The Baltic Course

Creditor protection

By Olga Lukashina (professor at Baltic Russian Institute),
Vitautas Plunksnis (analyst at Jusu tarpininkas),
Alexander Vene

Development of business activity is entering a new phase in the Baltic countries. The time when businesses could avoid responsibility for liabilities to their creditors by reorganizing the company or declaring bankruptcy at ease is gradually falling into oblivion, as new legislation in Latvia, Lithuania and Estonia provides for stricter measures on legal aspects regulating business activities

Latvia: loopholes closing up

We would like to believe that the recent Law on Commerce in Latvia, adopted a year and a half ago, will finally come into force as of January 1, 2002. Under pressure from lobbies, the effective date of the Commercial Law has already been postponed by the Latvian Parliament four times. As the existing entrepreneurial legislation allows for completely legal ways to avoid financial commitments to creditors, this fact is not surprising at all. There are four simple methods how to evade responsibility:

1. Selling the company - today the process of changing company ownership is very simple. The former and the new owner of the enterprise conclude a deal, introduce changes into the articles of association of the company or partnership and submit this information to the Company Register. Notification to creditors or their consent to such a transaction is not mandatory. Only after the deal has been concluded, do the creditors find out that a change of ownership has occurred, and suddenly instead of solvent Peter Carlson they now do business with Carl Peterson, who owns next to nothing and is now responsible for all the liabilities of the private company. The new Law on Commerce makes such a deal meaningless, as both seller and buyer will be jointly and severally liable for the financial commitments of the sold company for five years on going.

2. Reduction of liabilities - as we know, there are two types of liability regimes, depending on the company structure - unlimited and limited. Under an unlimited liability regime, it is the owner of the company who bears responsibility for liabilities to creditors (with all the property he or she possesses), whereas in the second case, the company itself is liable (with the property it owns) for all the debts it acquires. Sensing the risk of losing his own accruals and savings, the owner of an unlimited liability company or unlimited partnership can easily change the current form of business structure, let's say, to a limited partnership. The existing legislation does not provide for mandatory notification of creditors in cases of such reorganization, there are also no strict requirements to carry out any company audit in this case. It's no wonder that from the creditors' point of view the outcome of reorganization might seem rather mournful. The new law will bring justice in this sense at least, providing significant changes with respect to the procedures to be followed in order to reorganize a company from one type of entity to another. For instance, a person who was previously personally liable for the debts and obligations of the company will retain the status of unlimited liability for five years after reorganization.

3. Division- this method might turn out useful in cases when a limited partnership possesses rather unreliable debtors and very persistent creditors. The partnership is then divided into two independent legal entities: one inherits all the property values, while the other - the debts. Once again, creditors will only be notified of the change some time later. Following EU directives, the new commercial law provides for three requirements that must be met in order to carry out any kind of reorganization - firstly, the Company Register will appoint an auditor who will carry out an audit of all the companies intending to reorganize and prepare a report emphasizing whether the reorganization process could harm the interests of creditors having lent money to the particular companies. Secondly, creditors must be notified of reorganization in advance, so that they are able to submit any additional claims. Thirdly, any interested person should be entitled to lodge an appeal against the reorganization. Only after these particular and some other mandatory requirements are met, will the company's reorganization be officially acknowledged by the Company Register.

4. Slow and gradual death to a company due to its chronic loss-making operations- current Latvian legislation does not restrict the entrepreneurial activity of such companies. Once having gone bankrupt, possessing the status of a limited liability, they can easily avoid settlement of their financial obligations to creditors. In order to prevent further growth of financial problems, the new commercial law obliges the management and the board of directors of such unprofitable companies to take stricter measures even before indications of insolvency are detected. If these requirements are not met, the management of the particular company will be jointly and severally liable for the losses. Moreover, these people will also bear full responsibility for their negligence for five consecutive years after leaving their post at the respective company.

Lithuania: strict regulations

Amendments to the three most significant laws regulating the entrepreneurial activity - the law On Joint-Stock Companies, On Enterprise Bankruptcy and the Civil Codex - took effect in July 1, 2001.

If we take a closer look at the new legislation of Lithuania, we can find regulations similar to ones adopted in Estonia and Latvia, as well as requirements that are far stricter than in neighboring countries.

The minimum equity capital of public limited companies has been raised from the previous 100,000 litas to 150,000 litas (37,500 US dollars). Requirements for mandatory audits in major private limited companies have also been adopted.

Cancellation of the so-called doctrine of ultra vires is another important achievement. Earlier, the CEO of a company could sign an agreement with a creditor exceeding his authority, which meant that the particular agreement could be declared invalid and the company was not obliged to meet its liabilities to the creditor. According to the current legislation of all three Baltic countries, such limited authority of a company director is not valid if a third party is involved, so in case the head of a company has concluded a deal without being authorized to do so (in compliance to company regulations), the company must still meet its liabilities to the creditor.

Requirements for restricting the operation of unprofitable limited companies already existed before - they are very strict and come into force as soon as the company's equity capital falls below three-quarters of the subscribed share capital. New regulations aimed at satisfying the interests of bankrupt companies have also been adopted under the law On Enterprise Bankruptcy. Previously, the court could declare bankruptcy if a company had a negative equity - if the property value of a company was less than the amount of debts to its creditors - (in Latvia this requirement still remains in force), whereas according to the new regulations, companies can be declared bankrupt as soon as their liabilities to creditors exceed half of the company's property value.

Some words on reorganization. Regulations providing for mandatory audits of companies intending to reorganize, as well as requirements for compulsory creditor notification of the company in reorganization have been adopted. Moreover, in cases of company mergers and divisions, there is a requirement that allows the reorganization project to be worked out only after receiving assessment from an auditing company on the property value of the particular company.

In case of division, legal entity members who held the status of unlimited liability will for three consecutive years be responsible for all the liabilities they had before reorganization. The same also refers to private companies - the owner is liable for obligations of the company to the full extent of his property, even after liquidation of the business entity. These regulations apply also to limited partnerships.

Each company undergoing the process of reorganization is required to fulfill any additional claims presented by creditors whose rights have arisen before publication of the project of reorganization.

If a creditor of the company in reorganization has a sound reason to believe that the respective company will have problems meeting its liabilities, or it has not secured additional claims upon the creditor's request, the company management might be asked either to stop reorganization or repay its debts ahead of schedule and cover all losses - of course, such action should comply with the terms of agreement.

Still, it is too early to claim that the Lithuanian entrepreneurial legislation perfectly matches EU criteria. For instance, a law On Consolidation of Annual Financial Statements is yet to be adopted, as well as some amendments to the existing legislation, but most of the work has already been done.

Estonia: first in line

The Commercial Code of Estonia has been in force already for the seventh consecutive year, and regulations protecting the interests of creditors of companies intending to reorganize, undergo liquidation, or acquire a new owner, have been very clearly defined in the Estonian legislation. The Commercial Code foresees a five-year period of joint and several liability for company members who have the status of unlimited liability, mandatory audits of companies intending to reorganize, as well as creditor notification of companies intending to reduce their equity capital, undergo liquidation or commence reorganization. Nevertheless, during the course of time it became obvious that some important regulations still needed to be adjusted - these amendments made the Commercial Code even more effective. Estonia has set a good example for both Latvia and Lithuania.

According to Leonid Jakerson who represents the Tallinn-based bureau IPSO Jure, Estonia has seen several attempts at trying company directors for their negligence and wrongdoing; however, these attempts have failed to be successful. The scandalous case of Malle Eenmaa, former chairwoman of the now-bankrupt Maapank, who was found guilty of corruptive practices and sentenced to 18 months in prison, might be considered an exception, many deeming the case as a scapegoat for several others.

Still, there are cases of closing very unprofitable companies - such bankruptcy proceedings are basically initiated by creditors of the respective company. Very often creditors force the repayment of debts through threats of bankruptcy - an effective tool resulting in mutual agreement between creditors and debtors, involving no legal procedures.

In general, creditors are now trying to help their debtors so that they can pay back full debt amounts. The case of the Nitrofert chemical plant, which borrowed money from Eesti Gas and Eesti Energia is the most striking example. Nitrofert is now being kept under strict control and creditors apply all the possible measures to make the plant work with a maximum profit.

As opposed to other laws dealing with the regulation of business activities, the Commercial Law, due to its effectiveness with regard to protection of creditors, is now changed very seldom.

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