A Tale of two invalidations: Contract and Bankruptcy

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Yehualashet Tamiru Tegegn

It’s true that contract is an indispensable instrument for effective exchange of goods and services between and among persons. However, not all contracts are genuine and valid in the eyes of the law. Thus, for various policy justifications the law indicated an instrument to invalidate such type of transactions. Under the general law of contract, the meaning, grounds, and effect of invalidation are indicated in the Civil Code. Whereas the commercial code indicates the meaning, grounds, and effects of invalidation of suspect transactions in the context of bankruptcy. In this piece, which inspired by a famous commissioner’s understanding in one of the infamous cases, I will briefly examine the basic difference between the two invalidations.
There are lots of differences between invalidation of contracts and invalidation of suspect transactions under bankruptcy regime. The following are the basic differences.
The first and foremost difference is on the ground of invalidation. Contract is defined under Article 1675 of the Civil Code as “an agreement between two or more parties to create, vary or extinguish an existing obligation of proprietary nature.” As per this provision all contracts are agreements, but not all agreements are contracts. Moreover, not all agreements are enforceable and valid in the eyes of the law and thereby raising the issue of defect or vices which might render the contract susceptible to invalidation or no effect at times. Defects in the consent and capacity in the contract makes the contract voidable (subject to invalidation) while defect in the object and form of contract makes the contract void from the very beginning. However, as Planiol pointed out the theory of nullities is one of the most obscure in the field of the civil law. Thus, any of the above-mentioned requirements lead to the invalidity of the contract.
However, invalidation of a certain transaction under the law of bankruptcy does not require the absence of any of the four requirements: consent, capacity, legality, and formality. Rather, the most important matter is whether the transaction has taken place within the suspected period. Even if the contract has fulfilled the requirements indicated under Article 1678 of the Civil Code, the underline transaction can still be invalidated under bankruptcy law. Thus, the presumption is that the trustee is basically reviewing and invalidating an otherwise valid transaction, but that it is examined to ascertain whether it should be upheld in the light of interests of other creditors.
The second difference is the type of transactions that are subject to invalidation. In general contract law, whatever the contract may be, it is subject to invalidation if it failed to meet the requirements put in place under Article 1678 of the Civil Code. The distinction is not made between type and nature of transactions.
However, under bankruptcy law only selected types of transactions are subject to invalidation. With the view to secure equitable, if not equal, treatment of creditors, the law also set-in place invalidation of suspect transactions otherwise known as avoidance law. Accordingly:
Gratuitous assignment;
Payments of debts not due, whether in set-off or otherwise in cash or by assignment, sale, set-off or otherwise;
Payments of debts due otherwise than in cash, by negotiable instrument or by transfer of a bank; and
Security set up on the property of the debtor in respect of debts contracted before the setting up of such securities;
that are made between fifteen days before the date of suspension of payments and the date of adjudication shall be invalid and shall not affect the creditors of the bankrupt.
Payments made by the debtor in respect of debts due and all acts for consideration entered into by the debtor after the date of suspension of payments may also be invalidated on the request of the trustee where the parties who have received payment or have dealt with the debtor did so knowing that suspension of payments had taken place.
Furthermore, any security registration effected after suspension of payment or within one month before suspension may be invalidated where more than one month has elapsed between the act creating the security and the date of registration.
The third difference is time of invalidation. Invalidation under general law of contract is concerned only at the commencement or formation stage. Needless to say, contracts have three stages: formation, performance and extinction. Thus, under the general law of contracts invalidation only takes place at the formation stage. If there is no defect during the formation stage, the concept of invalidation is inexistent.
In a clear contrast to this, invalidation under bankruptcy law, most of the time, is dealt with during the performance stage. For example, as per Article 1029(b) of the Commercial Code payment of debt not due in a means other than cash will be invalidated. This presupposes the existence of valid contract. It is clear that at this stage, the bankrupt debtor tries to perform his contractual obligations which come after the formation stage; the same holds true for other transactions which are listed under Article 1029 et seq of the Commercial Code.
The fourth difference is the effect of invalidation. As stipulated under Article 1815 of the Civil Code, if the contract is invalidated “the parties shall as soon as possible be reinstated to the position which would have existed, had the contract not been made”. In other words, it will have a retroactive effect and hence the party who takes money or property will be required to return it. The parties will be returned to their original position or zero position.
However, the main effect of invalidation in bankruptcy is the recovery of assets and relegation of secured creditors into unsecured creditors. The creditor who gets some form of benefit(s) from the bankrupt debtor will be required to return it and will receive his claims in pro rata with other creditors, if there is any asset left after preferred creditors and claimants are paid. Whereas, in the case of invalidation of security, the secured creditor becomes unsecured creditor hence he receives in pro rata in equality with other creditors. After invalidation of security, he is no more secured, and his priority right is taken away.
It is important to note that the effect of invalidation to recover the property transfers depends on, whether the transfer or obligation being avoided is (1) an outright transfer of property, or (2) a lien. If an outright transfer is avoided, the trustee will then attempt to recover either the specific property transfer or its value. If a lien is avoided, however, then in most case the lien simply is nullified, the formerly secured creditor is relegated to unsecured creditor. Secured status and the property are freed from the encumbrance. Thus, the second policy justification behind invalidation of suspect transactions is maximization of debtor asset which in turn is the common security of the whole creditors.
The last yet important difference is the purpose behind invalidation. The very purpose of invalidation under the general contract law is to protect the interest of the person whose consent and capacity is vitiated. In reinforcing this objective, the mastermind behind the Civil Code stated that “where the contracts invalidity results from a vice in consent, its purpose is to protect one, and only one of the contracting parties, i.e., the victim of error, fraud or duress or the person whose want simplicity of mind, senility, or manifested business in experience has been explored. In such case, only the person that the law intends to protect can invalidate the contract.” Thus, in this case it is only one of the parties, the victim, who can claim the invalidation. Under the general law of contract, the law aims to protect one party and that is the only purpose of invalidation.
However, invalidation of suspect transactions in bankruptcy has different purpose. One of the most important purposes of invalidation in bankruptcy is to create equality between creditors. Unlike civil proceedings, in the absence of any other means to effect payment of due debt the debtor property may be attached in satisfaction of debts and the creditors who make the first attachment are entitled to have priority to the full amount of his claim and the slower creditors always suffer the risk while assets are distributed to the other party who is more active, in bankruptcy proceedings the governing principle is equality of creditors and hence replace race of the most diligent with pro rata distribution of assets.
The other function is maximization of asset. One of the immediate effects of invalidation of suspect transaction is recovery of assets on which the creditors has already taken. This increases the asset of the bankrupt debtor.
Deterrence is another purpose. There is a temptation that in the absence of invalidation of suspect transactions, those creditors who are aware of the debtor’s insolvency, and thus the looming equal sharing regime, will seek to ‘opt-out’ of the collective proceeding and relative for the debtor’s assets to ensure payment in full.
All in all, invalidation is an important legal instrument employed under the Civil Code and Commercial Code for various and different policy justifications. The main purpose of invalidation in contract is to protect the victim whose consent or capacity has been vitiated. In case of bankruptcy proceeding, on the other hand, the purpose is to protect and enhance equitable treatment of creditors.