Defaulting contract partners and outstanding debt from contracts – are we suitably prepared?

How to avert the risk of non-performance by one’s contractual partner, and what is the most effective response if such non-performance does occur?

Few of us lived through the first six months of 2020 without any concerns or stress, and we’d surely all appreciate if we could go “back to normal as quickly as possible. Alas, the European Commission forecasts a 7% drop for the Czech economy this year; for the first time after a long stretch, the unemployment rate has begun to rise; and epidemiologists appear to prepare for the deployment of additional quarantine measures at the beginning of fall.

Everyone would like to believe that the impact of the epidemic and the quarantine measures will be moderate and manageable. Even so, it makes sense to brace ourselves for the risks associated with the economic downturn. One of these risks is the increased frequency of default by contractual partners, and the need to enforce adherence to the contract.

Entrepreneurs and the management of corporations ought to approach the situation head-on and review what kind of preventative steps and improvements might be possible – i.e., what kind of amendment to agreements to make, what kind of new procedures and rules to introduce, and what kind of due diligence to apply.

Prevention – subjecting contract suppliers to a background check

As a matter of customary practice, numerous large corporations have already been following standardized rules for choosing (and screening) contractual suppliers. It ought to be a standard part of the process for choosing a supplier to review the reliability of one’s prospective partner from (official) sources in the public domain. The scope of this check will depend on the concrete type and scope of collaboration. 

  • By checking with the Insolvency Register kept by the Czech Ministry of Justice, we determine whether an insolvency procedure has been initiated against our contractual partner (note: bankruptcy or settlement proceedings which were opened pursuant to previous law, i.e., before 1 January 2018, are to be found in the so-called Public Debtors’ Record (Evidence úpadců).
  • A contractual partner who has been shirking their obligations in the area of VAT payments will be labeled as an unreliable payer/person in the Register of VAT Payers.
  • Debt enforcement proceedings conducted by court bailiffs under the Debt Enforcement Act are entered in the Central Register of Foreclosures. Unfortunately, its records are incomplete, as it does not contain any enforcement proceedings pursued by the courts, government authorities, regional and local government, the finance authorities, and health insurance companies. It may therefore be advisable to supplement the review by demanding certificates from the finance offices, the social security administration, and health insurers to the effect that the partner is not behind with their payment duties. 
  • For general information as to whether the business assets of a contractual partner are encumbered by third-party rights or pledges, one should check their entries in the Commercial Register, in the Land Register, and in the Register of Pledges. 
  • Useful data from the financial statements and annual reports can be gleaned from the Collection of Deeds administered by the Commercial Register (provided that the company has properly lodged these documents).

With the exception of the Central Register of Foreclosures, all these sources of information are free and publicly accessible. Also, all these records and lists are kept by competent public authorities or otherwise based on the law. In addition, there exist various private (paid) services and registers – for instance, the monitoring service run by CRIF – the Czech Credit Bureau. CRIF teamed up with the Czech Chamber of Economics to offer this service for free for two months during the pandemic).

For long-term agreements, and for agreements which touch upon areas or relations that have been particularly hard-hit by the quarantine measures, it is advisable to introduce rules for regular, repeated background checks of this kind.

Prevention – contractual arrangements

Contracts form the ideal substrate for a number of tools that can be deployed to strengthen the position of one party for the event that the other party defaults or goes bust. Among them are sanctions, such as default interest, contractual penalties, forfeiture of the right to pay in installments, or break clauses which kick in in the event of repeated or long-lasting events of default, or in the event of imminent risk of insolvency.

Aside from the outright termination of an agreement, it may be desirable to agree on a separate right to suspend performances under the agreement as long as the other party is in default. The contractual relationship is thus preserved, and once the issues have been resolved, performances may be resumed without the need for a new contract.

These clauses are commonly found in agreements, but they are often based on one-size-fits-all templates. We recommend going through the possible scenarios and choosing the right combination of sanctions which best reflects the concrete contractual relationship and the course of its implementation. For instance, agreements will standardly contain a clause to the effect that the parties are always entitled (or, conversely, never entitled) to damages in addition to the contractual penalty. Instead, it may be preferable to stagger sanctions: on the first breach, or in the event of a short/minor breach, the defaulting party merely pays a contractual penalty, but upon repeat offenses, they must also pay compensation for the damage incurred.

Risk prevention in connection with the non-performance in contractual relationships may also include clauses which trigger a right to set off claims which are not yet due, or prohibit third-party performances on behalf of the debtor, or stipulate that a specific court has territorial jurisdiction over disputes arising from the contract (whereas choosing a court in a larger town may ensure a higher level of professionalism for specific types of disputes; choosing the court of venue at the seat of the creditor may eliminate travel expenses; and concentrating disputes at a single court may enhance the economy of proceedings).

In the next issue of our bnt JOURNAL, we will turn to the recommended approach to non-performance by the contractual partner, and to the collection of claims…

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