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Principles of Bankruptcy

Published on: Tue, 2014-01-14 10:20

Principles of Bankruptcy

  1. Cardinal Principles

The cardinal principles are general principles from which all the subsidiary rules and principles of bankruptcy emanate. They are like constitutional principles from which all the bye-laws originate.

Principle I: Pre-liquidation rights shall be respected:

All the rights of individuals who acquired a right against the debtor before the latter is declared bankrupt shall be respected. Even if the debtor is declared bankrupt, the person who acquired a right before the date of declaration of such bankruptcy should not be affected. In other words, the fact that the debtor is declared bankrupt should not affect the rights of a person who is already entitled to a right before the date of declaration of bankruptcy. The person could be either the creditor of the debtor or otherwise. Declaration of bankruptcy does not affect the rights and remedies of those who own property in the possession of the debtor or who hold a security interest over all or any of his assets. For instance, assume that Ato Mogese is a debtor who failed to pay the debt he owes to his creditors. Because of fulfillment of the requirements, Ato Mogese was declared bankrupt on September 5, 2004. On August 5, 2004 Ato Mogese sold his car to W/ro Ayalnesh. The title of document was not handed over to W/ro Ayalnesh till the date of declaration of bankruptcy of Ato Mogese. In this case, even if the title of document is not yet transferred to W/ro Ayalnesh on the date of declaration of bankruptcy of Ato Mogese, the right of the former over the car would not be affected. W/ro Ayalnesh acquired the right on the date of conclusion of the contract of sale of the car. Therefore, it would not be legal to refuse to transfer the car to the buyer because of the fact that the seller is declared bankrupt before transferring the car.

Do you think that the above discussed principle is without exception? I am sure that your answer would be “No”. If you answered so, it is correct. You see, there are two important exceptions to the principle. The first is the case of undervalued transaction. Even if the third party has acquired the right before the date of declaration of bankruptcy of the debtor, where the right is acquired as a result of undervalued transaction, then the right shall not be respected. For example, assume that Ato Bogale is a debtor who could not pay his debts towards his creditors and as a result declared bankrupt on October 10, 2004. A month before the date of the declaration of bankruptcy, Ato Bogale sold his machinery to W/ro Meselech. The machinery was one he was using in his factory for the production of goods for sale. The market price of the machinery was 80,000 Birr, but Ato Bogale sold it for a price of 30,000 Birr. In this case, even if W/ro Meselech acquired the right over the machinery before the date of declaration of bankruptcy of Ato Bogale, her right would not be respected. This is because she acquired the right as a result of undervalued transaction. While the market value of the machinery is 80,000 Birr, Ato Bogale sold it for a price of only 30,000 Birr, which is very much lower than the market price. As the transaction is undervalued, W/ro Meselech would not succeed in claiming the right over the machinery. The assumption here is that the debtor entered in such undervalued transaction with the view to affect the interest of the creditors. In other words, it is presumed that the debtor, knowing that he would be declared bankrupt and the properties are going to be attached, he deliberately entered in such undervalued transaction with the view of getting the property sold and converted into money. Note, however, here that the presumption is irrebutable one. In this relation you may also refer the provisions of Article 1995 and 1996 of the Civil Code, which read as follows:

Article. 1995- Debtor’s fraud

A creditor may, in his own name, challenge the validity of acts whereby the debtor, in fraud of the creditor’s rights alienated property or entered into obligations.

Article. 1996- Fraudulent acts

(1) An act shall be deemed to have been done in fraud of the rights of creditors where it was done by the debtor so as to become insolvent, or with the knowledge that he was thereby increasing his insolvency.

(2) The payment of mature debts may not be challenged by the creditors.

The second exception to the principle is that where the right is acquired as a result of improper preference to a creditor. Basically the principle under bankruptcy law is equality of creditors. As a result, it would not be proper if the debtor gives improper preference to one or more of the creditors. If that happens, even if the right is acquired before the date of the declaration of bankruptcy of the debtor, it shall not be respected. For example, assume that Ato Dawit could not pay his debts towards the debtors and as a result declared bankrupt on January 1, 2005. There were four creditors (Abera, Addisu, Gete, and Fanaye) who claim debt from Ato Dawit. Two weeks before the date of declaration of his bankruptcy, Ato Dawit concluded a contract of donation with one of his creditors, i.e., Gete. The debt of all the creditors is due and all of them were to demand payment from Ato Dawit. In this case, the creditor for was benefit the contract of donation is concluded (Gete) acquired the right as a result of improper preference. While he was nor doing was the same favor to the other creditors, Dawit improperly gave preference to that creditor. The assumption here is that had the thing given through donation not been given solely to one of the creditors, it would have been available for the benefit of all the creditors. But as a result of the preference, it is only the creditor to whose benefit the donation is made (i.e. Gete) that gets benefit of it.  Therefore, the right of Gete would not be respected even if it was acquired before the date of declaration of bankruptcy of Ato Dawit.

Principle II: Only the properties over which the debtor has interest are caught:

There may be different properties under the possession of the debtor on the date of declaration of bankruptcy. Some of them may belong to the debtor himself and others belong to another person. The debtor might have received the properties belonging to other persons either on hire, bailment or other reasons. As a result of declaration of bankruptcy, the properties of the debtor are to be attached and realized for the benefit of the creditors. Assets are available for distribution among creditors only to the extent that the debtor has or acquires a beneficial interest in them. Property in the possession of the debtor, but belonging to another is returnable to its owner, subject to any right which the debtor may have to keep in his possession (e.g. under a lease). This is not an asset available for distribution to creditors. Even if they are under possession of the debtor on the day of declaration of bankruptcy, the properties which belong to other persons should not be the subject of attachment and realization. In other words, it is only the properties over which the debtor has interest that have to be attached. For example, assume that W/ro Tsehay is a debtor who could not pay her debts towards her creditors and as a result declared bankrupt. On the date of declaration of bankruptcy, W/ro Tsehay possessed a refrigerator which belongs to Ato Zegeye. The refrigerator was possessed because of contract of pledge between Zegeye and Tsehay. In this case, the refrigerator shall not be considered as the property of W/ro Tsehay and be the subject of attachment. Rather it has to be given to Ato Zegeye, subject to the rights to which W/ro Tsehay is entitled against Zegeye. 

What type of interest of the debtor do you think is to be considered? Did you answer “rights of ownership?” If your answer is so, that is correct. As we have seen earlier, the debtor may become possessor of properties belonging to other persons because of different reasons. He may become possessor because of pledge, mortgage, usufruct, bailment, etc. Where the possession is as a result of relationships other than those entitling to ownership, the rights of the real owner shall not be affected by the fact that the debtor is declared bankrupt. But where the debtor has acquired possession of the property as a result of a legal relationship that confers him the right of ownership, such property would be the subject of attachment and be realized for the benefit of the creditors.

To the rule that the trustee can take only assets belonging to the debtor at the date of commencement of the bankruptcy or acquired by the debtor thereafter, there are two principal statutory exceptions:

  1. The assets available to the general body of creditors may be swelled by the amount of payments or transfers made by the debtor before declaration of bankruptcy under a transaction which is void or voidable at the instance of the liquidation. Where the debtor has already made payments to persons entitled before the debt of declaration of his bankruptcy, that payment affects the assets available to the creditors. Where the debtor has already transferred certain properties belonging to him before the date of his declaration, still this affects the assets available for the general body of creditors. The trustee, representing the estate, takes what is available at the beginning of the bankruptcy proceedings. This is with the deduction of those payments or transfers made before the date of declaration of his bankruptcy.
  2. In a compulsory bankruptcy, all dispositions of the debtor’s property made after the presentation of the bankruptcy petition are void unless authorized or ratified by the court. The fact that a petition to the bankruptcy of the debtor could not prevent the debtor from entering into different transactions. The debtor may dispose his properties though an application to his declaration of bankruptcy is already presented. Such disposition of the properties of the debtor would be valid only where there is court authorization. In the absence of court authorization or ratification of the disposal already made to the properties of the debtor, the transaction would be void. But where the court has ratified the disposition or has authorized for such disposition, the trustees take what remains after such disposition. 

Principle III: Personal Rights would be converted into rights of proof

One of the important principles of bankruptcy law is that all the creditors shall stand at equal footing without any discrimination. In other words, all the creditors are expected to compete to get a certain portion from the proceeds of sale of the properties of the debtor. In order to compete, all the creditors are expected to prove their respective rights before the responsible bodies. Even if the debtor admits that he is indebted to a certain creditor, after the declaration of his bankruptcy, there would be no way to get the right without passing through the process of proving his claim. For example, assume that Ato Kebede is a debtor who is declared bankrupt because he could not pay his debts towards his creditors. After the declaration of bankruptcy, one of the creditors approached the debtor and claimed payment of the whole or part of his claim from the debtor. In this case, the debtor cannot pay to the creditor because all his properties are administered by other persons.

In order for the creditor to get payment, he shall enter the procedure of proving his claim just like the other creditors. Had the debtor not been declared bankrupt, the creditor would have got payment without going into the procedure of proving debts. It would have been possible for the creditor to personally approach the debtor and satisfy his claim. On the part of the debtor, it is also possible to admit that he is indebted to the creditor and pay the whole or part of the debt he owes to the creditor. Generally, it is a cardinal principle of bankruptcy that purely personal rights against the debtor, whether to money, property or the performance of services, ceases to be exercisable by action and become converted into rights to prove in competition with other unsecured creditors. This characteristic marks off real rights from personal rights. The former are in principle unaffected by the bankruptcy process, for the trustee takes subject to them; by contrast, bankruptcy puts an end to a creditor’s ability to enforce purely personal rights of an individual unsecured creditor to a share in realization of assets.      

IV. The unsecured creditors get pari pasu distribution

It is an underlying principle that the unsecured creditors rank pari pasu and are thus entitled to a dividend proportionate to their respective claims. As you know unsecured creditors are those creditors who held nothing in security that guarantee performance of the obligations by the debtor. The antithesis of unsecured creditors is secured creditors. The refers to those creditors who took possession of a certain property or the title to ownership of properties with the view of assuring performance of obligations by the debtor.

The overall objective of the bankruptcy proceeding is to collect the properties of the debtor and realize them for the satisfaction of the claim of creditors. In the process, those creditors who are secured would satisfy their claims from the property at their hand. As a result, it is the unsecured creditors who compete to get a certain share from the proceeds of sale of the properties of the debtor. In the process of distribution, each of the unsecured creditors could not get what he claimed. Rather the proceeds of sale, after certain expenses such as administration costs and the costs of carrying out the bankruptcy proceeding are deducted, would be distributed among the unsecured creditors based up on their claims.

What do you understand by pari pasu distribution? Did you answer saying, “it refers to proportionate distribution”? If your answer is so, that is great. It is distribution of the proceeds of sale of the properties of the debtor based upon the claim of each creditor. For instance, Ato Menbere is a debtor who is declared bankrupt for he failed to pay his debts towards the creditors. After all expenses are deducted, the proceeds from the sale of the properties of the debtor was 100,000 Birr. There were three creditors who proved their debts and claimed from Ato Menbere. One of the creditors, Ato Tesfu, claimed 30,000; the second creditor, W/ro Tizita, claimed 50,000 Birr; and the third creditor, Ato Geleta, claimed 100,000 Birr. In this case the claim of the creditors and the proceeds of sale of the properties of the debtor are not compatible. Therefore, what is available after sale has to be distributed proportionately among the three creditors in proportion to the claim of each creditor.         

The principle of pari pasu distribution, which has been the feature of bankruptcy law, is often diminished because of certain reasons. First and foremost by the extensive range of security rights and analogous devices that have evolved over the years. As a result of development, creditors usually get a certain kind of security to guarantee the debtor’s discharge of his duties. The existence of such securities enables the creditors to satisfy their claims from the securities in their hands. As a result, no competition would be with the other creditors for the proceeds of sale of properties of the debtor. Second, by the massive expansion of the range of debts made preferential by laws. Different laws recognize certain debts to be preferential and therefore the creditor would have preferential right against the debtor. In such cases, it is the other creditors, who are neither secured nor preferred, that compete for proportionate distribution of the proceeds of sale of properties of the debtor. 

Do you agree that creditors who acquire a right after declaration of the debtor’s bankruptcy are also entitled to pari pasu distribution? Did you answer “No?” If so, you are correct. The principle of proportionate distribution applies only in relation to unsecured creditors who acquired a right before the declaration of bankruptcy. As we have discussed earlier, it is pre-liquidation rights that are to be respected. Those creditors who become creditors as the result of contract entered into by the trustee/liquidator are entitled to have their claims treated as expenses of the bankruptcy process and paid out of the assets in priority even to the claims of preferential creditors. For example, assume that Ato Tadesse is the debtor who is declared bankrupt on June 1, 2005. Before his declaration of bankruptcy there were four creditors to whom he is indebted. On declaration of his bankruptcy, W/ro Yodit was appointed as trustee to carry out the bankruptcy proceeding. With the view of carrying out the bankruptcy process, W/ro Yodit entered into a contract for the hire of a warehouse belonging to Ato Kebede. In the contract, it was agreed that Ato Kebede was entitled to the payment of 40,000 for the service he renders and the money would be paid after a month. In this case, even if he acquired the right after the declaration of bankruptcy of Tadesse, Kebede’s claim would be paid in priority to the other creditors. The four unsecured creditors would get proportionate distribution of the proceeds from the sale of properties of the debtor. In other words, the proportionate distribution does not apply as regards the claims of Ato Kebede.   

The rationale behind such a priority is that to enable the trustee/liquidator or the commissioners obtain goods or services during the bankruptcy process. Where there is no such a distinct right the bankruptcy proceeding would not be carried out properly and speedily. No one would be willing to enter into transactions with a person or the representative of a person who is already declared bankrupt. But where one knows that he will be entitled to priority right in the distribution and not to compete for proportionate but full payment of his claims, then he would be encouraged to enter into transactions that can facilitate the bankruptcy process. In the above given example, had Kebede known that he would compete with the other unsecured creditors for pari pasu distribution, he would not have entered in such a transaction. As a result of the pari pasu distribution he would have got less than what he claimed (less than 40,000), while the priority right entitles him for the full amount he claims. 

Do you accept that there could be instances where the pre-liquidation creditors can get priority right? If you answered “Yes”, that is correct. Even pre-liquidation creditors will be able to jump the queue where the trustee is dependent on their continuing to supply goods or services and they make it a condition that existing debts must first be paid. In such a case, the liquidator is entitled to pay the pre-liquidation claims in question as being expenses of the liquidation necessary to preserve the debtor’s business or its other assets. For example, assume that Ato Debalke is the debtor who is declared bankrupt for he could not pay his debts to the creditors. Before his declaration of bankruptcy, he concluded a contract for the supply of a raw material with W/ro Yemisrach. The latter used to supply the agreed quantity of raw material to the factory of Ato Debalke. After the declaration of bankruptcy of Ato Debalke, the court ordered for the continuity of the business for justifiable reasons. For the business to continue, it is necessary that the raw material continues to be supplied. As a result, the trustee is to continue the relationship with W/ro Yemisrach. In case Yemisrach demands prior payment of the debts due and not yet paid before the declaration of bankruptcy, the trustee can pay in priority to other unsecured creditors. It is necessary to facilitate the bankruptcy process and therefore, W/ro Yemisrach is entitled to get payment in priority. 

  1. Subsidiary Principles

The following subsidiary principles buttress the above mentioned cardinal principles.

  • Contracts entered into by the debtor before liquidation remain in force until disclaimed

Before the adjudication of bankruptcy, the debtor is as free as any other person. As a result, he can enter into different contracts by which he may be creditor or debtor. Where he becomes creditor as a consequence of a contract entered before the date of declaration of his bankruptcy, the trustees can claim the right from the debtor of such contract during the bankruptcy proceedings. In other words, for the mere reason that the creditor is declared bankrupt the debtors of such contract could not refuse to discharge the obligations arising from the contract. Where he becomes debtor of the contract, the creditor of such contract can participate in the bankruptcy proceedings by proving his claims like any other creditor. Therefore, the principle is that the contract would not terminate as a consequence of declaration of bankruptcy of one of the parties. But where the contract is disclaimed, it shall not remain in force.

  • On liquidation, the debtor ceases to be the beneficial owner of its assets

As you know, liquidation involves the realization of assets of a person into money. The process of liquidation is to be carried out not by the person found to be a debtor by another neutral person. In the case of bankruptcy, liquidation is to be carried out by the trustees. It is obvious that the trustees are not the owners of the properties belonging to the bankrupt person. In principle, it is the owner who can transfer valid title to another person. During liquidation, therefore, in principle the trustees could not transfer a valid title. Since one cannot transfer what he does not have, the debtor ceases to be the beneficial owner of the assets. In effect, by operation of the law, the ownership right is conferred on the trustees and as a result the debtor loses such right.

  • No unsecured creditor has any interest in specie in the debtor’s assets or realization

Basically, the right of unsecured creditors is a right in personem, and it is not a right in rem. In other words, the unsecured creditors have a right against the debtor, but not against the properties of the debtor. As their right is a right against the debtor and not against the assets, they cannot claim to take the properties of the debtor in distribution. Nor can they claim to participate in the realization of the properties of the debtor. What normally they are entitled to is to get distribution of the proceeds of sale of the properties of the debtor. To this effect, the properties of the debtor have to be identified and realized by a neutral body of persons, usually the commissioner and the trustees. Where the assets are not sufficient to cover the claims of creditors not secured, they are to get proportional distribution of the proceeds of sale. But as regards secured creditors, since they hold either movable or immovable properties belonging to the debtor, they have a right and interest in specie in those properties or the realization of such properties. 

 



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