Theory and practice of enforcing and satisfying priority claims in bankruptcy proceedings

Generally speaking, regarding priority claims. Insolvency proceedings deal with the satisfaction of creditors' claims at a time when the assets do not provide sufficient liquidity to satisfy all claims. The legislator sets rules according to which creditors' claims are satisfied, but not all claims will be satisfied in full. Along with this assumption, in most jurisdictions, the legislator (for various reasons) establishes the priority of certain types of claims over others, thereby essentially denying the principle of par conditio creditorum.

This article describes the procedure for enforcing and satisfying priority claims in insolvency proceedings and the problematic aspects associated with this, whereby priority claims are understood to mean unsecured claims that are satisfied before other unsecured claims. Within the framework of Czech law, the application and satisfaction of priority claims will be analyzed from the perspective of bankruptcy as one of the ways of resolving a debtor's insolvency.

Priority claims derive their status from legislation. Garrido believes that they are a political tool and that each specific group of creditors puts pressure on the government to obtain a more advantageous position in insolvency proceedings. [2] Garrido defines creditors of priority claims as creditors who have a statutory right to obtain a position ahead of creditors of unsecured claims. [3] The legal regulation of priority claims, or rather the range of claims falling under this category, is regulated differently by the legal systems of individual states, which Gropper considers an obstacle to any unification on an international (or federal) scale. [4] Garrido even considers the different national regulations on priority claims to be the biggest obstacle to the harmonization of insolvency law in European Union law. [5] Nevertheless, there are overlaps in the legal regulations of different countries in the area of priority claims. Ziegel identifies two significant groups, namely employee claims and state claims in the area of taxes. [6] The debtor's employees are involuntary creditors (unlike, for example, lending banks), often have no participation in their employer's bankruptcy, are unable to effectively defend themselves against their employer's bankruptcy (e.g., by establishing a lien to secure their claim), and are generally unable to diversify the risk among their multiple debtors; it is therefore reasonable to give employees priority status in insolvency proceedings. According to Eastby, employees are protected by prioritization in almost every insolvency proceeding. [7] For tax claims of the state, the argument is used that the state is responsible for the public budget and its revenues, and it is therefore appropriate to give priority to the general interest of all citizens concentrated in the hands of the state. Heath adds and describes two further groups, namely (i) claims arising from costs incurred in connection with the conduct of the insolvency proceedings themselves and (ii) a summary group of claims to which priority status has been enshrined in law for various reasons. [8] Claims arising from the costs of insolvency proceedings are given priority because they enable controlled supervision of the maximisation of the value of the debtor's assets, where these costs serve to maintain, preserve and increase the value of the debtor's assets. [9]

Procedure for enforcing and satisfying priority claims

Czech legislation implemented by Act No. 182/2006 Coll., on Bankruptcy and Methods of its Resolution (hereinafter the “Insolvency Act”) regulates priority claims in particular in Sections 168 and 169. Within these provisions, in the third paragraph and the second paragraph, respectively, the legislator assumes that priority claims are satisfied in full at any time after the decision on bankruptcy.

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The entitled person shall assert the priority claim in accordance with the provisions of Section 203(1) of the Insolvency Act against the person with the right of disposal, which in the case of bankruptcy is the insolvency administrator. [10] The person with the right of disposal shall then satisfy the claim on the due date from the assets of the estate. [11] However, if the priority claim is not satisfied, the creditor must pay special attention to the limitation period and, if necessary, file a lawsuit in accordance with the provisions of Section 203(4) of the Insolvency Act, as the assertion of the claim against the person with the right of disposal has no effect on the limitation period.

The problematic aspect of satisfying priority claims over time

A problematic aspect of satisfying priority claims in insolvency proceedings may be the fact that, although the insolvency administrator does not question the nature of the claim asserted by the creditor, he does not satisfy such a claim from the assets of the estate. The most common argument used is that there are doubts as to whether the assets of the estate will be sufficient to satisfy other priority claims arising, for example, in the future, if the priority claim asserted were to be satisfied in full.

Priority claims may arise on the basis of the insolvency administrator's own actions, for the payment of which the insolvency administrator is specifically responsible under Section 37(3) of the Insolvency Act. Priority claims may also arise on the basis of the debtor's actions. Not all priority claims have the same real significance for the estate, as some may be related to the operation of the debtor's business, and the payment of which therefore contributes to the preservation of the debtor's business, or, conversely, these claims are not related to the operation of the debtor's business, and their payment is not significant for the preservation of the debtor's business, and their fulfillment does not expand the debtor's estate. [12]

However, the insolvency administrator cannot proceed with the satisfaction of priority claims in isolation without taking into account the basic principles governing insolvency proceedings and other provisions of the Insolvency Act.

If the insolvency administrator does not pay the priority claims of creditors in full and within the due date, the creditors of these claims are entitled, pursuant to Section 203(4) of the Insolvency Act, to seek their satisfaction by bringing an action against the insolvency administrator. Since this is not an incidental dispute, the proceedings for the payment of the priority claim are conducted before a general court[13]. At the same time, the insolvency administrator is exposed to the risk of failure in the case, and the plaintiff creditor may be awarded a judgment that will be paid from the estate, thereby incurring additional costs to the estate. [14]

Once the general court's decision on the action becomes final, the insolvency court will set a deadline for the satisfaction of the claim and will also decide which part of the estate is to be used to pay the claim. The insolvency court will only decide on a motion filed by either the insolvency administrator or an entitled person, i.e., a creditor. In this way, the priority claims of creditors could be satisfied even at a time when the insolvency administrator, due to the continuing lack of necessary information regarding the total amount of priority claims and the amount of proceeds from the liquidation of the estate, did not proceed to satisfy them in the amount and manner specified in the decision of the insolvency court. In practice, it is not unusual for priority claims not to be satisfied on the due dates as provided for in the Insolvency Act. The letter of the Insolvency Act is therefore not reflected in the practice of insolvency proceedings.

With regard to the basic principles of insolvency proceedings, the insolvency administrator is obliged to ensure the proportional satisfaction of creditors whose claims are satisfied within the same group of claims; this also applies to creditors of priority claims. If the proceeds from the liquidation of the estate are insufficient to cover priority claims, pursuant to Section 297(1) of the Insolvency Act, funds obtained as an advance payment for the costs of insolvency proceedings[15] and an advance payment provided by the creditors' committee may also be used to cover the priority claims specified therein.

If, even after using the above-mentioned advances, not all priority claims are satisfied, it is necessary to pay the outstanding priority claims according to the priority and order of the individual groups of priority claims specified in Section 305(2) of the Insolvency Act.

The insolvency court is entitled to decide on the order or proportional payment of individual unpaid priority claims at the request of the insolvency administrator pursuant to Section 297(2) in conjunction with Section 305(2) of the Insolvency Act. It follows from the case law of the Supreme Court[16] that the insolvency court may only issue a decision on the order of payment or proportional payment of priority claims pursuant to Section 297(2) of the Insolvency Act after the final report of the insolvency administrator has been approved. Pursuant to Section 302(2)(a) of the Insolvency Act, this report must contain information on which priority claims have been satisfied and which remain to be satisfied, or when and how the insolvency administrator intends to satisfy them. Creditors of priority claims may therefore have to wait a very long time for their claims to be satisfied, which is not always certain.

The Insolvency Act thus regulates the procedure of the insolvency administrator in a situation where not all priority claims can be paid, explicitly only for the end of the insolvency proceedings, but it is completely silent on how the insolvency administrator should proceed in the event of doubts that not all priority claims will be paid during the insolvency proceedings, and it does not regulate the specific situation where the insolvency administrator continues to operate the debtor's business and expects further income from the operation and liquidation of this business. The insolvency administrator is entitled and obliged to pay priority claims during the insolvency proceedings without the need for the consent or other decision of the insolvency court. It is therefore entirely the responsibility of the insolvency administrator to decide which priority claims and in what amount will be satisfied during the insolvency proceedings. However, the limits of his discretion are not specified. Therefore, if a certain priority claim is given preference over other claims that are qualitatively the same from the perspective of the Insolvency Act, the insolvency administrator bears the risk of not satisfying claims of the same type proportionally, despite the fact that such action will be beneficial to the estate as a whole. According to Section 36(1), last sentence, of the Insolvency Act, the insolvency administrator is obliged to give priority to the common interest of creditors over his own interests or the interests of other third parties. According to Section 2(j) of the Insolvency Act, the common interest of creditors means an interest that takes precedence over the interests of individual creditors, the aim of which is to achieve the most profitable way of resolving the debtor's insolvency.

According to Žižlavský[17], a situation where individual creditors or groups of creditors have different interests does not relieve the insolvency administrator of the obligation to seek and fulfill the common interest of creditors. Ševčík[18] states that the operation and maintenance of the debtor's business is in the common interest of creditors, to which the particular interests of individual creditors must give way. Ševčík[19] further states that it is clear that certain supplies and services are essential to ensure the continued operation of the business (he cites energy, raw materials, and fuel as examples), and that failure to pay these key costs jeopardizes the continued functioning of the business and may lead to the end of the plant's operation in a short period of time. As mentioned above, maintaining the debtor's plant in operation may be in the common interest of all creditors, and failure to ensure its continued operation would therefore lead to a failure to fulfill this common basis.

Based on the assumption of the existence of key claims, Ševčík concludes that claims arising from the delivery or provision of key services and supplies (where the assessment of which supplies and services are key lies solely with the insolvency administrator) can be paid promptly and as a priority over other claims that are also in the same group of priority claims, but whose non-payment in the short term does not jeopardize the continued operation of the business.

In connection with this argument, Ševčík also criticizes the blind promotion of the principle of creditor equality to the detriment of the principle of fulfilling the common interest of creditors and the principle of maximum satisfaction of creditors. According to Ševčík, however, the limit of the prioritization of certain claims is the “reasonable” assumption of the insolvency administrator that claims of the same rank will ultimately be paid in full or at least to the same extent.

De lege ferenda

If it is not clear that the proceeds from the liquidation of the estate will guarantee the satisfaction of all priority claims, the insolvency administrator will, from a practical point of view, tend to refrain from satisfying priority claims on an ongoing basis and propose their (even full) satisfaction only in the final report. Such an approach will not comply with the ongoing satisfaction required by the Insolvency Act, but the insolvency administrator will not be exposed to the risk of liability for the payment of a priority claim that should not have been satisfied in the final determination.

Theoretically, it is also possible to consider a different approach to the satisfaction of priority claims, with inspiration provided by the Insolvency Act itself. According to Section 168(2)(a) of the Insolvency Act, priority claims also include cash expenses and the insolvency administrator's remuneration. According to Section 38(4) of the Insolvency Act, the insolvency court may grant an advance payment for this claim in the course of ongoing insolvency proceedings. The final remuneration and cash expenses of the insolvency administrator are only known in the final phase of the insolvency proceedings, when they are summarized in the final report. If, during the insolvency proceedings, the insolvency administrator was granted an advance payment in excess of his final remuneration and cash expenses, he is obliged to return the difference to the estate.

If other priority claims could also be paid to creditors in advance, this would reduce the insolvency administrator's uncertainty regarding priority claims that have already been satisfied but which ultimately turn out not to have been satisfied at all because the proceeds did not “reach” their group. On the other hand, the creditor would not have to wait until the final stage of the insolvency proceedings, or would not have to file a lawsuit for payment, and could continue to dispose of the funds at the time of the advance payment. On the other hand, a certain risk associated with such a proposal can certainly be found in the morality (or objective possibility[20]) of returning advances already paid on priority claims at the moment when it is determined that the creditor should not have been satisfied. It is therefore difficult to assess without further analysis whether such an approach would solve the problem of current practice, i.e., the ongoing non-satisfaction of priority claims, without causing other problematic aspects of advance payment of the proceeds of the estate without certainty of its return if necessary.

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