CZECH REPUBLIC: An Introduction to Restructuring/Insolvency

The Czech insolvency market has recently experienced significant changes as a result of the adoption of new legislation. This article aims to provide a closer look at these legislative innovations, which may set new trends in the field of insolvency.

Will Preventive Restructuring Be the New Trend?

Preventive restructuring procedures are a “new” trend on the EU legal playing field aimed at “contributing to the proper functioning of the internal market” by helping companies restructure in ways that prevent bankruptcy. The minimum standards have been set in EU Directive 2019/1023, on preventive restructuring frameworks, adopted on 20 June 2019 (hereinafter the “Directive”). The Czech Republic transposed the Directive into the legal system by Act No. 284/2023 Coll., on Preventive Restructuring (hereinafter the “APR”), which came into force on 23 September 2023.

The main aim of the Directive, and therefore the APR, is to prevent defaults that generally yield low percentages of debt recovery, and help enterprises experiencing financial difficulties to overcome their challenges and continue operating. This, in turn, would also mean that creditors would have a better chance of having their receivables paid. The recovery rates in Czech bankruptcy cases are very low, usually only a few percent. Company management most often resolves the adverse financial situation of their companies too late, which significantly reduces the prospect of financial recovery. Research done by the Prague University of Economics and Business found that companies that had fallen into bankruptcy had been struggling with significant financial problems for the last three years.

The Directive therefore establishes the need for an Early Warning System and, correspondingly, the Czech Republic has launched a web application called “Financial Health”, which is designed to help especially small and medium-sized entrepreneurs, who often do not have the necessary resources to assess their financial viability and the functioning of their companies, to identify negative trends in their business in time to adopt remedial measures. The algorithm used by the application evaluates tens of financial indicators in order to determine the probability of financial distress. The application is freely accessible, anonymous and does not store entered data, so it can be used without concern.

Before the introduction of the APR, any preventive restructuring depended on reaching an agreement between the distressed company and its creditors. Not all creditors, however, were keen on debt leniency agreements. In the event that a company's financial problems could not be resolved by agreement, there was no other option than to initiate formal and, importantly, public insolvency proceedings, which are governed by strict rules (including procedural) and usually last for several years, leaving the debtor only limited options to enact their ideas for resolving the insolvency situation.

Thus, the new legislation introduces a new preventive restructuring procedure, whose main advantages are the possibility to negotiate with only selected creditors and the non-public process. Additionally, a general moratorium can be issued for a cumulative period of up to six months, during which creditors are prevented from filing an insolvency petition, which provides the debtor with time for negotiation. Provided that the resultant restructuring plan is supported by the required majority of creditors and approved by the court, it also becomes binding on dissenting creditors (“cross-class cram-down”).

Another quite innovative option that was introduced by the APR is the possibility to condition the conclusion of a standstill agreement between a distressed company and its creditor(s) with changes to be made in the company's elected bodies, without the creditor being considered or becoming a controlling person of the debtor. This will certainly be appreciated especially by banks, which will be able to influence the management of such debtor companies without exposing themselves to the risk of compensation under the regulation on controlling persons. Under these conditions, banks are significantly more likely to support a preventive restructuring, as an independent and open-minded “crisis manager” can better assess the company's operations, determine its objective economic condition and the real causes of its financial problems.

Since the APR has come into force, it was only 3 months before the first company filed a petition to issue a general moratorium and initiate restructuring proceedings, namely the largest metallurgical and steel company in the Czech Republic with outstanding liabilities of around EUR 200 million. Although a restructuring plan was successfully negotiated and received massive support from the creditors, only few months later the company failed to fulfil the plan and was forced to file an insolvency petition and start insolvency proceedings. This series of events raised doubts about the honesty of the company's original intention and its ability to have realized the proposed restructuring. This case will surely shape the forthcoming case law and only time will tell if the new institute will fulfil its intended purpose.

Government Favours the Insolvent

In conjunction with the preventive restructuring regulation, a further amendment to the Insolvency Act has recently been implemented following the adoption of the Directive. This amendment, like those preceding it, favours debtors over creditors.

The Directive requires that honest insolvent or over-indebted entrepreneurs can be able to be fully discharged from their debts incurred in the course of their business after a reasonable period of time that does not exceed three years, thereby allowing them a second chance and a fresh start. Accordingly, the discharge period under Czech law was shortened from five to three years. However, the Czech government has decided to apply this shortened discharge period not only to entrepreneurs, but also to natural persons who are not entrepreneurs and whose debts do not originate from business (ie consumers). As a counterweight to the shortening of the discharge period, debtors are expected to more tightly cooperate with the insolvency courts and the Labour Office, thoroughly report their incomes and strictly comply with the insolvency calendar.

Requirements have also been eased in relation to the conditions for obtaining a full discharge of debt, iecancellation of the outstanding dischargeable debts. In the past, one needed to pay at least 30% of their debts in order to be discharged from the outstanding portion. This requirement was removed by the aforementioned amendment, which, instead, only vaguely states that the necessary level of satisfaction of creditors' claims will be determined by the court, taking into account the debtor's financial circumstances, efforts and cooperation. This means that courts can grant a full discharge of debt after the shortened three-year period has expired even if the rate of satisfaction of the creditors' claims is very low, in fact anything above zero.

These changes were not received well by the expert public, especially in relation to natural persons who are not entrepreneurs as those do not fall under the scope of the Directive. Proponents argue that over-indebted people will get a second chance to get out of the debt trap faster and back into the legal economy. According to critics, though, this shortening of the discharge period in conjunction with the relaxation of other conditions for a full discharge of debt will disproportionately worsen the position of creditors, as the recovery rates will likely be reduced significantly. Many critics view this legal amendment as a significant legitimisation of the failure to meet one's obligations.