Bankruptcy law works with the assumption that debtor asset is insufficient to meet the demands of creditors. In principle, a solvent debtor has every right to effect payments to any of his creditors since in this case there is no race to court room problem. Thus, to understand suspect transactions, it is necessary to define what insolvency means and when do we say the person is insolvent?
Simply, insolvency is inability to pay the debt when they become due and payable. There are two primary tests which have been employed in determining whether a person or a company is insolvent. These are cash flow test and balance sheet test.
The cash flow test provides that a company is insolvent when it is unable to pay its debts as they fall due. The important point is whether or not the company pays its debt in carrying on the business. If a company fails the test it means in effect, that it has insufficient resources available to pay creditors. On the other hand, balance sheet test states that if its total liabilities (including the cost of liquidation) out weight the value of its assets and therefore the company’s assets are insufficient to discharge its debt. UNCITRAL guideline to insolvency law define balance sheet test based on excess of liability over assets as an indication of financial distress. Thus, a payment or transfer of debtor asset with in suspect period will have detrimental effect to the other creditors and hence it is suspect transaction. It is reasonable to raise the question, what means by suspect transaction?
Suspect transaction is simply transactions which result in a creditor obtaining an advantage or irregular payment. Thus, it is a transaction which benefits one or more creditors at the expense of other creditors. This creates a race of the most diligent which in turn dependent up on access to information. Furthermore, such type of transactions encourages favoritism by the debtor to some selected creditors by anticipating future relationship.
Such types of transactions not only have the effect of frustrating business but also defeat the very objective of bankruptcy law. One of the most important ways to undo such transactions is by invalidation.
The underpinning policy justifications behind invalidation of suspect transactions found in the objective of bankruptcy law in general. Generally there are three main policy justifications behind invalidation of suspect transactions.
Unlike civil proceedings, in the absent of any other means to effect payment of due debt the debtor property may be taken in satisfaction of debts and the creditors who make the first attachment are entitled to have priority to the full amount of his claim and the slower creditors always suffer the risk while assets are distributed to the other party who is more active, in bankruptcy proceedings the governing principle is equality of creditors and hence replace race of the most diligent with pro rata distribution of assets. Generally speaking, it is impossible to bring equal treatment of creditors rather bankruptcy aims at bringing equitable treatment of similarly situated creditors. In bankruptcy what is equality is equity. For instance, in bankruptcy treatment of secured and unsecured creditor is quite different, but there is no difference between and among unsecured creditors and hence there is preferential and differential treatment in bankruptcy proceedings.
The objective of equitable treatment is based on the notion that, in collective proceedings, creditors, with similar legal right should be treated fairly, receiving distribution on their claim in accordance with their relative ranking and interests. This key objective recognizes that all creditors do not need to be treated identically but in a manner that reflects the difference bargains they have struck with the debtor. Therefore, one policy justifications behind invalidation of suspect transactions is to enforce equality of creditors.
One of the immediate effects of invalidation of suspect transaction is recovery of assets on which the creditors has already taken. This increases the asset of the bankrupt debtor. Invalidation and recovery of assets are two distinct but interrelated concepts. Invalidation is a judicial declaration that the transaction should be set aside. However, this declaration by and on itself brings nothing to the bankrupt estate. It is like a court decree, in which it is a means and green light to enforce the judgment. Thus, the trustee should bring recovery claim.
It is important to note that the effect of invalidation to recovery the property transfers depends on, whether the transfer or obligation being avoided is (1) an outright transfer of property, or (2) a lien. If an outright transfer is avoided, the trustee will then attempt to recover either the specific property transfer or its value. If a lien is avoided, however, then in most case the lien simply is nullified, the formerly secured creditor is relegated to unsecured creditor. Secured status and the property are freed from the encumbrance. Thus, the second policy justification behind invalidation of suspect transactions is maximization of debtor asset which in turn is the common security of the whole creditors.
The rational of deterrence effect can be classified in to deterrence effect on debtor and creditors. The objective of invalidation law regarding debtor is deterring debtors from setting themselves up as the law maker and judging the relative worthiness of creditors. The intention of the debtor to confer a preference is the crucial element in this regard. On the other hand, the argument on creditors deterrence effect is that in the absence of invalidation of suspect transactions, those creditors who are aware of the debtor’s insolvency and thus the looming equal sharing regime, will seek to ‘opt-out’ of the collective proceeding and relative for the debtor’s assets in order to ensure payment in full.
Some scholars seriously criticize this policy justification. They argue that even if the payment is found to be preferential, the worst that can happen is the creditor must return the payment. There is no penalty imposed and the creditor is not worse off for having accepted it. The biggest loss the creditor stands to face is potential legal costs.
In the absence of any guideline from the parliament and legislative history from the drafter of the Commercial Code, it is for everyone to guess the appropriate Ethiopian policy justification behind invalidation of suspect transactions.
It is possible to automatically exclude the maximization of asset as a possible policy justification. This is because the close reading of Ethiopia invalidation of suspect transaction, Article 1029-1033 of Commercial Code, reveals no mention of recovery of asset. Since the law maker failed to embody this concept clear in the law, it is impossible to bring it as policy justification. Therefore, we are left with the other two policy justifications i.e. equitable treatment of creditors and deterrence effect on the debtor and creditors.
The major policy justification behind invalidation of suspect transaction under Ethiopia law is equitable treatment of creditors. The type of ‘equitability’ is that of strong one. There are two clues to reach such a conclusion. First, as provided under Article 978 of Commercial Code, it is possible to extend suspension of payment back to two years. This period is too long and any transaction with this period may be invalidated. This is nothing other than to create equitability among creditors. Second, there are quite few transactions that are not subject to invalidation by way of exceptions. For instance, payment of debt in cash, extending security with in the period specified and others. Furthermore, the creditor is not entitled to raise defense like ordinary business transactions. This in turn shows firm policy justification to create equality of creditors.
The second policy justification is deterrence effect. The close reading of Article 1030 of the Commercial Code reveals that if the creditors transact knowing the debtor is insolvent, the transaction will be invalidated. Therefore, the intention of the creditor is required. This is why it is said to deterrence effect on creditors.
Also close look at Article 1029(b) of Commercial Code which regulate the debtor transferring something in bad faith i.e. with the intent either to flee his property or unduly favor for some creditors. Despite the fact that wording of the above mentioned Article does not say anything about bad faith of the debtor those very transactions envisage under the considering Article are presumed to be taken place with bad intent. If the debtor pays before due date, it is nothing but bad faith. This is called deterrence effect on debtor.
All in all, the policy justifications behind invalidation of suspect transaction under Ethiopian law are equitable treatment of creditors and deterrence effect on debtor and creditor(s).
There are lots of differences between invalidation of contracts and invalidation of transactions under bankruptcy law. The following are the basic differences:
However, the main effect of invalidation in bankruptcy is the recovery of assets and relegation of secured creditors in to unsecured creditors. The creditor who gets some form of benefit(s) from the bankruptcy debtor will be required to return it, which he will receive in pro rata with other creditors. Whereas, in the case of invalidation of security, the secured creditor becomes unsecured creditor hence he receives in pro rata in equality with other creditors. After invalidation of security, he is no more secured and his priority right is taken away.
There is a discrepancy between the Amharic version and its English counterpart. The Amharic version read as follow “….የመክፈያ ጊዜያቸው ከደረሰ በኋላ በጥሬ ገንዘብ ሳይሆን በንግድ ሰነዶች ወይም በባንክ በኩል በማስተላለፍ የተደረገ የዕዳ አከፋፈል ሁሉ….” whereas the English version states that "payment of debts is due otherwise than in cash, by negotiable instrument or by thing.”
The Amharic version gives the message that payment of due debts other than in cash will be invalidated. Whereas, the English version gives the message that payment of debt that are due either in cash, negotiable instrument or bank will be invalidated. Not only for the sole reason that in the case where there is a contradiction between the Amharic and English version the Amharic version prevails but also the Amharic version is realistic and in line with the purpose of the suspect transactions.
Terminologically, Article 1029(c) is narrow since it used the word "payment" in contradiction with transfer. The common usage and dictionary meaning of payment is to pay money to someone. However, transfer is broader.
The close reading of the article under consideration has two elements.
This is one of the most important provisions and citing the whole article may be relevant here.
"Other payment made by the debtor in respect of debts due and all acts for consideration entered in to by the debtor after the date of suspension of payment may be invalidated on the request of the trustees where the parties who have received payment or have dealt with the debtor did so knowing that suspension of payment has taken place." It is important to break down the element of this article so that the readers may understand the content of this article clearly as it contains many elements, indeed.
The type of situation envisaged here is that there is a preexisting contract for which no security was pledged, however, debtors latter on transfer security to his creditor. According to Article 1029 (d) securities set up on the property of the debtor in respect of debts contracted before the setting up of such securities, between fifteen days before the date of suspension of payment and the date of adjudication shall be invalid and shall not be affect the creditors of the bankrupt. (Emphasis supplied).
This provision gives a grace period for the debtor to give security for his debt however, if the security was given fifteen days before the suspension of payments and adjudication, it is seen through a very suspicious eye by the law.
This envisages the possibility whereby the effect of the contract between contractual parties is discrepant with effect of contract against third parties (perfection). As stated under Article 3052 of the Civil Code a mortgage however created shall not produce any effect except when it is entered in the registration. Therefore, registration is a necessary requirement for perfection. Article 1031 (1) puts the principle that rights arising out of securities in rem validly set up may be registered up to the date of adjudication. This sub-provision gives unfettered power for creditors to register their security interest.
The exception is provided under Article 1031 (2), registration effected after the suspension of payments or within one month before suspension may be invalidated where more than one month has elapsed between the act creating the security and the date of registration. (Emphasis supplied). According to this sub-provision both the date of concluding a contract and date of perfection are important. The effect of not registering a security is to relegate the secured creditor to the unsecured one.
Before winding up this section it is better to look in to how Art 1032 operates. Hence, this article operates with the assumption that there is more than one secured creditor in the same property and for any reason the first security is invalidated. Then by virtue of Article 1032, the estate of a bankrupt debtor will replace the first creditor and the remaining, if any, will go to the other secured creditor over the same property. Thus, unlike the ordinary security law, there is no windfall benefit accrued to second secured person.
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