What should creditors to Israeli borrowers should know about Israeli Insolvency Law

9 January, 2022

We will review in this article the most important features of the Israeli Insolvency Law with focus on the following issues:

the framework and types of the insolvency proceedings under Israeli law; issues related to foreign creditors, and debts governed by foreign law; the requirements for the perfection of security interest; the order of priority among creditors; restrictions on the realization of pledges after the commencement of insolvency proceedings and the risk of nullification of certain transactions entered into certain ‘suspect periods’ prior to the commencement of insolvency proceedings.  

Two Types of Insolvency Proceedings Under the Israeli Insolvency Law

The Israeli Insolvency and Economic Rehabilitation Law, 2018 (the “Insolvency Law”) includes two insolvency proceedings for corporations – Rehabilitation Proceedings and Liquidation.

As one of the main objectives of the Insolvency Law focuses on the rehabilitation of corporations, it is expected that the courts will tend to prefer ordering Rehabilitation Proceedings over Liquidation Proceedings, where applicable and appropriate at the court’s discretion.

(a) Rehabilitation Proceedings – A corporation as well as any of its creditors may apply to the court and request the court to order to commence Rehabilitation Proceedings.

The court may order the commencement of Rehabilitation Proceedings in the following conditions are met: (i) there is a reasonable prospect of the economic rehabilitation of the corporation; (ii) there is no reasonable concern that the Rehabilitation Proceedings will prejudice the creditors’ interests; and (iii) there are adequate sources to finance the expenses of the Rehabilitation Proceedings.

Under such proceedings the court issues a ‘moratorium order’, which restricts creditors from filing claims against the corporation and from undertaking execution/recovery actions against its assets without the court’s approval and subject to conditions stipulated by the court. Concurrently with the issuance of this order the court shall appoint a trustee, who endeavours, for a limited period of time, to operate the company’s business and reach arrangements with the creditors, under the supervision of the court. 

The trustee may offer a scheme for the rehabilitation for the corporation, which is subject to the approval of both the creditors and the court. The general purpose of the scheme is to continue the operations of the corporation in order to achieve economic rehabilitation.

The proceedings of corporate rehabilitation and the issuance of a moratorium order remain in effect for a limited duration of up to nine months.

The court may extend that period for additional periods of three months each, if it finds the extension is required for the preparation of the economic rehabilitation scheme for the company or for the sale of the business activity of the company. 

At the end of the Rehabilitation Proceedings, the corporation either returns to the solvency track or enters liquidation proceedings.

(b) Liquidation proceedings – If one or more of the conditions for Rehabilitation Proceedings are not met, the court will order the commencement of Liquidation Proceedings.

Upon the issuance of Liquidation Proceedings order, the court will appoint a trustee to the corporation. The authorities and duties of the trustee include the repayment of debts and the institution of a debt settlement, under court approval. 

Stay of Proceedings

The Insolvency Law regulates a stay period once an Insolvency Proceeding order is issued, and provides that upon the issuance of the Insolvency Proceeding order:

(a) the assets of the corporation will serve solely for the repayment of the corporation’s past debts and the expenses of the insolvency proceedings;

(b) the repayment of corporation’s past debts will be conducted only in accordance with the provisions of the Insolvency Law;

(c) all proceedings against the corporation shall be suspended;

(d) the court shall appoint a trustee for the implementation of the Insolvency Proceedings.   

The Insolvency Law generally defines the term Stay of Proceedings, as follow:

(a) it is forbidden to commence collection proceedings for past debts against the corporation or to continue such proceedings; 

(b) the realization of assets subject to fixed pledge or floating charge becomes subject to the certain limitations and provisions (which will be described in Part II of this series of articles).

Status of Non-Israeli Creditors, Choice of Foreign Law Clauses 

The Insolvency Law states that the status of foreign creditors and their rights regarding the initiating and participation in Insolvency Proceedings are identical to the status and rights of Israeli creditors.

Often the agreement between the non-Israeli creditor and the Israeli insolvent corporation includes a choice of law and jurisdiction provision that elects a non-Israeli law as the governing law of the agreement.

In general, Israeli law recognizes the freedom of contracting parties to have their contractual relationships governed by foreign law, and, therefore, Israeli courts generally respect the contracting parties’ choice of law and apply the relevant foreign law to the legal issues in question.

However, insolvency of the Israeli counterparty, where rights of third parties are involved, may be an exception to this rule. 

The Israeli Supreme Court discussed the question of the enforceability of choice of law provisions in an agreement between an Israeli and a non-Israeli counterparty upon insolvency of the Israeli counterparty. The Supreme Court distinguished between procedural matters of law – which are to be governed by the law of the forum, i.e. Israeli law – and substantive matters of law.

The court stated that the question of which law governs substantive matters of law is a hard one, and made an additional sub-distinction – between substantive matters relating to general laws, such as contract law or property law, and substantive matters relating to the insolvency aspects of the dispute, like issues of priority and perfection.

The court stated that in the post insolvency context, substantive matters of the first type, such as questions regarding the validity of a contract and its interpretation, will be governed by law contractually elected by the parties, even if the dispute is being adjudicated through an insolvency process.

However, the court did not go so far as to determine which choice of law would apply to the second type of substantive matters of law.

The bottom line is that, unfortunately, there is still no bright line test for when in an insolvency context, a substantive matter of law will be determined by the governing law of the contract or the local Israeli law.

Security Interests Under Israeli Law

Perfection and realization of Pledges prior to Insolvency Scenarios

A security interest, often referred to as a pledge, is created by an agreement between the pledgor of the asset and the secured creditor.

“Perfection” refers to the act of making the security interest effective vis-à-vis third parties, other than the pledgor and the secured creditor.

Failure to perfect, or any defect in the perfection process, does not affect the bilateral relationship between the pledgor and the secured creditor. The Israeli Pledge Law provides that a security interest that is not duly perfected is not effective against other creditors of the pledgor, except for those creditors that knew or should have known of the creation of the security interest.

In particular, a security interest that was not duly perfected is ineffective and will not be upheld by the liquidator or any other insolvency officer of the pledgor.

The primary method of perfection with respect to security interests created by companies is registration of the pledge with the Israeli Companies Registrar.

This is a simple and inexpensive procedure. The agreement creating the security interest must be filed together with a designated form within 21 days of the creation of the security interest, and if filed within such period, the security interest is retroactively valid against third parties as of the date of its creation.

If the pledgor is an individual or a partnership, the pledge is to be registered with the Registrar of Pledges. For filings with the Registrar of Pledges there is no maximum period for the filing, and the security interest is valid against third parties as of the date of registration.

The Order of Priority Among Creditors of an Insolvent Israeli Counterparty

Under the Israeli Insolvency Law, the order of priority among creditors of an insolvent debtor is as follows:

(a) Secured creditors: namely: (a) the holders of duly perfected fixed charges (pledges); and (b) the holders of a possessory lien over an asset. The holders of a possessory lien over an asset have priority over creditors having a security interest in the same asset.

As among different holders of security interests over the same asset – the security interest created first in time prevails, unless otherwise agreed among the creditors, and assuming always that the security interest was properly perfected.

Secured creditors that have not duly perfected their security interest are considered unsecured creditors for the purposes of the creditors’ order of priority.

(b) Insolvency proceedings expenses: including expenses incurred by the trustee or that relate to his or her activities.

(c) Preferred creditors: certain types of unsecured creditors have statutory priority: (i) employees, with respect to their wages up to a certain amount; (ii) certain tax authorities with respect to certain taxes triggered prior to the insolvency proceedings.

(d) Holders of a floating charge: A floating charge is generally inferior to fixed charges. However, the debenture creating the floating charge may include a negative pledge covenant, i.e., a restriction on the creation of subsequent fixed charges.

If such restriction is noted in the form filed with the Registrar of Companies, a later fixed charge will be inferior to the floating charge.

In accordance with the Insolvency Law, a holder of a floating charge may only take towards the repayment of the secured debt up to 75% of the proceeds of realization of the assets subject to the floating charge, and the remaining 25% of the proceeds will become part of the pool of assets available for the unsecured creditors.

If such 75% of the proceeds are not sufficient to repay in full the secured debt, the balance of the debt shall be deemed unsecured debt. 

(e) Unsecured creditors: among themselves pro-rata to the amount of their respective debts.

(f) Post Insolvency Interest: Interest accumulated from the date of the commencement of the insolvency proceedings, including interest on arrears.

(g) Subordinate creditors: Creditors who specifically agreed to be subordinate to other creditors, and, under certain circumstances, shareholders of the insolvent company with respect to loans they extended to the company and punitive fines imposed on the debtor.

Realization of Security Interests in Insolvency Scenarios 

Limitations on Realization of Pledges after the commencement of Insolvency Proceedings

The Insolvency Law sets forth the general principle that a secured creditor is entitled to repayment of its debt from the pledged asset.

The secured amounts may include interest but will not include interest on arrears accumulated following the commencement of the insolvency proceedings.

However, if the debtor is under Rehabilitation Proceedings, a secured creditor is not entitled to realize the pledged assets, without the permission of the court.

The court should approve the realization of the pledged asset if: (i) the pledged asset does not guarantee an Adequate Protection for the secured creditor, and no other means have been determined to provide an Adequate Protection for the secured creditor; or if (ii) the pledged asset is not required for the economic rehabilitation of the corporation or for the corporation to be able to actively conduct its business.

An “Adequate Protection” to a secured creditor is defined as preserving the ability of the secured creditor to be repaid the proceeds that would be expected to be recovered by the secured creditor, had the court allowed the creditor to realize the secured interest independently and not within the framework of the Rehabilitation Proceedings, taking into account the likelihood of such recovery.

In terms of procedure, in order to realize a security interest, the secured creditor is required to inform the trustee of its intension to do so and to submit to the trustee a debt claim and a valuation of the pledged assets.

The trustee may, within 14 days of receiving a debt claim, redeem the pledge, namely, repay the debt to the secured creditor and release the pledge. If the valuation of the pledged assets significantly exceeds the secured debt, the realization of the pledge shall be executed by the trustee; and if the valuation of the pledged assets is not significantly higher than the secured debt, the realization of the pledge shall be executed by the secured creditor.

Under the Insolvency Law, the trustee in Rehabilitation Proceedings may decide to utilize for the activities of the corporation any of its assets, including assets subject to security interest.

However, the trustee shall not be entitled to utilize the assets if the court has determined that: (i) the assets are not required for the Rehabilitation Proceedings, or (ii) the utilization of the assets will not afford an Adequate Protection to the secured creditor.

The trustee in Rehabilitation Proceedings may also sell an asset which is subject to a fixed pledge, subject to the court’s approval.

The court may approve the sale if: (i) it is required for the economic recovery of the corporation, and (ii) the expected proceeds from the sale ensures “Adequate Protection” for the secured creditor.

As opposed to the powers of the trustee in Rehabilitation Proceedings, if Liquidation order was issued, the trustee shall act as soon as possible to realize the assets of the debtor and distribute the proceeds to the creditors, in accordance with the order of priority among creditors, as describe at part II to this series of articles. However, the court may order that the trustee shall operate the debtor’s business to the extent necessary for its liquidation or for the purpose of increasing the proceeds that can be distribute to the creditors, and in such case the trustee shall have similar powers to the powers in Rehabilitation Proceedings, however such powers shall be used only if they are required for the Liquidation of the corporation. 

Cancelation of Transactions Entered into during Suspected Periods

The Insolvency Law sets forth three pre-insolvency ‘suspect periods’, where transactions or actions implemented in such periods can be nullified by the court under different conditions.

(a) Three Months Period 

The court may order the nullification of a transaction or action performed during the three months period preceding the filing of the insolvency application, that led to the repayment of a debt to a creditor or to the advancement of a creditor in the priority order, including a collection action, a transfer of title in an asset or the creation of a security interest, if: 

(i) At the time of the performance of the transaction or action, the corporation was insolvent; For this purpose, there is a presumption that the debtor was indeed insolvent in the relevant suspect period, and the burden of proof to refute the insolvency presumption is on the counterparty to the said transaction or action; and (ii) As a result of the transaction, the creditor received a larger portion of its debt than the portion that it was entitled to according to the priority order.

A transaction or action shall, however, not be nullified where the insolvent corporation received an adequate consideration from the creditor for the transaction (the repayment of the creditor’s debt, per se, is not be considered adequate consideration.), or if relevant action and the repayment of the debt were in the ordinary course of business of the debtor. 

(b) Two Years Period

The court may order the nullification of a transaction or action performed during the two years period preceding the filing of the insolvency application, that reduced the pool of assets available to the creditors if: 

(i) The transaction or action was performed without consideration or with inadequate consideration under the circumstances; (ii) At the time of execution of the transaction or action, the debtor was insolvent or the performance of the transaction led to the insolvency.

(c) Seven Years Period

If the action that reduced the pool of assets available for the creditors was done for the purpose of extracting the asset from the pool, it can be nullified even if it was conducted during the seven years period preceding the filing of the insolvency application and even if the debtor was not insolvent on such time.

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