The Czech Law of Business Charges: A View from the World of Theory and Practice of Debt Financing

As M. Jensen and W. Meckling have shown, debt financing gives rise to agency costs. Through the contracting process in the credit market, creditors force debtors to internalise those costs by charging an increased interest rate. Debtors therefore have an incentive to minimise the agency problems embedded in the credit relationship. According to E. Berglof, debtors have two principal ways of convincing creditors that agency problems will be kept in check: they can part (in favour of the creditors) with control over their investment decisions, or with ownership title to their assets. The first approach, also called control-oriented financing, usually takes the form of various affirmative and negative covenants in loan or bond documentation. The second approach, also called arm's-length financing, takes the form of creating security interests over the debtor's assets. In an ideal world, a charge over the debtor's business as a going-concern would be a very attractive tool of reducing the agency problems of debt. It would allow the debtor to create security over after-acquired assets (whether current or fixed) and potentially valuable intangible assets (such as goodwill, copyrights, etc.) which cannot be made subject of traditional types of fixed security. In order to strike an efficient balance between the interests of the parties to the secured transaction and third persons (who need to be protected against the impression of false wealth and against externalities created by the contractual relation), an ideally drafted legislative instrument on business charges would (a) be clear on the subject of the security interest, the debtor's authority to grant the charge and the perfection requirements, (b) disclose the existence of the charge to the outside world through an appropriate public registration system, (c) give the chargee security interest in all of the chargor's assets in any given moment, (d) give the chargor a business dealing licence to dispose, in the ordinary course of business, of its current assets free of the security interest, (e) give the chargor priority over subsequent security interests, acquirers of the charged assets (other than those who acquired current assets under the business dealing licence) and attaching general creditors, (f) upon default give the chargee the right to terminate the business dealing licence and to enforce the security interest through the sale of all, or any part of, the charged assets or through appointing an officer who would manage the charged business and collect proceeds for the benefit of the chargee, and (g) not prejudice the chargee's rights described above upon insolvency of the chargor. The present article shows on a number of examples that the recently enacted Czech law on pledge of business does not meet almost any of the criteria set out above. It is unclear on the nature and extent of the subject of the security interest, the debtor's authority to grant the charge and the perfection requirements. It is unclear on registration requirements. In addition to that, the one register in which all business charges must be registered (in addition to special asset-related registers, where registration requirements are not clear) is not public. There is reasonably clear basis to conclude that the charge comprises after-acquired assets. But there is a lot of doubt as to the extent of the business dealing licence. There are significant cracks in the priority status of the business charge vis-a-vis attaching general creditors. There are fatal defects in the process by which the charge must be realised outside bankruptcy (basically preventing realisation outside the bankruptcy process). And there are serious deficiencies in the chargee's rights once bankruptcy has been declared. Not only is the chargee subject to what is in effect an unlimited stay on its right to enforce (that right belongs to the trustee, who is not under any strict time limit to exercise it) during which the chargee is not entitled to interest on the secured claim. The charge also stops to cover after-acquired property while it is not clear whether it covers proceeds into which the charged assets are converted upon sale. Many of the defects above are in fact not policy choices but simply results of incompetent legislative drafting. In this respect, the Czech legislator would be well advised to look eastwards for inspiration. The Slovak Republic had recently adopted brand new legislation on secured transaction. The legislation was to a large extent inspired by the 1994 Model Law on Secured Transactions, developed by the EBRD. Subject to clarifying the management of the charged business following default (Art. 25 of the EBRD Model Law) and removing certain misconceived provisions resulting in the risk that upon the sale of the charged assets, the purchaser will also become bound by the chargor's liabilities, the Slovak legislation can function as a model for the Czech Republic as well as any other country in need of a coherent and efficient law on secured transactions.