insolvency proceedings.

The satisfaction of unsecured creditors in bankruptcy is usually only in the range of a few percent. Therefore, the damages for which members of the governing body of a corporation may be liable can be quite high. At the same time, the creditors may require that the member of the governing body is ordered to deposit an adequate amount of compensation for these damages in escrow with the court even as insolvency proceedings are still pending.

Surrender of income by the members of the company’s governing body

Beyond the scope of the Insolvency Act, the Companies Act stipulates the liability of a member of the governing body who, by violating their duties, directly contributed to the insolvency of the business corporation. In such a case, the insolvency court may require the director to surrender to the bankruptcy estate the income he or she has previously received in connection with the performance of his or her office in the corporation. Typically, this will involve remuneration for the performance of office or any other benefit, such as compensation for the use of a company car or flat for private purposes, etc.

If the assets of the corporation are the subject of bankruptcy, the court may order that a member of the governing body is obliged to provide funds to the bankruptcy estate up to the amount of the difference between the total liabilities of the company and the value of its assets. This is based on an action to establish a personal liability to contribute to the company’s assets, and the insolvency court takes into account in particular the extent to which the director in question has contributed to the insufficient value of assets in the bankruptcy estate.

The insolvency court may also order a member of the governing body to be excluded from holding any office in business corporations for up to 3 years. The person in question is then barred from being a member of the governing body in any business corporation in the future, and will also cease to be a member of the governing body in any business corporation in which he or she may still be active.

Company rescue and restructuring

The above-mentioned duties of members of the governing bodies are intended to help in solving the financial difficulties of the company at a time when it is still possible to save the going concern of the company, whether in the hands of the existing management and shareholders, or under the leadership of new investors who can take over the company via a standard acquisition or through the insolvency proceedings.

Insolvency proceedings do not always mean the end of a business; rather, they offer an opportunity for restructuring and further development. Indeed, the Insolvency Act offers a solution in the form of a reorganisation which allows the company to continue its business operations, provided that the creditors’ claims are restructured and paid at least partially and further restructuring measures are adopted. However, the prerequisites for a successful reorganisation are the early recognition of the company’s crisis situation and the prompt adoption of the necessary recovery measures.

An example of a timely and successful resolution of insolvency are the insolvency proceedings of the company MERKO CZ, in which HAVEL & PARTNERS participated as a legal counsel to a secured creditor. MERKO CZ, a traditional manufacturer of concrete batching plants and accessories for concrete production, ran into financial difficulties. Subsequently, the company was restructured as part of a reorganisation that involved the conversion of debt into equity (debt/equity swap) and the transfer of real estate assets to the secured creditor. Those assets were subsequently sold to a real estate investor, and MERKO CZ subsequently leased them back for the purposes of its ongoing business activities.