Dead or Alive – Liquidation or Restructuring under the Hungarian Insolvency Law?

Contributed by Konrád Siegler and Tamás Simon
As a result of past low financing costs, over-leveraging of businesses, excessive securitization activity and relaxed lending standards, as well as the current scarcity of new financing, the level of bad debts in Hungary has been growing.  These developments have forced the government, lenders and other creditors to address the problem.
From a policy perspective, it is generally accepted that an effective insolvency law and a well-functioning, market-friendly regulatory regime have a major positive impact on the economy, as they are capable of saving companies experiencing temporary financial difficulties, and thereby saving businesses and jobs or – in the worse case – facilitating the quick liquidation of insolvent businesses and reducing the overall level of bad debt.
The three entries in this series will review the basic features of the Hungarian insolvency law, namely bankruptcy and liquidation proceedings, the two insolvency proceedings regulated by Act XLIX of 1991 on Bankruptcy Proceedings and the Liquidation Proceedings (the Hungarian Bankruptcy Code), as well as certain considerations for viable and workable re-organizations and work-outs under the current Hungarian legislation.
As discussed in more detail below, because of certain existing constraints in the Hungarian bankruptcy system, there have been very few cases in which a bankrupt Hungarian debtor successfully reorganized through an in-court bankruptcy proceeding, emerged from bankruptcy, and continued its operations.  Nearly all bankruptcies in Hungary end in liquidation.  This leaves private, negotiated work-outs of insolvent debtors as the only practical approach available to avoid liquidation in most cases.
The first entry in this series describes reorganization proceedings under Hungarian law.
Hungarian Bankruptcy
What is bankruptcy under the Hungarian Bankruptcy Code?
The Hungarian Bankruptcy Code defines bankruptcy as a proceeding in which a debtor is granted a temporary stay and is allowed to attempt to reach a composition agreement with its creditors in order to preserve or restore the debtor’s solvency.  A stay of 90 days is immediately and automatically granted to the debtor upon its application, provided that the application meets the formal requirements prescribed by the law.
Owner’s prior approval
Because one of the requirements for a successful application for a stay is proof that the members’ or shareholders’ meeting of the debtor has approved the initiation of the proceedings, creditors could be in a position to learn of the intended request for bankruptcy protection and may initiate liquidation proceedings before the prior approval at the members’ or shareholders’ meeting is obtained, thereby frustrating the commencement of bankruptcy proceedings and the granting of the stay.  This practical problem can arise, especially in the case of public companies limited by shares, where the invitation to the shareholders’ meeting, together with the agenda (which includes the proposal to approve the initiation of the bankruptcy), must be published prior to the meeting.  However, it may also arise in the case of closed companies limited by shares or limited liability companies with several owners because the articles of these companies typically provide for the publication of the invitation and the agenda of the owners’ meeting.  Even if the agenda of the meeting is not required to be published, one or more of the owners may initiate liquidation proceedings or disclose the information to a third party who, in turn, may initiate liquidation proceedings before the prior approval at the owners’ meeting is obtained.
A creditor is also entitled to initiate the bankruptcy of a debtor pursuant to the Hungarian Bankruptcy Code.  However, because – among other things – the prior approval at the owners’ meeting of the debtor also needs to be submitted together with a creditor’s application, in practice creditors cannot force a debtor into a bankruptcy proceeding against its will and without the cooperation of the owners of the debtor.
Once the stay is granted, the bankruptcy court issues a decision declaring the commencement of bankruptcy proceedings in respect of the debtor, which includes the appointment of the bankruptcy administrator and an invitation to the creditors to register their claims with the administrator within 30 days of the publication of the court’s decision.
The role of the bankruptcy administrator
The role of the bankruptcy administrator is to monitor the debtor’s business activities during the stay, with due regard to the creditors’ interests and with the objective of facilitating the conclusion of a composition agreement.  The administrator reviews the financial position of the debtor and its books, accounts and assets, assists the debtor in enforcing its claims vis-à-vis third parties, and registers the creditors’ claims.  Following the commencement of bankruptcy proceedings, the debtor may not undertake new obligations and make payments unless the administrator has previously approved them.   In the absence of such prior approval, the administrator may challenge such undertakings and payments.
During the stay, therefore, the rights and obligations of the debtor’s management are not suspended, but they may only be exercised and performed in cooperation with the bankruptcy administrator.
The purpose of the stay
The purpose of the stay is to suspend enforcement proceedings by creditors and preserve the assets of the debtor in bankruptcy until a composition agreement can be reached (or the stay expires).  During the stay, the debtor may not perform payment obligations that become due (other than salary-type payments and taxes), and creditors may not enforce their monetary claims and security interests (other than security deposits) or otherwise initiate or continue enforcement proceedings, and no set-off can be applied (with certain exceptions, including close-out netting).
Creditors’ meeting
Within 45 days of the start of the bankruptcy proceedings (i.e., the publication of the court’s decree ordering the commencement of the proceedings), the debtor will call a creditors’ meeting in order to attempt to agree on a composition agreement and/or extend the duration of the stay.  The stay may be extended to 180 days from the start of the proceedings by a simple majority of votes of both secured and unsecured creditors, and to 365 days by a two-thirds majority of such votes.  As a condition to extend the duration of the stay, the creditors may request that the administrator be granted a joint signatory right on behalf of the debtor, including the joint right of disposal over the bank accounts of the debtor.
In general, each creditor who has duly registered its claim with the administrator (i.e., within 30 days of the publication of the court’s decision declaring the commencement of the bankruptcy proceeding), paid the registration fee, and whose claim is recognized and uncontested will have one vote for each HUF 100,000 (approximately €330 or $430) of the claim at the creditors’ meeting.  Claims of controlling shareholders or controlled subsidiaries of the debtor (and certain other claims resulting from a guaranteed assignment by the debtor) have 1/4 of a vote for each HUF 100,000 of the claim.
Composition agreement
The composition agreement typically includes a reorganization plan aimed at restoring or preserving the debtor’s solvency, a rescheduling and/or forbearance of debt, as well as a conversion of debt into equity, provision of security by the debtor, and the implementation of the foregoing.  The agreement is reached if the simple majority of both secured and unsecured creditors vote for it and if, upon the application of the debtor, the bankruptcy court approves it.  The court will approve the composition agreement if it complies with the applicable statutory requirements (including that the composition agreement does not discriminate against non-participating or participating, but non-consenting, creditors), thereby concluding the bankruptcy proceedings.  The court-approved composition agreement is also binding on those creditors who did not vote for it (provided that they were properly notified of the bankruptcy proceedings) and also on those creditors whose claims were contested by the debtor.
A recent amendment to the Hungarian Bankruptcy Code appears to have clarified the position of creditors who did not register their claim within the 30-day deadline from the publication of the court’s decision opening the bankruptcy proceedings.  According to the new rules, the composition agreement is not binding upon such creditors; however, they cannot enforce their claims against the debtor unless a third party subsequently initiates liquidation proceedings against the debtor and the creditor’s claim is not yet time-barred.
Before this amendment, a composition agreement approved by a majority of creditors and the court did not prevent the non-participating creditors or creditors of contested claims from initiating a lawsuit subsequent to the composition agreement and claiming the award of the entire claim; such a rule weakened the binding nature of the composition agreement.  Obviously, if these creditors could sue after the approved composition agreement is entered into and realize a higher percentage of their claims than creditors of the same class that participated in the composition, then the bankruptcy proceedings and the implementation of the composition agreement could on occasion be successful.
Finally, if no composition agreement is reached with the creditors and approved by the court during the stay, then the court shall ex officio declare the debtor insolvent and initiate its liquidation.
New money problem – no DIP-type financing
A significant deterrent to successful bankruptcy reorganizations in Hungary is the so-called “new money problem.”  Financially troubled companies usually need liquidity.  However, the applicable rules in Hungary do not provide for DIP-type (i.e., debtor in possession) financing.  Exceptions to the “challengeable transactions” rules, discussed below, are needed to enable the providers of “new money” to benefit from additional, newly created security with “superpriority” in terms of satisfaction, without running the risk that such transactions and security will later be voided or not given the priority that the parties to the composition agreement and the reorganization plan intended.
Practically no successful bankruptcy reorganizations
Due to the constraints described above, there have been practically no bankruptcy proceedings in Hungary that did not eventually result in a liquidation.
One recent exception is the case of Vértesi Erőmű Zrt., a major Hungarian power generation company belonging to the group of the Hungarian state-owned electricity works, MVM Zrt.  In February of 2011, it managed to agree with its creditors on a reorganization plan in a bankruptcy proceeding. and the bankruptcy court eventually approved the related composition agreement.
This outcome resulted from a unique set of circumstances.  All secured creditors of Vértesi approved the composition agreement, as did 90% of unsecured creditors.  However, MVM Zrt. was the only secured creditor, and the Hungarian State was also a significant debt holder among the unsecured creditors.  Vértesi, which owed a total of HUF 20 billion (approximately €67 million or $87 million) to creditors, agreed to pay 30% of its unsecured debt.  Also, as part of the reorganization plan, MVM Zrt. will provide a three-year, HUF 4 billion (approximately €13.3 million or $17.3 million) loan to Vértesi in order to facilitate debt payments.  The availability of such financing was an essential element of the plan and was exceptional in that it is being provided by a state-owned parent company.
As mentioned above, DIP-type financing is generally not available in Hungary.
The Vértesi bankruptcy procedure should also be distinguished from other more ordinary procedures, as the largest creditor is a state-owned company with the capability of using its political influence to persuade other creditors.  Further, the survival of the debtor company’s core business largely depends on state subsidies.
The next entry in this series will discuss liquidations under Hungarian law.