Insolvency & Restructuring

Insolvent Borrowers Successfully Challenge Security Granted to Banks in Bulgaria

Banks in Bulgaria are seriously concerned with borrowers fraudulently manipulating their accountancy books with the effect that banks’ security interests are declared invalid and banks are declassed into ordinary (unsecured) insolvency creditors.

Bulgarian legal regime

A debtor is balance sheet insolvent when it is unable to pay its debts as they become due or it has financial liabilities exceeding the value of his assets. Whether and as of which day a debtor is balance sheet insolvent is a question of fact to be determined with the support of accountants and valuation experts.

If a court determines that the debtor is balance sheet insolvent, the debtor will be declared “judicially insolvent”.

Pursuant to a much-criticised legal provision in Bulgaria, if a balance sheet insolvent debtor is declared judicially insolvent, this will invalidate by operation of law: (i) any performance of a financial obligation and (ii) any creation of a security interest over any asset of the insolvency estate, in each case, made after the debtor became balance sheet insolvent. Accordingly all security interests and payments made by a balance sheet insolvent debtor, including those that have been re-scheduled or restructured, may be declared void if the court opens insolvency proceedings.

In an attempt to eliminate fraudulent preferential treatment of creditors, Bulgarian law has adopted the voidance “per se” approach towards all creditors without exceptions. Creditors may not rely on defences by proving, for example, that the payment was made or the security was created without intent to defraud the other creditors.

Therefore, in such cases the insolvency administrator of a judicially insolvent debtor may claim repayment or request invalidation of security interests. The creditor is then left only with its claim as an unsecured creditor (pari passu with all other unsecured creditors) in the debtor’s judicial insolvency proceedings.

There is no limit backward in time of the “suspect period” (the period by reference to which certain transactions may be subject to avoidance), nor is there a so-called “hardening” period before or after which a security interest or payments made by a balance sheet insolvent debtor may be deemed valid and immune from claw-back.

Unfair treatment of creditors

The exact date from which the debtor is to be deemed balance-sheet insolvent is fixed by the court in its decision for opening of insolvency proceedings. The date may be months, even years, before the application for commencement of insolvency proceedings is filed with the court. The farther back the date is fixed, the more payments and security transactions may be declared void. Accordingly, there is an increasing number of cases where unsecured creditors, acting in concert with the insolvency debtor, are seeking to demonstrate that the debtor incurred much debt long in the past. In principle, managers of balance sheet insolvent debtors must file for insolvency within 30 days from when the status of insolvency or over-indebtedness was established. However, as it is often rather difficult to prove damages suffered by creditors as a result of delay in filing an insolvency application, and as it is easy for directors to escape criminal liability for not timely applying for insolvency, managers often agree to take part in schemes to “backdate” insolvency. Fictitious and backdated contracts or promissory notes executed by managers and sham creditors are submitted as evidence so that the debtor can be found balance sheet insolvent before the date of certain payments and security interests, which are challenged. If the sham creditors succeed, the challenged payments and security interests is declared invalid.

In a time of continuing global crisis, the inflow of “fresh” loans is reduced, the average loan portfolio of banks matures and loan problems become increasingly apparent over time. As of mid-2012, the share of non-performing loans in Bulgaria was 16.86%, and the share of the corporate non-performing loans in particular was 19.42%. Banks are increasingly involved in insolvency proceedings against borrowers. So banks are seriously concerned with attempts of insolvent borrowers to manipulate their accountancy books so that securities and payments in favour of the banks are invalidated by operation of law. The straightforward application of the far-reaching insolvency law provision mentioned above poses a real threat to banks, and calls for a legislative solution are increasing.

Legislative proposal

There is a recent legislative proposal to amend this law pursuant to which only payments in discharge of non-matured obligations may be declared invalid. The draft bill would also introduce a temporal limitation for the suspect period, whereby the making of (non-mature) payments and the creation of security interests will be void only if they occur within one year before the date on which the application for commencement of judicial insolvency proceedings was filed.

The proposed legislative amendment may need some technical improvement, but it is certainly a step in the right direction and will help to establish an effective insolvency regime in Bulgaria.

In a time of continuing global crisis, the inflow of “fresh” loans is reduced, the average loan portfolio of banks matures and loan problems become increasingly apparent over time.